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Edexcel A Level Business Your notes

3.5 Assessing Competitiveness

Contents
Interpretation of Financial Statements
Ratio Analysis
Human Resources

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Interpretation of Financial Statements

Your notes
Using The Statement of Comprehensive Income
The Statement of Comprehensive Income is also known as the Profit and Loss Account
It shows the income and expenditure of a business over a period of time - usually a year - and
calculates the amount of profit made (see sub-topic 2.3.1)
An Example of a Statement of Comprehensive Income for Head to Toe Wellbeing Ltd

The extract from the statement of comprehensive income for Head to Toe Wellbeing Ltd shows figures
for both 2022 and the previous year, allowing comparison over time

Stakeholder Interest in the Profit & Loss Account

The profit and loss account is a very useful source of information for stakeholders to evaluate the
performance of a business
Shareholders

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Interested in profits earned, business growth and dividend payments

Employees
Your notes
Interested in profits earned and potential for wage increases and job stability
Managers & Directors
Interested in key performance data such as an improvement in sales revenue and net profit
Suppliers
Interested in the continued success of the company they are supplying
This information is also used by suppliers to determine the level of trade credit offered to
businesses
Government
Used to determine how much tax is payable
Local community
Interested in the stability of the business and what this may mean for jobs in the community
Another interest is to see if the firm is generating enough profit to perhaps approach them for
local sponsorship
Using the Statement of Financial Position
The Statement of Financial Position contains the financial information required to draw conclusions
about the liquidity of the business
Liquidity is the ability of a business to meet its short term commitments (e.g. payments to
creditors) with its available assets
A business that cannot pay its bills will usually fail very quickly, even if they are profitable
Managing liquidity is a key way to manage risk in a business and helps a business prepare for the
unexpected
The Statement of Financial Position shows the financial structure of a business at a specific point in
time
It identifies a businesses assets and liabilities and specifies the capital (money) used to fund the
business
The Statement of Financial Position is also known as the Balance Sheet
An Example of a Statement of Financial Position for Packer Sports Ltd

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Your notes

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Your notes

Stakeholder Interest in the Balance Sheet

Stakeholders will use the Balance Sheet alongside the profit and loss account to perform ratio
analysis and compare performance over time or with other businesses
How Stakeholders use the Balance Sheet

Stakeholder Interest in the Balance Sheet

Shareholders Used to identify the asset structure of the business and how their investment
has been put to use
Used to calculate the working capital of the business and determine its
solvency
Used to determine the rough value of a business, which helps a judgement on
whether their investment is growing

Managers & Used to identify the financial position of the business at a given point in time
Directors
Useful to assess the working capital position of the business and determine if
there are enough liquid current assets to pay its bills
Provides information on the capital structure of the business, which helps guide
decisions on whether to raise further funds through borrowing or via other
means (e.g. share issue)

Suppliers & Used to judge the solvency of the business to determine the risk when offering
Creditors firms trade credit
Businesses with low levels of working capital may find it difficult to pay short-
term debts and so suppliers may offer trade credit, but with stricter terms

Employees Is the business financially stable or are jobs at risk?

Has the businesses performance improved or worsened?
What is the business spending its money on?
How much are senior executives paid?

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How much tax is the business paying?

Your notes

Examiner Tips and Tricks

Information found in the profit and loss account and balance sheet can be used in a range of
answers.
For example, if you are answering a question about sources of finance, you might be able to use the
capital structure of the business to recommend whether a business should borrow or look at an
alternative source.
If a business already relies heavily on borrowing, it may be more sensible to recommend seeking to
raise more share capital.

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Ratio Analysis
Your notes
An Introduction to Ratio Analysis
Ratio analysis involves extracting information from financial accounts to assess business
performance and answer key questions, including
Why is one business more profitable than another in the same industry?
Is a business growing?
How effectively is a business using assets and capital invested?
What returns on investment are expected?
How risky is the financial structure of the business?
Information Extracted from the Profit & Loss Account and Balance Sheet for Ratio Analysis

Profit & Loss Account Balance Sheet

Revenue Current Assets

Cost of Sales Current Liabilities
Gross Profit Inventory (stock)
Operating Profit Trade Receivables
Profit for the Year (Net profit) Trade Payables
Long-term liabilities
Capital & Reserves

Ratio analysis supports evidence-based decision making, as it provides measurable data that can be
used to support judgements and compare performance against objectives

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Your notes

The Ratio Analysis Process

Types of Ratios
The Gearing Ratio
The gearing ratio shows the long-term financial structure of the business
It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used
to fund a business
The outcome is expressed as a percentage
The Gearing Ratio is calculated using the formula

Non Current Liabilities

Gearing Ratio = x 100
Capital Employed

Capital employed can be calculated by subtracting current liabilities from total assets

Worked Example
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The table shows an extract from the company accounts of Keals Cosmetics.

