3.5 assessing competitiveness Flashcards
interpretation of financial statements
what is the statement of financial position/balance sheet?
a snapshot of the assets and liabilities of a business at a point in time
non-current assets:
(fixed assets)
these are assets used to operate the business
intangible non-current assets:
not physical assets
→ brands and patents (intangible)
tangible non-current assets:
physical assets such as property and equipment (used in the production
process)
current assets:
assets that the business expects to use or sell within the year (inventories, receivables) these can be converted into cash to pay off liabilities
inventories:
the stock the business is holding
receivables:
debts from trade that a business anticipates will be paid within 12 months
current liabilities:
payments due within one year
borrowings/debts
include short term debts (overdrafts, short term loans)
how to calculate net current assets:
total assets - total liabilities = net current assets (the value of a business)
non-current liabilities
debts that a business does
not expect to pay within a year
(long term loans, provisions)
what are provisions?
money put aside in anticipation of bad debt
total equity:
represents how a business has been funded/capital employed (will always balance with net assets)
what do statements of financial position contain?
the financial information required to draw conclusions about the liquidity of the business
what is liquidity?
the ability of a business to meet its short term liabilities with its available assets
what will happen to a business that cannot pay its debts?
it will usually fail very quickly, even if they are profitable
what does a statement of financial position show?
the financial structure of a business at a specific point in time
→ it identifies a businesses assets and liabilities
→ it specifies the capital (money) used to fund the business
what we can find out from a statement of financial position:
-the value of a business (equity)
-the current assets a business owns
-short term liabilities that need to be paid in a year
-the liquidity of a business
-how a business has been financed
-the long-term debts of a business
why are stakeholders interested in the statement of financial position?
to perform ratio analysis and compare performance over time or with other businesses
which stakeholders use the balance sheet?
-shareholders
-managers
-suppliers
-employees
how do shareholders use the balance sheet?
-to identify the asset structure of the business and how their investment has been used
-used to calculate the working capital of the business and determine its solvency
-used to determine the rough value of a business, which helps a judgement on whether their investment is growing
how do managers use the balance sheet?
-to assess the working capital position of the business and determine if there are enough liquid current assets to pay its bills
-information on the capital structure of the business, which helps guide decisions on whether to raise further funds
how do suppliers use the balance sheet?
-to see whether the business will be able to pay its debts
-to support any decisions around credit agreements
-businesses with low levels of working capital may find it difficult to pay short-term debts and so suppliers may offer trade credit, but with stricter terms
solvency
the ability of a business to pay its debts
how do employees use the balance sheet?
-is the business financially stable or are jobs at risk?
-has the businesses performance improved or worsened?
-how much are senior executives paid?
what is the statement of comprehensive income/profit and loss account?
it shows the income and expenditure of a business over a period of time
what is revenue?
sales quantity x selling price
what is the cost of sales?
the direct costs associated with the production and sale of the product or service
what is gross profit?
-the profit after direct costs have been deducted (gives a broad indication of the success of a business’s trading activity)
what are operating expenses?
general indirect overheads such as office salaries, expenses claims, rent and administrative costs
what is operating profit?
gross profit - operating costs (overheads)
what is exceptional income?
-expenses or incomes not associated with the direct activity of the business
-they may be one-off items
what is net profit?
gross profit - tax & interest
what can be found out from a statement of comprehensive income?
-changes in sales revenue
-changes in the direct costs of sales
-how well a business is managing its operating costs
-the profitability of a business
-unusual incomes/expenses during the year
-profitability ratios
which stakeholders are interested in the statement of comprehensive income?
-shareholders
-managers
-government
-employees
-suppliers
-local community
why are shareholders interested in the statement of comprehensive income?
interested in…
-profits earned
-business growth
-dividend payments (mainly based on net profit)
why are managers interested in the statement of comprehensive income?
use revenue, gross profit and operating profit to measure performance and set targets
why are governments interested in the statement of comprehensive income?
used to determine how much tax is payable to the HMRC
why are employees interested in the statement of comprehensive income?
