10. Finance And Accounting

10.4 Finance And Accounting Strategy

10.4.2 The Use Of Accounting Data And Ratio Analysis In Strategic Decision-Making

Assessment Of Business Performance Over Time And Against Competitors

• Purpose Of Assessment
  • Businesses Must Continuously Evaluate Their Performance To Identify Strengths, Weaknesses, And Opportunities For Improvement.
  • Ratio Analysis Provides A Quantitative Method For Assessing Performance.
• Comparisons Over Time (Trend Analysis)
  • Comparing Ratios Across Several Years Highlights Whether Performance Is Improving Or Declining.
  • Example: If Net Profit Margin Improves From 10% To 15% Over Three Years, It Shows Rising Profitability.
  • Trend Analysis Helps Identify Early Warning Signs Of Declining Liquidity Or Increasing Debt.
• Comparisons Against Competitors (Inter-Firm Comparison)
  • Businesses Must Benchmark Their Performance Against Industry Averages And Competitors.
  • Example: A GPM Of 35% May Look Good In Isolation, But If Competitors Achieve 50%, The Business Is Underperforming.
  • Investors Use Such Comparisons To Decide Where To Place Their Capital.
• Comparisons Against Industry Standards
  • Industry Associations And Financial Publications Provide Benchmark Ratios.
  • Businesses Compare Their Own Ratios To Industry Averages.
  • Example: A Supermarket With A Net Profit Margin Of 3% May Be Performing Well If The Industry Average Is 2%.

The Impact Of Accounting Data Including Ratio Results On Business Strategy

• Influence On Strategic Choices
  • Managers Use Ratio Analysis To Decide On Expansion, Diversification, Or Cost-Cutting Strategies.
  • Example: A Falling Liquidity Ratio May Lead To A Strategy Of Reducing Inventory Or Improving Credit Control.
• Profitability Ratios And Strategy
  • If GPM Is Falling, The Business May Adopt A Strategy Of Cost Reduction Or Increasing Selling Prices.
  • If ROCE Is Low, Management May Consider Restructuring Or Selling Unprofitable Divisions.
• Liquidity Ratios And Strategy
  • A Low Current Ratio May Lead To A Strategy Of Raising Short-Term Finance Or Reducing Current Liabilities.
  • Example: A Company With Current Ratio Of 0.9:1 Might Delay Expansion Until Liquidity Improves.
• Efficiency Ratios And Strategy
  • Poor Inventory Turnover Ratio May Lead To A Strategy Of Adopting Just-In-Time Systems.
  • High Receivables Days May Lead To Stricter Credit Control Policies.
• Investor Relations Strategy
  • Strong Ratios Are Communicated To Investors To Increase Confidence.
  • Weak Ratios May Lead To A Strategy Of Improving Transparency Or Adjusting Dividend Policy.

Written And Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course

The Impact Of Debt Or Equity Decisions On Ratio Results

• Debt Financing (Loans, Debentures, Bonds)
  • Increases Gearing Ratio Because Of Higher Non-Current Liabilities.
  • Interest Payments Reduce Profitability Ratios Such As Net Profit Margin And ROCE.
  • Example: A Business That Borrows $2 Million To Expand Will Have Higher Interest Costs, Reducing Net Profits.
• Equity Financing (Issuing Shares)
  • Increases Share Capital And Reduces Gearing Ratio.
  • May Dilute Earnings Per Share (EPS) Because More Shares Are Issued.
  • Example: If A Business Issues Additional Shares To Finance Growth, EPS May Fall Even If Overall Profits Increase.
• Strategic Implications
  • High Gearing Ratios May Limit The Business’s Ability To Borrow Further.
  • Low Gearing May Attract Risk-Averse Investors But Limit Potential Returns.
  • Businesses Must Balance Debt And Equity To Achieve Optimal Capital Structure.

The Impact Of Changes In Dividend Strategy On Ratio Results

• Dividend Yield
  • If A Business Increases Dividend Per Share, Dividend Yield Rises.
  • Example: A Share Price Of $20 With A Dividend Of $1 Gives A Yield Of 5%. If Dividend Rises To $2, Yield Increases To 10%.
• Dividend Cover
  • If More Profit Is Paid As Dividends, Dividend Cover Falls.
  • Example: Profit After Tax = $400,000, Dividend Paid = $200,000 → Cover = 2 Times. If Dividend Rises To $300,000 → Cover = 1.33 Times.
• Earnings Per Share (EPS)
  • Dividend Policy Does Not Directly Affect EPS, But Retaining More Profits May Increase Future EPS Through Reinvestment.
  • Example: Tech Firms Like Amazon Retain Profits For Growth, Leading To Higher Future Share Prices Despite Low Current Dividends.
• Strategic Implications
  • High Dividend Payments Attract Income-Seeking Investors.
  • Lower Dividend Payments With Higher Retained Earnings Support Growth Strategies.
  • Businesses Must Balance Short-Term Investor Expectations With Long-Term Investment Needs.

