Using Ratio Analysis To Make Strategic Decisions (Cambridge (CIE) A Level Business): Revision Note

Assessing business performance over time

• Ratio analysis involves comparing financial figures from the accounts to create meaningful measurements of profitability, liquidity and efficiency

• When ratios are tracked over several time periods, they help identify trends in a business’s performance

• Ratio analysis:

  1. Identifies improvements or problems

     • By comparing ratios year-on-year, businesses can see if performance is getting better or worse

     • For example, a rising profit margin suggests improved profitability, while a falling current ratio may signal cash flow issues

  2. Supports decision-making

     • Trends revealed through ratio analysis help managers decide whether to expand, cut costs, raise finance or change strategy

  3. Highlights consistency or instability

     • Stable ratios suggest a reliable and well-managed business, while sudden changes may point to risks or changing conditions

Comparing business performance with competitors

• Ratio analysis can also be used to compare a business’s performance with that of other firms in the same industry

  1. Benchmarks performance

     • Comparing ratios helps businesses judge whether they are performing above or below the industry average

  2. Reveals strengths and weaknesses

     • A higher return on capital employed (ROCE) than a rival suggests better use of investment

     • A lower current ratio may show weaker short-term financial health

  3. Supports strategic planning

     • If a competitor has stronger profitability or better cost control, the business can investigate and improve its own operations to stay competitive

Ratios and debt and equity decisions

• When a business chooses how to finance its operations, it directly affects several key ratios used in analysing performance

• These choices can change how the business appears in terms of risk, profitability, and financial strength

The impact of debt and equity decisions on ratios

1. Gearing ratio

• Taking on more debt increases the gearing ratio

  • This indicates greater financial risk and a higher dependency on borrowed funds

• Using equity reduces gearing

  • This indicates a more stable capital structure with lower financial risk

2. Return on capital employed (ROCE)

• Raising equity increases capital employed

  • This can reduce ROCE unless profits rise too

• Using debt may lead to a higher ROCE if the borrowed funds increase profits

  • However, this approach carries greater financial risk

3. Dividend cover

• More debt means higher interest payments, which reduce net profit

  • This may lower the dividend cover, making dividend payments less sustainable

• Raising finance through equity avoids interest costs and may result in a higher dividend cover

  • This suggests more secure payouts, though profits must be shared among more shareholders

Ratios and dividend strategy

• Dividend strategy is how a business decides:

  • How much profit to return to shareholders as dividends

  • How much profit to keep (retain) in the business for future investment

How does the dividend strategy affect key ratios?

1. Return on capital employed (ROCE)

• If more profits are retained (fewer dividends paid), capital employed increases

• This could lower ROCE, unless operating profit increases due to reinvestment

  • E.g. When KohliTech Plc, an Indian technology firm, reduced dividends to invest in innovation, ROCE fell in the short term but rose later when profits increased

2. Current ratio and acid test ratios

• Paying high dividends reduces cash, a key current asset

• This may reduce liquidity, making it harder to pay short-term debts

  • E.g. South African supermarket chain Choppies paid large dividends to its shareholders before the pandemic and, as a result, struggled with cash flow when sales dropped in the early part of 2021

3. Price/earnings ratio

• A change in dividend strategy doesn't directly affect the price/earnings ratio

  • However, lower dividends may worry investors, reducing share price, which lowers the ratio

  • If reinvestment leads to higher profits, share price may rise, increasing the ratio over time

Business growth and ratio results

• When a business grows, whether by increasing sales, opening new branches, acquiring other firms or expanding into new markets, it can have an impact on a range of financial ratios

The impact of business growth on selected ratios

Other business strategies and ratio results

1. Cost-cutting strategy

• A business might reduce its costs by lowering wages, using cheaper materials, or cutting back on overheads like advertising or travel

2. Paying higher dividends

• A business may decide to return more profits to shareholders by increasing dividends

Limitations of using published accounts and ratio analysis in decision-making

• Published accounts (like the income statement and statement of financial position) and ratio analysis are useful tools

• However, they should never be the only tools used when making strategic decisions

• A business should always consider the full picture, including market trends, people, and future risks

Key limitations of using accounts and ratio analysis to make decisions

Historical information

• Accounts are based on past performance, not the future

• Ratios reflect what has happened — not what will happen next

Non-financial factors are ignored

• Ratios and accounts don’t include qualitative factors such as

  • Staff morale

  • Customer loyalty

  • Brand reputation

  • Innovation and leadership

• These factors can have a significant impact on business success, so ignoring them means only a partial picture of a business is gained

Different accounting methods

• Businesses can choose different methods for things like depreciation or valuing inventory

• This makes it difficult to compare companies directly

Window dressing

• Some businesses try to make their accounts look better than they really are

• For example, delaying bill payments or boosting end-of-year sales temporarily

Outdated or incomplete data

• Published accounts may be up to 12 months old by the time decisions are made

• The impact of important recent events, such as losing a major contract or the impact of an external economic downturn, might not yet be evident

Ratios need context

• A ratio on its own is not very useful

• In order for financial performance data to be meaningful, a business must compare it to

  • Past performance (trends)

  • Industry averages

  • Similar businesses