-interested in profits earned and potential for wage increases and job stability
-the profitability of the business may indicate the potential for remuneration and rewards
why are suppliers interested in the statement of comprehensive income?
-interested in the continued success of the company they are supplying
-used by suppliers to determine the level of trade credit offered to businesses
why are local communities interested in the statement of comprehensive income?
-interested in the stability of the business and what this may mean for jobs in the community
-to see if the firm is generating enough profit to perhaps approach them for local sponsorship
Examiner Tips and Tricks
Information found in the profit and loss account and balance sheet can be used in a range of answers.
For example, if you are answering a question about sources of finance, you might be able to use the capital structure of the business to recommend whether a business should borrow or look at an alternative source.
If a business already relies heavily on borrowing, it may be more sensible to recommend seeking to raise more share capital.
what is ratio analysis?
extracting information from financial accounts to assess financial performance and the financial structure of a business
what does ratio analysis support?
evidence-based decision making → it provides measurable data that can be used to support judgements and compare performance against objectives
what are the two types of ratios:
-gearing ratios
-ROCE (return on capital employed)
what does gearing ratio show?
it is used to examine the capital structure of a business / how a business has raised its long-term finance (the long-term financial structure of business)
what does gearing ratio show the proportion of?
the proportion of a firm’s equity that is financed from long term borrowed
how is gearing ratio expressed?
as a percentage
how is gearing ratio calculated?
(non current liabilities / capital employed) x100
how can capital employed be calculated?
total assets - current liabilities
total equity + non-current liabilities
simple explanation of gearing ratio:
it shows how reliant a business is upon borrowed money
what is a highly geared business?
a business that has more than 50 per cent of its capital in the form of loans (the gearing ratio calculation will be greater than 50 per cent)
what is a highly geared business vulnerable to?
more sensitive to increases in interest rates
↳ business costs increase
effects of increased interest on a business that is highly geared:
-profit available to pay as dividends to shareholders is reduced
-retained profit is limited
-the business is likely to be considered a risk for further investment
-likely to face difficulties in raising further loan capital
when might a high gearing ratio make more sense?
-if there are low interest rates
-if profits are consistent & high
-if the owner wants to keep control of the business and avoid using shares
why is a high gearing ratio always a concern?
1) it suggests that a business is very leveraged
2) vulnerable to increases in interest rates, poor economic conditions could negatively effect liquidity
3) reduced financial flexibility, can’t seize opportunities that arise (opportunity cost of debt) → less ability for R&D
4) investors see it as a sign of instability & could sell shares → lower share price
why may a high gearing ratio not be a concern?
1) the root cause of the high gearing ratio is more important
→ due to declining sales?
→ due to recent expansion?
2) the interest rate may be low
3) there may be a long term history of stable profits
4) the nature of the industry
→ high gearing ratios are common in the property & airline industry due to initial fixed costs
→ high gearing ratios are often low in the tech industry as equity financing is preferred
how to reduce gearing ratio
-decrease non current liabilities (pay of debts) → could reduce cash
-increase share capital → could lose control
when is a business low-geared?
when the percentage is 20 - 50%
advantages of a low gearing ratio:
-the business has the opportunity to borrow funds in order to expand
-lenders such as banks are more likely to approve loan applications from low-geared businesses
drawbacks of a low gearing ratio:
-the business may be missing out on the opportunity to access finance without the need to dilute existing shareholders’ control, especially when interest rates are very low
-an unwillingness to access loan capital may indicate a risk-averse business which may deter investors
when might a low gearing ratio make sense?
-in a high interest rate environment
-if the business has low/inconsistent profits
-if the business is satisfied with using share capital
steps to increase the gearing ratio:
-buying back ordinary shares to reduce share capital in relation to borrowing
-obtain more loans
what is ROCE?
compares operating profit earned with the amount of capital employed by the business / measures how well a business generates profit from the funds invested in the business
how should ROCE be compared?
the rate differs between industries so comparison across sectors is not recommended
how to calculate ROCE?
