1 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

ASSESSING COMPETITIVENESS OVERVIEW

1. INTERPRETATION OF FINANCIAL STATEMENT

a. Gross profit margin b. Net profit margin c. ROC (Return on Capital) d. ROCE (Return on Capital Employed) e. Acid test ratio f. Current ratio g. Gearing ratio h. Interpretations of these margins and ratios i. Limitations of ratios as a decision making tool

2. HUMAN RESOURCE COMPETITIVENESS

a. Labour productivity b. Labour turnover

i. Unavoidable leavers c. Limitations of these calculations

INTERPRETATIONS OF FINANCIAL STATEMENTS

Ratio analysis is an examination of accounting data by relating one figure to another. The approach allows more meaningful interpretation of the data and the identification of trends.

BUSINESS STUDIES FOR A LEVEL 3RD EDITION BY IAN MARCOUSÉ

Before we proceed onto actually calculating the ratios, it is very important to familiarise ourselves with a financial statement, as these statements are what we need to calculate these ratios. The gross profit margin, the net profit margin and the ROCE is calculated from the profit and loss account. The table to the left is an example of a profit and loss account. The expenses are essentially costs that are not involved in the production of goods and services such as advertising, wages of the administration staff as well as depreciation (the value of the company’s capital decreases with age). Cost of sales are the costs directly related to production including wages for labour as well as the overheads for rent, fuel etc.

Figure 1 - This has been taken from Dave Hall's book, Business Studies 4th Edition←

2 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

GROSS PROFIT MARGIN

First, we need to calculate the gross profit, and then we can calculate the margin.

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟) − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡

𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟) × 100

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =£400,000£900,000

× 100 = 4449

%

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ≈ 44%

NET PROFIT MARGIN

First, we need to calculate the net profit, and then we calculate the margin. As a simple rule of thumb, the net profit is the profit before tax – essentially, after you have taken all the costs, other expenses not directly linked to the production of the product as well as interest payable, you get the net profit: the value that the business is taxed on. The net profit will be very clearly stated in the tables that the exam board will provide, because its exact location can vary depending on the financial transactions of each individual business.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟) × 100

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =£110,000£900,000

= 1229

%

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ≈ 12%

ROCE (THE RETURN ON CAPITAL EMPLOYED)

To calculate this value, we need to be familiar with the balance sheet. The balance sheet is essentially a financial statement that lists a firm’s assets and liabilities: in simple terms, it’s what a business owns and owes. We need to remind ourselves that long term loans are also counted as investment into the business and therefore do count as capital employed into the business. The business made an operating profit of £5,600,000.

• Fixed assets are assets that the business will have in the long term i.e. buildings, machinery etc. basically, assets that the business will have for more than a year.

• Current Assets are assets that will last for less than a year. These assets are the most liquid assets the business has; examples include things such as cash etc.

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠) = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠

𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠)

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 = 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑅𝑂𝐶𝐸 =𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

× 100

𝑅𝑂𝐶𝐸 =£5,600,000

(£17,400,000 + £8,000,000) × 100 ≈ 22%

3 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

ROC (RETURN ON CAPITAL)

This essentially measures the profitability of a business. If a business invests into a project, it will want to know the profitability of the project.

𝑅𝑂𝐶 (𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙) =𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑× 100

This value is expressed as a percentage.

THE CURRENT RATIO AND THE ACID TEST RATIO

Both these ratio assess the liquidity of a business i.e. . Again, this is another how easily a business’ assets can be turned into cashratio that is concerned with the balances sheets a business publishes.

CURRENT RATIO

The current ratio of a business is essentially the ratio between its current asses and its current liabilities.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

ACID TEST RATIO

The acid test ratio takes into account that stocks are the least liquid of all the current assets and should not be counted as an asset that can be easily liquefied.

𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑡𝑜𝑐𝑘𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

GEARING RATIO

This essentially is a ratio that gives an indication of how much debt the business is under, giving insight into the long term stability of the organisation.

