Assessment of Business Performance
Using accounting data over time
→ Businesses can compare financial data from different years to identify trends.
→ Managers may compare:
- revenue
- profit
- profit margins
- liquidity
- gearing
- efficiency
- investor returns.
→ A trend can show whether the business is improving, deteriorating or remaining relatively stable.
→ Revenue ↑ → gross profit ↑ → operating profit ↑ may indicate improved performance, but managers should also examine whether costs have increased.
Comparing performance with competitors
→ Ratio analysis allows a business to compare its performance with competitors of different sizes.
→ For example:
→ Business A has a profit margin of 15%.
→ Competitor B has a profit margin of 10%.
→ Business A generates more operating profit from each unit of revenue, but management should investigate why.
→ Useful comparisons include:
- profitability ratios
- liquidity ratios
- efficiency ratios
- gearing ratios
- investment ratios.
→ Competitor comparison must consider differences in:
- industry
- business size
- accounting policies
- product range
- market position
- location
- business objectives.
Impact of Accounting Data on Business Strategy
Profitability ratios
→ Profit margin falls → operating costs may be rising → management may reduce costs, improve productivity or review prices.
→ Gross profit margin falls → cost of sales may be rising → business may negotiate with suppliers, reduce waste or increase selling prices.
→ ROCE falls → capital may be being used less effectively → management may improve asset utilisation, sell unused assets or reconsider investment.
Liquidity ratios
→ Current ratio falls → ability to meet short-term obligations may be weakening → improve working capital, collect receivables faster or reduce inventory.
→ Acid test ratio falls → business may be increasingly dependent on selling inventory → improve cash management and receivables collection.
Efficiency ratios
→ Inventory turnover falls → inventory is being held for longer → improve demand forecasting, reduce excess stock or introduce JIT.
→ Trade receivables days increase → customers take longer to pay → strengthen credit control.
→ Trade payables days increase significantly → cash is retained longer, but supplier relationships may suffer → review payment policy.
Gearing
→ Gearing increases → greater reliance on long-term debt → financial risk and interest commitments may increase → management may reduce borrowing or raise equity finance.
Investor ratios
→ Dividend yield falls → shareholders may receive a lower return relative to market price → management may review dividend policy.
→ Dividend cover falls → a larger proportion of profit is being distributed → management may reconsider dividend levels and retained earnings.
→ P/E ratio changes → may indicate changing investor expectations → management may review growth and investment strategies.
Impact of Debt and Equity Decisions on Ratio Results
Increasing debt finance
→ Business takes a new long-term loan.
→ Non-current liabilities ↑
→ Capital employed ↑
→ Gearing ratio ↑
→ Interest payments may ↑
→ Profit from operations is unaffected directly, but profit for the year may ↓ because of higher interest costs.
→ Interest cover may fall if the business’s interest obligations increase significantly.
→ Additional borrowing may also increase financial risk.
Repaying debt
→ Non-current liabilities ↓
→ Gearing ratio ↓
→ Interest payments ↓
→ Profit after interest may ↑
→ Financial risk may ↓
→ However, cash available for other investment may ↓.
Issuing new shares
→ Equity ↑
→ Capital employed ↑
→ Non-current liabilities remain unchanged.
→ Gearing ratio generally ↓
→ No compulsory interest payment is created.
→ However, profits and dividends may need to be shared among a larger number of shareholders.
Comparison
| Finance decision | Gearing | Interest burden | Possible strategic effect |
|---|---|---|---|
| Take more debt | ↑ | ↑ | Greater expansion potential but greater financial risk |
| Repay debt | ↓ | ↓ | Lower financial risk but less cash available |
| Issue shares | ↓ generally | No direct interest | More finance without additional debt |
| Retain profits | ↓ generally | No direct interest | More internal finance for growth |
Impact of Dividend Strategy on Ratio Results
Increasing dividends
→ Dividends ↑
→ Retained earnings ↓
→ Equity ↓
→ This can cause gearing to increase, particularly if debt remains unchanged.
→ Dividend cover also falls because a greater proportion of profit is distributed.
Dividend cover = Profit for the year ÷ Dividends
→ Higher dividends → denominator ↑ → dividend cover ↓
→ The business has less retained profit available to finance future expansion.
Reducing dividends
→ Dividends ↓
→ Retained earnings ↑
→ Equity ↑
→ Gearing may fall
→ Dividend cover ↑
→ More profit remains available for:
- expansion
- new technology
- research and development
- debt repayment
- working capital.
Dividend yield
Dividend yield = Dividend per share ÷ Market price per share × 100
→ Increasing dividends per share, assuming the share price remains unchanged:
→ Dividend ↑ → dividend yield ↑
→ Reducing dividends, assuming the share price remains unchanged:
→ Dividend ↓ → dividend yield ↓
→ However, share prices can change in response to dividend decisions, so the actual effect on dividend yield may differ.
Impact of Business Growth on Ratio Results
Growth through borrowing
→ Business expands using additional loans.
→ Debt ↑ → gearing ↑
→ Interest payments ↑
→ Liquidity may initially fall because of finance repayments/investment spending.