Current Assets £6.2 million Your notes

Current Liabilities £3.4 million

Non-current Liabilities £9.6 million

Capital Employed £43.3 million

Calculate the gearing ratio of Keals Cosmetics. (2 marks)

Step 1: Identify the data required to calculate the gearing ratio

Non-current liabilities = £9.6 million
Capital employed = £43.3 million
Step 2: Divide non-current liabilities by capital employed
£43.3 million ÷ £9.6 million = 0.22 (1 mark)
Step 3: Multiple the outcome by 100 and express the result as a percentage
0.22 x 100 = 22% (1 mark)
22% of Keals Cosmetics capital structure is made up of long-term loans

Return on Capital Employed (RoCE)

The Return on Capital Employed is also known as the Primary Ratio
It compares the profit made by a business to the amount of capital invested in the business
It is a measure how how effectively a business uses the capital invested in the business to generate
profit
Return on Capital Employed is a key performance indicator that can be compared over time and also
with competitors and other potential capital investments
Return on Capital Employed is expressed as a percentage and can be calculated using the formula

Operating Profit
Return on Capital Employed = × 100
Capital Employed

Worked Example
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The table shows an extract from the company accounts of Keals Cosmetics.

Current Liabilities £1.5 million Your notes

Revenue £7 million

Total Assets £15.4 million

Operating Profit £2.2 million

Calculate Keals Cosmetics' Return on Capital Employed. (3 marks)

Step 1: Calculate the capital employed

Capital employed = Total assets − current liabilities

Capital employed = £ 15 . 4m − £ 1. 5m (1 mark)

Capital employed = £ 13 . 9m

Step 2: Divide Operating Profit by Capital Employed

Operating Profit
Return on Capital Employed =
Capital Employed

£ 2. 2m
Return on Capital Employed = (1 mark)
£ 13 . 9m

Return on Capital Employed = 0. 16

Step 3: Multiply the result by 100 and express the outcome as a percentage
0.16x 100 = 16% (1 mark)
The capital employed in Keals Cosmetics has generated a return of 16%

Interpreting Ratios to make Business Decisions

The Gearing Ratio
The Gearing Ratio is used to examine the capital structure of a business

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It compares the amount of capital raised from shareholders with capital raised from loans and other
forms of long-term borrowing to show the proportion of business assets that are financed by long-
term borrowing Your notes
In short it shows how reliant a business is upon borrowed money
Highly geared business
In a highly-geared business more than 50 per cent of its capital employed are long-term loans
The outcome of the gearing ratio calculation will be greater than 50 per cent
Substantial levels of interest will need to be paid on this high level of borrowing which means
The level of profit available to pay as dividends to shareholders is reduced
Profit available to retain within the business is limited
The business is likely to be considered a risk for further investment
It is also likely to face difficulties in raising further loan capital
Steps to reduce the gearing
A highly-geared business may take steps to lower its ratio by
Issuing more ordinary shares to create further share capital
Retaining more profits to avoid further borrowing
Repaying loans to lower interest costs for the business
Low geared business
A low-geared business has less than 50 per cent of its capital employed as long-term loans
The outcome of the gearing ratio calculation will be less than 50 per cent
The business may be missing out on the opportunity to access finance without the need to dilute
existing shareholders' control
This is especially true when interest rates are very low as has been the case in the UK over the last
15 years
Lenders such as banks are more likely to approve loan applications from low-geared businesses
An unwillingness to access loan capital may indicate a risk-averse business which may deter
investors
Steps to increase the gearing
A low-geared business may take steps to increase its ratio by

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Buying back ordinary shares to reduce share capital in relation to borrowing

Issue more preference shares with limited loss of control Your notes
Obtain more loans

Worked Example
Catseye Pressings Ltd is considering making an application for a long-term loan to purchase a new
storage facility.
The table shows extracts from its balance sheet.

Non-current Assets £16.40m

Current Assets £3.62m

Current Liabilities £2.18m

Non-current Liabilities £5.75m

Calculate Catseye Pressings Ltd's gearing ratio and advise whether an application for a loan is likely
to be approved on this basis. (5 marks)
Step 1: Calculate the capital employed

Capital employed = Total assets − current liabilities

Capital employed = ( £ 16 . 40 m + £ 3. 62 m ) − £ 2. 18 m (1 mark)

Capital employed = £ 17 . 84 m

Step 2: Apply the formula to calculate gearing

Non Current Liabilities

Gearing Ratio = x 100
Capital Employed

£ 5. 75 m (2 marks)
Gearing Ratio = x 100
£ 17 . 84 m

Gearing Ratio = 32 . 23 %

Step 3: Identify whether the loan application is likely to be approved

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The loan application is likely to be approved (1 mark) as Catseye Pressings Ltd is a low-geared
business and thus a relatively low-risk (1 mark) to lenders.
Your notes
Interpreting Return on Capital Employed (RoCE)
RoCE measures how well a business generates profit from the funds invested in the business
The rate differs between industries so comparison across sectors is not recommended
However, it can be compared with other forms of return, such as interest rates on savings and with
other businesses within the same industry
RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to
determine the most profitable option given the level of capital employed
With RoCE the higher the rate, the better, as it indicates that the business is profitable and using its
capital efficiently
Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth
is being achieved
A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial
position
To increase the RoCE level a business can
increase the level of profit generated without introducing new capital into the business
maintain the level of profit generated whilst reducing the amount of capital in the business

Worked Example
Faced with increasing costs Kent & Medway Properties Ltd is looking to close one of its three high
street estate agency branches.
The table below shows some key data for each of the branches.