𝐺𝑒𝑎𝑟𝑖𝑛𝑔 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒)𝑟𝑎𝑡𝑖𝑜 =𝐿𝑜𝑛𝑔-𝑡𝑒𝑟𝑚 𝐿𝑜𝑎𝑛𝑠𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

× 100

This value (like every other ratio that is multiplied by 100) is expressed as a percentage. In boom times, investors and banks find gearing a good thing, as the business is focusing on growth, however this entails great risk. However, if a recession suddenly hits, then the business will be in grave danger because now the business still has to pay back the interest with a reduced income from battered sales.

4 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

INTERPRETATIONS OF THESE MARGINS ANS RATIOS

RATIO OR MARGIN ANALYSIS

GROSS PROFIT MARGIN

The gross profit will differ from industry to industry and hence needs to be looked at with the context of the business in mind. Can be improved by:

• Raising sales revenue without increasing total costs – i.e. make production cheaper e.g. can be done via automation.

NET PROFIT MARGIN

Similarly to the gross profit margin, this will vary from industry to industry and has to be looked at with the context of the business in mind. For example, the food industry has both a low gross and net profit margins, but since there is a very high volume sold, it is not a problem. Can be improved by:

• Same as gross profit margin.

ROCE (RETURN ON CAPITAL EMPLOYED)

This is a fundamental ratio that essentially shows how well the business is making use of its resources and essentially, how lucrative it is for investment. The ROCE of a business needs to be compared with previous years to identify a trend in its growth. Also, if the ROCE is less than 6 %, then there is little incentive to invest as if an investor were to invest this money into the bank instead, then the person would be much better off still making money with no risk. Can be improved by:

• Increasing the efficiency of the business through generating greater profits from the same amount of capital invested.

ROC (RETURN ON CAPITAL) This measures the profitability of a project or operation and thus is a good indicator of how successful the project was to the business.

CURRENT RATIO

Shows the ratio between assets and liabilities. The business would do best to keep this at 1.5:1. However if this is too high, it means that the business has too much money that it is not investing. However, having too low a current ratio means that it may not be able pay back debts in times of crisis such as a downturn. Can be improved by:

• Selling under-used fixed assets • Selling shares to gain more share capital • Postpone or reduce planned investments • Take long term-loans

ACID TEST RATIO

Arguably, the best ratio is 1:1. A result that is too low means that that the business may not be able to pay off its short term debts. However, companies such as supermarkets operate with very low liquidity ratios. In fact, some of the major companies such as BP, Imperial Tobacco and TESCO have very low acid test ratios.

• Adopting JIT, this way you have not stock to worry about – and you can divert more capital into production

• Selling under-used capital or selling old machinery • Selling shares to increase share capital • Take long term loans

GEARING RATIO

The more geared the business is, the more debt it has. By this, it means that investing in this business is risky as well as it will be hard for the business to gain finances from banks. However, whether a business that is geared will get investment will also depend on the state of the industry. Can be improved by:

• Issue more shares to raise share capital • Buy back debentures (bonds) • Retain more profit • Repay loans

5 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

VALUE AND LIMITATIONS OF THESE RATIOS AS A DECISION MAKING TOOL

WINDOW DRESSING

Window dressing is the legal manipulation of company accounts by a business to present a financial picture which is to its benefit.

BUSINESS STUDIES 4TH EDITION, DAVE HALL

• Business managers may want to paint a good financial image of the business in order to attract investors.

• Businesses might manipulate the financial picture to look bleak for the short term to make it look better in the long term – business tend to choose to get over with a financial crisis quickly than having poor financial performance for a long time; if the business shows strength in coming out of a financial crisis then they will become a favourite with investors.

• Making financial statements look worse can be used to reduce the tax on a business.

• Businesses trying to sell itself or one of its operations will do their best to manipulate accounts in order to get the best possible value for the business.