→ If expansion succeeds:
→ Sales ↑ → profit ↑ → retained earnings ↑
→ Over time, increased equity may reduce gearing.
Growth through equity finance
→ New shares issued.
→ Equity ↑
→ Gearing generally ↓
→ More finance becomes available without increasing long-term debt.
→ However, ownership may become more widely distributed.
Growth through retained profit
→ Profit retained rather than distributed as dividends.
→ Retained earnings ↑
→ Equity ↑
→ Gearing may ↓
→ Dividend cover may ↑ because dividends are lower relative to profit.
Rapid growth
→ Rapid expansion may cause:
- inventory ↑
- trade receivables ↑
- borrowing ↑
- capital investment ↑.
→ These changes can affect liquidity, gearing and efficiency ratios.
→ Therefore, sales growth does not automatically mean improved financial performance.
Impact of Other Business Strategies on Ratio Results
Cost reduction strategy
→ Lower operating costs → operating profit ↑
→ Profit margin ↑
→ ROCE may ↑
→ However, excessive cost cutting may reduce product quality or employee motivation.
Increasing prices
→ Selling price ↑ → revenue per unit ↑
→ If demand remains strong, revenue and profit may ↑
→ Profit margin may ↑
→ However, demand may fall if customers are price sensitive.
Investment in technology
→ Initial investment ↑
→ Cash ↓ or borrowing ↑
→ Gearing may ↑ if debt finance is used.
→ In the longer term:
→ Productivity ↑ → unit costs ↓ → profit ↑ → profitability ratios may improve.
JIT and inventory reduction
→ Inventory ↓
→ Current assets ↓
→ Current ratio may ↓
→ However, less capital is tied up in inventory.
→ Inventory turnover may ↑ because inventory is being sold more quickly relative to the average stock held.
→ Therefore, a lower current ratio does not necessarily mean the strategy has failed.
Faster collection of receivables
→ Trade receivables ↓
→ Cash ↑
→ Liquidity may improve.
→ Trade receivables turnover days ↓
→ Cash becomes available for other business activities.
Expansion into new markets
→ Investment and marketing costs may initially ↑
→ Profitability ratios may fall in the short term.
→ If successful:
→ Sales ↑ → profit ↑ → profitability ratios may improve over time.
Diversification
→ New products/markets require investment.
→ Initial costs may reduce profit.
→ Gearing may increase if borrowing is used.
→ Long-term success could increase revenue and profitability, but the strategy carries additional risk.
How Strategic Decisions and Ratios Influence Each Other
→ Strategy changes financial results.
→ Financial results change ratio values.
→ Ratio changes provide information for future strategy.
This creates a continuous cycle:
Strategic decision → financial impact → accounting data → ratio analysis → performance assessment → strategic adjustment
Limitations of Published Accounts and Ratio Analysis
Historical information
→ Published accounts mainly show what has already happened.
→ Past performance may not predict future performance.
Different accounting policies
→ Businesses may use different accounting methods.
→ This can make direct comparisons misleading.
Inflation
→ Inflation can increase revenue, asset values and costs.
→ Ratio changes may therefore reflect price changes rather than genuine improvements in performance.
Window dressing
→ Businesses may arrange transactions near the end of an accounting period to make financial statements appear stronger.
→ This can reduce the reliability of comparisons.
Different business structures
→ Businesses may have different products, markets and levels of risk.
→ A ratio that is appropriate for one business may not be appropriate for another.
Industry differences
→ A supermarket and a construction company are likely to have very different liquidity, inventory and gearing ratios.
→ Industry averages are therefore important when interpreting ratios.
Ratios do not explain causes
→ A falling profit margin shows what has changed, but not necessarily why it changed.
→ Managers need additional information to identify the cause.
Ratios ignore qualitative factors
→ Ratios do not fully measure:
- employee motivation
- customer satisfaction
- brand image
- management quality
- product quality
- innovation
- environmental performance.
One ratio can be misleading
→ A high current ratio may appear positive, but it could result from excessive inventory that is difficult to sell.
→ A high gearing ratio may indicate greater financial risk, but borrowing may also have financed profitable expansion.
Share prices affect investor ratios
→ Ratios such as dividend yield and P/E depend partly on market share prices.
→ Share prices can change because of investor expectations and wider economic conditions, not just business performance.
No universal ideal ratio
→ There is rarely one ratio that is automatically considered good or bad.
→ Interpretation depends on:
- industry
- business objectives
- economic conditions
- competitors
- historical performance
- stage of business growth.
Strategic Use of Accounting Data
→ Published accounts → provide financial information.
→ Ratio analysis → identifies trends and comparisons.
→ Management interpretation → investigates causes.
→ Non-financial information → provides wider context.
→ Strategic decision → finance, growth, dividends, costs, investment, markets or operations.
→ New financial results → ratios change.
→ Further analysis → strategy is monitored and adjusted.
The key point: ratio analysis is a decision-making tool, not a decision by itself. Managers need to interpret the figures in context and combine them with qualitative and forward-looking information.