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Set out what makes up a business model

CFA® Level I · Corporate Finance · Business Models · CI.6.a

The idea

A business model states who the customer is, what is sold to them, how it reaches them and how the company is paid. The elements that matter analytically are the target market, the value proposition, the channel, the pricing approach and the cost structure that supports them. Two companies in the same industry with different models can have entirely different economics: one selling through distributors at low margin and high volume, another selling direct at high margin and low volume. Reading the model first tells an analyst which financial ratios will be informative and which will mislead.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which element is part of a company's business model?

  1. How the product reaches the customer - correct
  2. The prevailing risk-free interest rateWhy not: A market-wide input that applies to every company alike and describes none of them.
  3. The auditor's opinion on the accountsWhy not: A statement about the reliability of the accounts, not about how the business earns its money.

A business model is the description of how a company makes money. It covers who the customers are, what is offered, how it reaches them (the channel) and how it is priced. So how the product reaches the customer is part of it. Things outside the firm do not describe it. The risk-free interest rate, the return on very safe government debt, is the same for every company. The auditor's opinion is a check on the accounts, not a description of how the firm earns.

A harder one

Why does understanding the business model change how financial ratios are read?

  1. Because ratios are calculated differently under different modelsWhy not: The arithmetic is the same everywhere; what differs is what a given value means.
  2. Because the model determines which ratios are informative and what normal looks like - correct
  3. Because accounting standards vary by business modelWhy not: Standards vary by jurisdiction and transaction type rather than by business model.

A financial ratio is a figure that compares two numbers from the accounts, for example profit divided by sales. The arithmetic is the same for every firm, but what counts as a healthy result depends on how the firm earns money. For example, a distributor selling huge volumes at thin margins and a direct seller with high margins can both be healthy while showing very different margin and turnover figures. Idea: the business model sets the benchmark, so the same ratio can mean good news for one firm and bad news for another.

The hardest tier

A high-margin direct seller and a low-margin distributor-led seller report the same return on capital. What does that suggest?

  1. That one of them has misreportedWhy not: Two honest sets of accounts can arrive at the same return through entirely different routes.
  2. That both reach the same economics by different routes - correct
  3. That the industry has no competitive differencesWhy not: The competitive differences are real and visible, in the margin and turnover that combine to the same result.

Return on capital can be split into two parts. Formula: return on capital = margin x capital turnover, where capital turnover = sales / capital. A high-margin direct seller usually turns its capital slowly, while a low-margin distributor turns it quickly. For example, 20% x 0.5 = 10% and 5% x 2.0 = 10%. The same return can therefore come from different routes. Splitting it into margin and turnover shows the two firms are comparable on results but not on margin alone.

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