1. 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

2. 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

3. 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?
Why are numbers so important when understanding a business’ performance?
View M&S key facts.

4. 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.

5. Ratio Analysis - Gearing
Statement of financial position £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Non-current liabilities x 100
Total equity + non-current liabilities
x 100
x = 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?

6. 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?

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

8. 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
X 100 = 27%
17235
For every £1 of capital employed in the business 27 pence is generated in operating profit.

9. 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

10. 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?

11. 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

12. 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