Theme 3: Business decisions and strategy Recap year 1 Draw a spider diagram to show: Internal finance External sources of finance External methods of finance 3.5.2 Ratio analysis

3.5.2 Ratio analysis In this topic you will learn about Calculate: Gearing ratio Return on capital employed (ROCE) Interpret ratios to make business decisions The limitations of ratio analysis

What is meant by the term benchmark? Ratio Analysis Allows for a more meaningful analysis of published accounts Shows relationship between figures Used for comparisons over time Inter and intra business comparisons Intra means between businesses e.g. to compare performance to competitors or to benchmark Inter means within a business e.g. over time within one organisation or between branches What is meant by the term benchmark? http://corporate.marksandspencer.com/investors/key-facts Why are numbers so important when understanding a business’ performance? View M&S key facts.

Ratio Analysis - Gearing Measures what proportion of a business’ capital is funded through long term loans Loans are “compulsory interest bearing” i.e. you have to pay interest on them even if profits are low or non-existent A highly geared business is of greater risk if interest rates are likely to increase Non-current liabilities x 100 Total equity + non-current liabilities Explain where interest rates would appear on a statement of comprehensive income and which profit figure(s) would be affected by a change in interest rates.

Ratio Analysis - Gearing Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Non-current liabilities x 100 Total equity + non-current liabilities 6000 x 100 11235 + 6000 6000 x 100 = 35% 17235 For every £1000 invested in this business how much of it is from long term loans? Why might a high gearing ratio be more of a concern to a business with small profit margins?

Ratio Analysis - Profitability Return on Capital Employed (ROCE) A measure of how efficiently a business is using capital employed to generate profits Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from: Share capital Reserves Long term loans Formula: Operating profit x 100 Total equity + non-current liabilities Challenge: Capital employed can also be calculated as total assets minus current liabilities. Can you explain why?

Return on capital employed Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Statement of comprehensive income £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Interest (260) Exceptional item 300 Profit for the year 4620 Operating profit x 100 4580 x 100 Total equity + non-current liabilities 11235 + 6000 4580 x 100 = 27% 17235

Interpretation of ROCE Why would it be meaningful to compare this to the current rate of interest? Why might a high street retailer compare ROCE between individual stores? Return on capital employed Operating profit x 100 total equity + non-current liabilities 4580 X 100 = 27% 17235 For every £1 of capital employed in the business 27 pence is generated in operating profit.

Interpret ratios to make business decisions Gearing How to finance future strategies Risk of rising interest rates Negotiating credit terms with suppliers Rewards to be paid to shareholders based on their levels of risk Set investment criteria Strategic direction Return on capital employed Managers’ financial rewards Efficiency targets - identify training needs Future investments Disposal or purchase of non-current assets Capacity utilisation targets

Value of financial ratios when assessing performance Limitation Possibility that accounts have been window dressed Need to consider reasons behind ratios e.g. is ROCE lower than previous years because of an investment programme Quantitative information only Value Provides a tool for the interpretation of accounts Structure from which comparisons can be made Overtime With other businesses Aids decision making Internally Externally by investors What other quantitative information could be used to assess the performance of a business? What other qualitative information could be used to assess the performance of a business?

Activity – interpreting published accounts In pairs choose 2 businesses who operate in the same industry e.g. 2 supermarkets, 2 football clubs Go onto the internet and print off the balance sheet and income statement (Google company name/investors) The layout will vary from company to company but you should be able to identify the key information Prepare a presentation comparing the performance of the two businesses over time and in comparison to each other Present your findings to the rest of the class

3.5.2 Ratio analysis In this topic you have learnt about Calculate: Gearing ratio Return on capital employed (ROCE) Interpret ratios to make business decisions The limitations of ratio analysis