(operating profit / capital employed) x100
how can ROCE be used?
to support strategic decisions & determine the most profitable option given the level of capital employed
what is a good result of ROCE?
the higher the rate, the better, as it indicates that the business is profitable and using its capital efficiently
which businesses do investors prefer according to ROCE?
-investors prefer businesses with stable and rising levels of ROCE, as this indicates low-risk growth is being achieved
what is the minimum good level of ROCE?
a ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position
how can ROCE be increased?
-increase the level of profit generated without introducing new capital into the business
-maintain the level of profit generated whilst reducing the amount of capital in the business
Examiner Tips and Tricks
When calculating financial ratios, check that you are using the correct units.
In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases you will be working in thousands (£000) or millions (£m).
Ensure that you convert correctly, e.g. £0.39m is equal to £390,000 and £34.9 (000) is equal to £34,900
Make sure the decimal place is in the correct place
Calculate to two decimal places unless stated otherwise
strengths of ratio analysis:
-allows a business to calculate and compare trends over time
-shows greater insight than financial accounts on their own
-information can be used against benchmark data (such as an industry average)
-can be used to assess the performance of functional areas of the business
what are the limitations of ratio analysis?
-does not take into account the impact of long-term decisions, such as investments today that may lower profitability in the short term but boost it in the long term
-ratios do not take into account economic conditions or the performance of other businesses
-making comparisons
-balance sheet limitations
-qualitative information
limitations of ratio analysis: making conparisons
-over time, the nature of a business can change, affecting the desired level of ratio
-comparisons between firms are only meaningful where significant similarities exist (same industry, similar size, comparable products)
limitations of ratio analysis:
balance sheet limitations
as a ‘snapshot’ of a businesses assets, liabilities and capital at a specific point of time, the balance sheet may not be representative of its usual circumstances
limitations of ratio analysis:
qualitative information
-ratios only use numerical data from a businesses accounts
-key qualitative factors that affect its performance are ignored (eg: competitor actions, economic variables)
which groups of people use ratio analysis?
-venture capitalists
-banks and insurance providers
how do venture capitalists use ratio analysis?
they use ratios to support their analysis when they consider investing in or lending to businesses
how do banks and insurance providers use ratio analysis?
to determine the level of risk a business presents and determine the products to which it may be suited
Examiner Tips and Tricks
Calculating ratios is straightforward - the real skill is in the interpretation of results and making recommendations.
If a business is highly-geared, further borrowing is likely to be neither attractive nor possible in most cases. That’s quite a simple analytical point.
However, it may be possible to further develop this analysis
For example, in a time of very low interest rates, maximising borrowing to take advantage of cheap finance may be preferable to diluting the control of existing shareholders by issuing further share capital. Now you have evaluation because you’ve considered both sides of the argument.
If you find evidence in the case study that indicates that shareholders would be unhappy with this dilution of control then you have a balanced, applied piece of evaluation.
HR & managing costs:
-human resources need to be managed as staff costs can make up a large proportion of a businesses costs
-monitoring of employee performance is a key element of effective financial and operational control
which human resources metrics do businesses commonly monitor?
-labour productivity
-labour turnover
-labour retention
-absenteeism
what is labour productivity?
a measure of output per employee over a given period of time
formula for labour productivity:
total output of employee in a time period /number of employees at work
which business aspects does labour productivity effect?
profit margins and decisions around pricing
interpretation of labour productivity
generally speaking the higher the labour productivity the better the business is performing
drawbacks of labour productivity:
-it does not take into account technology used in the production process
-it may be affected by many other factors - such as internal disruptions to production, or the nature of the task or product being produced, which will also influence this calculation
what is labour turnover?
a measure of the proportion of employees leaving a business during a specific time period
how is labour turnover expressed?
as a percentage
formula for labour turnover:
(number of staff leaving in a year /
average number of staff) x100
what can increasing labour turnover rates suggest?