VALUE LIMITATIONS

Ratios are very simple to calculate, most of them have a consistent formula.

Comparisons have to be made with businesses that are similar (same industry, similar operations) and also businesses in the same time frame in order to get a fair comparison. Sometimes, businesses in the same industry are vastly different. Sainsbury focuses on food and groceries alone, while TESCO is moving onto home appliances – these new products will have a different gross profit margin and will affect comparisons.

Analysis can be carried out very quickly as they are very simple to calculate and demand only basic financial statements.

Businesses might also have different accounting techniques, which will determine how their financial statements are made – financial statements determine ratios.

Can be used to compare one company with another; they can be used to compare businesses in the same industry. Comparisons can also be made within the companies as it may have many on-going projects.

The ratios are limited to the quality of the balance sheets – the balance sheet represents a ‘snapshot’ of the business at the end of a financial year and is not representative of the business’ circumstance over the entire year.

Can be used by decision makers to identify the strengths and weaknesses of a business. For example, if gross profit margin is very high, but the Net profit margin is very low, then the business may try to reduce operational costs as well as reduce its debts.

Qualitative information is ignored, making it quite ineffective in the service industry.

The ratios are only as good as the financial accounts. Inflation can make a business’ assets look more valuable – when there might not actually be a change in real value.

6 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

HUMAN RESOURCE COMETITIVENESS

Both labour productivity and turnover show the effectiveness of the work force and can be a very useful yard-stick for measuring the efficiency of the business in question.

LABOUR PRODUCTIVITY

𝐿𝑎𝑏𝑜𝑢𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 (𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒)

This essentially measures the how many products (on average) a worker produces over a specific period of time. There can be many ways to improve this:

• Making production more capital intensive will reduce the need to labour as well as produce at a cheaper rate as machines can work continuously unlike workers.

• Often, changing the type of production can improve the efficiency of a business; using cell production instead of assembly line production is an example as it meets worker’s social needs.

• Training can make workers more able, allowing them to perform their work more efficiently. • Overall, increasing the motivation of workers by giving them more power or authority is also a great way to increase

productivity, as they can highlight the main problems with the production process and can therefore come up with a better solution.

High labour productivity will drive the costs of the business down and hence the business can sell cheaper products to gain greater sales or keep prices the same and get more profit – depending on the elasticity of the product.

However, even after adoption these measures, often businesses are unable to compete:

• Often competing businesses may offshore production to places such as China, where the labour cost is very cheap. • Rivals may be able to increase productivity at an even faster rate, than the business, through a combination of

technology and cheap labour. • Rival might also enhance the quality of the product while at the same time increasing the productivity of the business.

LABOUR TURNOVER

𝐿𝑎𝑏𝑜𝑢𝑟 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆𝑡𝑎𝑓𝑓 𝐿𝑒𝑎𝑣𝑖𝑛𝑔 (𝑜𝑣𝑒𝑟 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑎𝑓𝑓 𝑖𝑛 𝑝𝑜𝑠𝑡 𝑖𝑛 𝑝𝑜𝑠𝑡 (𝑜𝑣𝑒𝑟 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒) × 100

Labour turnover can be caused by a variety of reasons. Some being:

• The company paying staff low wages • Relatively few training programmes • Poor methods in recruitment and selection

process • Poor working conditions – unsafe, bullying etc. • Lack of transport may also be a reason • Some turnover is unavoidable as some businesses

may have passed the working age.

Problems with recruiting new staff:

• It takes time and has high administration costs o Induction programmed given by large

companies increase the cost of recruitment

Why turnover may be a good thing:

• New staff bring in new ideas • Some workers may be ineffective • If a business is shrinking, reducing business size

can be good in cutting costs. • If a business pays low wages, it might prefer hiring

new workers than increasing the wage.

7 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

USES AND LIMITATIONS

• These ratios give an indication of a problem in the business, but does not give any specific detail about the problems that the business and often business have to carry out additional research to get to the root of the problem.