Paper 2- Theme 3.5- Assessing competitiveness ✅ Flashcards
define ratio analysis
examples
a measure used to obtain financial ratios that indicate the financial performance of a firm (e.g liquidity, profit, solvency, ….)
e.g. profitability ratios. liquidity ratios, gearing ratio, ROCE
define gearing ratio
the proportion of investment funds in a business that are financed by long term borrowing/debt
(long term = over 1 year old)
uses of the gearing ratio
- way to measure the long term stability of the business
- –> can analyse the future cashflows, based on levels of repayment
- can highlight risk of solvency, based on financial structure
- –> high gearing can mean high risk
drawbacks of using a gearing ratio
- focus on financial performance, doesn’t consider other aspects (e.g. brand loyalty, product quality, customer service)
- doesn’t consider how good a firm’s cash flow is
- –> may actually benefit from high gearing due to cheaper source of finance
define capital employed
all the long term finance of resource to the business
e.g. share capital, retained profit and non current liabilities
formula for capital employed
total equity + non current liabilities
define total equity
all money invested into and earned from business
gearing ratio formula
. non current liabilities
gearing ratio = —————————– x 100
capital employed
OR
. non current liabilities
gearing ratio = —————————————————– x 100
total equity + non current liabilities
how is gearing interpreted
50% ≤ = highly geared
25% ≤ = low gearing
between 25% and 50% is consider normal by an established business happy to finance its activities by debt
how to increase gearing
- convert short term loans to long term
- buy back ordinary shares
- —-> decreases total equity (lower share capital)
- pay higher dividends (as reduces retained profits)
- invest in revenue growth rather than profit
- –> advertising to gain market share
- –> promotional offers
how to reduce gearing
- repay long term loans
- pay less dividends, retain more profit
- increase equity finance —> issue more shares
- focus on profit margins improving rather than growing
- —> reduce costs
- ——–> lead to increase retained profit
define solvency
ability of a company to meet its long-term debts and other financial obligations
benefits of high gearing
- access to large sums of capital
—-> respond to seasonal changes in demand
—-> access growth opportunities, can get first mover advantage
….. however …. may have less strive for reducing costs - relatively cheap source of finance
- —-> don’t pay tax on debt finance (lowers income tax), whereas pay tax on equity finance
- less capital is required to be invested by shareholders (don’t lose control and share in profits)
- if cash flow and profit margins are strong, is easy to pay
- —> affects bigger firms less
benefits of low gearing
- less exposed to interest rate and economic climate changing
- less risk of defaulting on debts (not being able to pay it back)
- —> improve solvency
- shareholders rather than debt providers have influence over business
- –> more interest in business success
- available to increase if required
- –> meet changes in demand
drawbacks of a higher equity finance strategy that a low gearing takes
• more expensive as have to pay income tax on it, and dividends
•lose control to shareholders, who may strive for short termist gains
—> environmental impact —> losing sustainable competitive advantage
•lose share of profits
—-> less likely to be reinvested by shareholders
define return on capital employed (ROCE)
- what profits the business has made on the resources available to it (capital employed)
formula for ROCE
. operating profit
ROCE = ————————— x 100
. capital employed
why is operating profit used
it is the profit the business has made without considering how the business is financed (without financing costs taken off)
interpreted ROCE values
10 = average
15% = strong
benefits of high ROCE
- greater profit made off of available resources
- –> higher % of profits can be reinvested back into business
- –> means that higher dividends can be paid to shareholder
how to improve ROCE
- increase operating profit (increase revenue or decrease cost of sales or decrease fixed overheads)
- reduce value of capital employed while maintaining profit (getting rid of debts, paying higher dividends)
uses/benefits of ROCE analysis
- compare to previous years to see if ROCE is rising or falling
- benchmark performance with industry averages or competitors over time
- evaluate profitability of investments (can compare to interest rates to see saving is more worthwhile)
- provide target return for future investments (used with ARR)
drawbacks of ROCE
- only snapshot of business current sheet
- —> operating profit may change
- operating profit may includes exceptional items that would innacurately alter profits
- ROCE varies between industry
- —> isn’t a set % that is considered good, so up to managers to interpret
uses of ratios in general
- helps create budgets, forecast and plan by analysing previous trends
- can compare easily with industry average or competitors, see where you must improve or have competitive disadvantage
- helps determine range of performance indicators (e.g profits, liquidity, efficiency of operations, solvency)
- gain investment funds (by showing growth or financial stability)
drawbacks of ratios in general
- doesn’t consider profit quality (likelihood profit continues into future)
- –> includes profits generated by one off payments
- ratios only cover financial performance, not others like customer service or product quality (must be used with others)
- only a prediction, still need quality managers to interpret, and make decisions
- —> recruitment, selection costs
- snapshot of business performance
- –> doesn’t consider external changes in future, as look at past
- ——-> poor indicator of future performance
- ratios dependent on financial situation of major customers
- —> outstanding payments are included as receivables as a current asset,
- ——->big impact on acid and current ratio