-poor management → workers losing commitment
-a poor recruitment and selection approach → staff leaving soon after starting their job
-low wage levels compared to those that could be earned elsewhere
which other factors can increase labour turnover in a business?
external factors:
(eg:)
-a buoyant local economy where workers are attracted to employment opportunities elsewhere
-improved transport links that provide an opportunity for workers to seek work across a wider geographical area
what is labour retention?
a measure of the proportion of employees remaining with a business during a specific time period
how is labour retention expressed?
as a percentage
formula for labour retention:
(number of staff remaining in one year/average number of staff) x100
what does a high level of labour retention mean?
few staff are leaving the business during a given period
problems of high labour turnover & low labour retention:
-increased recruitment and selection costs
-increased induction and training costs
-lower productivity levels as workers settle into new roles
opportunities of high labour turnover & low labour retention:
-workers with existing skills can be recruited to reduce the need for training
-new ideas and creativity introduced to the business
-new perspective and approaches to problem-solving can improve business performance
is high labour turnover always a problem?
-some industries will expect high rates of labour turnover (for example holiday companies, due to contracts being seasonal)
-high rates of labour turnover may be encouraged as a business goes through a period of change
what is absenteeism?
a measure of the proportion of staff were absent from work during a specific period of time
how is absenteeism expressed?
in a percentage
formula for absenteeism rate?
(number of staff absent for time period / total employees) x100
interpreting absenteeism:
high levels of absenteeism may also be an indicator of demotivation or tensions in the workforce
consequences of high levels of absenteeism:
-absence due to illness requires sick pay to be paid
-hiring temporary staff to cover for those absent increases costs
-output is likely to be temporarily reduced if staff are key to production process
-other staff may become demotivated if they have to constantly cover for absent workers
-a wider culture of absenteeism may develop
what are key objectives of human resource?
-raising the labour productivity & retention
-reducing staff turnover and absenteeism
why do HR want to increase labour productivity?
-increased labour productivity = lower the labour cost per unit and contribute to improved competitiveness
-more output produced → more output to sell - potentially increasing revenue
-money is saved on recruitment, selection and training costs and a positive group spirit may emerge
which strategies do HR use to improve employee performance?
-using financial rewards
-employee share ownership
-empowerment strategies
-consultation strategies
what are examples of financial strategies?
-piecework
-loyalty bonuses
-attendance bonuses
what is piecework?
when employees are paid according to the output that they reach
what is a loyalty bonus?
financial rewards that are linked to the length of time employees have been with the company
what is an attendance bonus?
when employers may link bonuses to attendance
benefits of financial rewards:
-may increase commitment and effort, leading to higher output and productivity
-if financial rewards are greater than those of other employers, staff are less likely to want to leave
-attendance and loyalty rewards may improve the intrinsic motivation of workers as they feel valued
what is an employee ownership scheme?
-employees can buy into a sharesave scheme that allows them to purchase company shares at a fixed price
-employees make capital gains on these shares as the price increases over time
-however, should share prices fall, employees get their investment back in cash
benefits of employee ownership schemes:
-rewarding senior executives and managers with shares may increase their commitment to achieving objectives
-employees who own shares in the business may work harder and take less time off as they have a financial stake in the success of the business
what is consultation?
involves managers obtaining the views of employees when making decisions
benefits of consultation:
-workers are likely to feel more involved within the business and may be less likely to take days off work or leave the business
-employees will feel more connected to their company if they feel as though they have an influence on
the way the business is run
-consultation often resolves any negative working practices / issues that could eventually lead to labour turnover or absenteeism
what is empowerment?
providing employees with autonomy and responsibility to make their own decisions and work on their own behalf
methods of empowerment:
-extra training
-feedback (employees want to know how they are doing and receive praise when it is deserved)
-delegate authority (allow employees to make decisions on how they work)
-offer flexible working practices
employees & empowerment:
-employee are encouraged to make use of their own knowledge and experience and develop their own solutions
-workers must be properly trained and equipped with the necessary resources to be properly empowered
leaders & empowerment:
leaders need to be prepared to hand over authority and focus on providing encouragement praise and feedback
