Paper 2- Theme 3.5- Assessing competitiveness ✅

Question 1

define ratio analysis

examples

Answer 1

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

Question 2

define gearing ratio

Answer 2

the proportion of investment funds in a business that are financed by long term borrowing/debt

(long term = over 1 year old)

Question 3

uses of the gearing ratio

Answer 3

• 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

Question 4

drawbacks of using a gearing ratio

Answer 4

• 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

Question 5

define capital employed

Answer 5

all the long term finance of resource to the business

e.g. share capital, retained profit and non current liabilities

Question 6

formula for capital employed

Answer 6

total equity + non current liabilities

Question 7

define total equity

Answer 7

all money invested into and earned from business

Question 8

gearing ratio formula

Answer 8

. non current liabilities
gearing ratio = —————————– x 100
capital employed

OR

. non current liabilities
gearing ratio = —————————————————– x 100
total equity + non current liabilities

Question 9

how is gearing interpreted

Answer 9

50% ≤ = highly geared
25% ≤ = low gearing

between 25% and 50% is consider normal by an established business happy to finance its activities by debt

Question 10

how to increase gearing

Answer 10

• 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

Question 11

how to reduce gearing

Answer 11

• 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

Question 12

define solvency

Answer 12

ability of a company to meet its long-term debts and other financial obligations

Question 13

benefits of high gearing

Answer 13

• 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

Question 14

benefits of low gearing

Answer 14

• 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

Question 15

drawbacks of a higher equity finance strategy that a low gearing takes

Answer 15

• 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

Question 16

define return on capital employed (ROCE)

Answer 16

• what profits the business has made on the resources available to it (capital employed)

Question 17

formula for ROCE

Answer 17

. operating profit
ROCE = ————————— x 100
. capital employed

Question 18

why is operating profit used

Answer 18

it is the profit the business has made without considering how the business is financed (without financing costs taken off)

Question 19

interpreted ROCE values

Answer 19

10 = average

15% = strong

Question 20

benefits of high ROCE

Answer 20

• 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

Question 21

how to improve ROCE

Answer 21

• 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)

Question 22

uses/benefits of ROCE analysis

Answer 22

• 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)

Question 23

drawbacks of ROCE

Answer 23

• 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

Question 24

uses of ratios in general

Answer 24

• 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)

Question 25

drawbacks of ratios in general

Answer 25

• 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