Written And Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course

The Impact Of Business Growth On Ratio Results

• Effect On Profitability Ratios
  • In Early Growth, Profits May Be Low Due To High Investment Costs.
  • Over Time, Economies Of Scale Improve GPM And Net Profit Margins.
  • Example: Tesla Reported Losses During Early Years But Later Improved Profit Margins With Increased Production Volumes.
• Effect On Liquidity Ratios
  • Growth May Increase Demand For Working Capital.
  • Current Ratio May Decline If Cash Is Tied Up In Inventory Or Receivables.
  • Example: Retail Chains Expanding Rapidly Often Struggle With Liquidity Due To High Stock Purchases.
• Effect On Gearing Ratio
  • Businesses Often Borrow To Finance Growth, Increasing Gearing.
  • Example: Telecommunications Firms Often Have High Gearing Because They Borrow To Build Infrastructure.
• Effect On Investor Ratios
  • Growth May Increase EPS And Share Prices, Improving P/E Ratio.
  • However, High Reinvestment In Growth May Reduce Dividend Yield.
• Strategic Implications
  • Managers Must Balance Growth With Maintaining Healthy Ratios.
  • Over-Expansion May Lead To Liquidity Crises Or High Gearing.

The Impact Of Other Business Strategies On Ratio Results

• Cost Leadership Strategy
  • Focus On Low Costs Improves Profit Margins And ROCE.
  • Example: Walmart’s Strategy Of Everyday Low Prices Relies On High Volume And Cost Efficiency.
• Differentiation Strategy
  • Heavy Investment In R&D And Marketing May Reduce Short-Term Profit Margins.
  • However, Successful Differentiation Increases Long-Term Profitability And EPS.
  • Example: Apple Accepts High R&D Costs But Gains High Profit Margins From Premium Pricing.
• Mergers And Acquisitions
  • May Increase Gearing Due To Borrowing.
  • May Improve Efficiency Ratios Through Economies Of Scale.
  • Example: Facebook’s Acquisition Of Instagram Improved Its Market Reach And Long-Term Profitability.
• Sustainability Strategy
  • Investment In Green Technology May Increase Costs In The Short Term.
  • However, Long-Term Benefits Include Lower Operating Costs, Better Reputation, And Attracting Ethical Investors.
• Restructuring Strategy
  • Selling Off Unprofitable Divisions May Improve Profitability Ratios.
  • Example: Unilever Sold Off Its Spreads Business To Focus On Core Brands, Improving Profit Margins.

Written And Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course

The Limitations Of Using Published Accounts And Ratio Analyses

• Historical Nature Of Accounts
  • Published Accounts Show Past Performance, Not Future Prospects.
  • Example: A Profitable Firm In The Past May Face Future Decline Due To Technological Change.
• Lack Of Non-Financial Information
  • Ratios Do Not Consider Customer Satisfaction, Employee Morale, Or Innovation.
  • These Qualitative Factors Can Be Crucial For Long-Term Success.
• Different Accounting Policies
  • Businesses May Use Different Methods For Depreciation Or Inventory Valuation.
  • This Makes Comparisons Between Companies Difficult.
• Window Dressing
  • Businesses May Manipulate Accounts To Present A More Favourable Picture.
  • Example: Delaying Payments To Suppliers Temporarily Improves Liquidity Ratios.
• Inflation Effects
  • Published Accounts May Not Reflect The True Value Of Assets Or Profits During Periods Of High Inflation.
• Limited Comparability
  • Industry Differences Mean Ratios Are Not Always Comparable Across Sectors.
  • Example: Supermarkets Have Low Profit Margins, While Luxury Brands Have High Margins.
• Ignores External Factors
  • Ratios Do Not Consider Political, Legal, Or Economic Changes That Affect Business Performance.
  • Example: A Sudden Change In Tax Laws Can Affect Profitability Despite Good Ratios.

Evaluation Of The Use Of Accounting Data And Ratio Analysis In Strategic Decision-Making

• Strengths
  • Provides Quantitative Insights Into Business Performance.
  • Helps Managers And Investors Make Informed Decisions.
  • Identifies Trends And Areas For Improvement.
  • Useful For Comparing Performance Over Time And With Competitors.
  • Supports Strategic Objectives Such As Growth, Profitability, And Efficiency.
• Limitations
  • Over-Reliance On Ratios May Lead To Ignoring Qualitative Factors.
  • Depends On Accurate Accounting Data And Assumptions.
  • External Factors Such As Market Trends And Economic Conditions Are Not Reflected.
  • Different Accounting Standards Reduce Comparability Between Firms.
• Overall Assessment
  • Ratio Analysis Is A Powerful Tool For Strategic Decision-Making.
  • It Must Be Used In Combination With Other Financial And Non-Financial Information.
  • Provides A Strong Basis For Evaluating Performance, Setting Objectives, And Developing Strategies.

Written And Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course