Branch Capital Employed Operating Profit

Sevenoaks £2.4m £0.37m

Whitstable £3.1m £0.57m

Rochester £2.9m £0.51m

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Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on
profitability terms, should close. (5 marks)
Your notes
Step 1: Apply the formula to calculate the RoCE for each branch

Operating Profit
Return on Capital Employed = × 100
Capital Employed

£ 0. 37 m
Return on Capital Employed Sevenoaks = × 100 = 15 . 42 % ( 1 mark )

£ 2. 4m

£ 0. 57 m
Return on Capital Employed Whitstable = × 100 = 18 . 39 % ( 1 mark )

£ 3. 1m

£ 0. 51 m
Return on Capital Employed Rochester = × 100 = 17 . 59 % ( 1 mark )

£ 2. 9m

Step 2: Identify the least profitable branch for closure

Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected
for closure. (2 marks)

Examiner Tips and Tricks

When calculating financial ratios, check that you are using the correct units.
In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases you will be
working in thousands (£000) or millions (£m).
Ensure that you convert correctly, e.g. £0.39m is equal to £390,000 and £34.9 (000) is equal to
£34,900
Make sure the decimal place is in the correct place
Calculate to two decimal places unless stated otherwise

The Limitations of Ratio Analysis

There are some drawbacks of using ratio analysis which businesses need to be aware of
The Limitations of Ratio Analysis

Limitation Explanation

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Making It is important to compare like for like

Comparisons
Over time, the nature of a business can change, affecting the desired level of Your notes
ratio
E.g. a business may diversify into a less competitive industry where higher
levels of RoCE may be expected
Comparisons between firms are only meaningful where significant similarities
exist (e.g. same industry, similar size, comparable products)
E.g. a high street jewellery business will have very different working capital
needs to those of a fast food outlet and their profit margins will differ

Quality of Accounts may have been legally window dressed (manipulated) to present a
Accounts particular financial picture.
Examples of this include
Bad debts can be written off
Property can be revalued
Income and costs may be reported during an earlier or later reporting
period (e.g. payments to suppliers may be delayed to maximise the level of
current assets
Window dressing will have an impact on the quality of ratio analysis calculations

Balance Sheet As a 'snapshot' of a businesses assets, liabilities and capital at a specific point
Limitations of time the balance sheet may not be representative of its usual
circumstances
E.g. a balance sheet may be completed one day before a business sells a
large amount of stock or buys a new property, rendering current and non-
current assets figures invalid almost immediately

Qualitative As ratios only use numerical data from a businesses accounts key qualitative
Information factors that affect its performance are ignored
E.g. the collapse of a competitor may lead to increased sales revenue and
profit
Increased profit increases the RoCE without any strategic decisions being
made

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Despite these limitations, ratio analysis is used by a wide range of internal and external analysts to
assess the performance of companies
Your notes
Venture capitalists and other investors use ratios to support their analysis when they consider
investing in or lending to businesses
Banks and insurance providers will use ratios to determine the level of risk a business presents and
determine the products to which it may be suited
Investment analysts and journalists make use of ratio analysis to report to clients and the media in
easy-to-digest terms

Examiner Tips and Tricks

Calculating ratios is straightforward - the real skill is in the interpretation of results and making
recommendations.
If a business is highly-geared, further borrowing is likely to be neither attractive nor possible in most
cases. That's quite a simple analytical point.
However, it may be possible to further develop this analysis
For example, in a time of very low interest rates, maximising borrowing to take advantage of cheap
finance may be preferable to diluting the control of existing shareholders by issuing further share
capital. Now you have evaluation because you've considered both sides of the argument.
If you find evidence in the case study that indicates that shareholders would be unhappy with this
dilution of control then you have a balanced, applied piece of evaluation.

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Human Resources
Your notes
An Introduction to Human Resources
In common with all resources a businesses employees - its human resources - need to be managed
Staff costs can make up a large proportion of a businesses costs so objective monitoring of
employee performance is a key element of effective financial and operational control
Businesses commonly monitor the following human resources metrics
Labour productivity
Labour turnover
Labour retention
Absenteeism

Labour Productivity
Labour productivity is a measure of output per employee
It is calculated using the formula

Total Output
Labour Productivity =
Average number of employees

Figures used in this formula are for a specific time period (e.g. a week, month or year)
Businesses aim to increase the level of labour productivity to improve competitiveness

Higher labour productivity improves businesses competitiveness

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Your notes
Worked Example
Last year Marinka Homewares made 424,000 lava lamps with a production workforce of 350
employees. This year it forecasts that 480,000 lava lamps will be made with a production workforce
of 365 employees.
Calculate the percentage increase in annual labour productivity per worker between last year and
this year's forecast. (4 marks)
Step 1: Apply the labour productivity formula to calculate the labour productivity for both years

Total Output
Labour roductivity =
Average number of employees

424 ,000
Labour Productivity last year =
350
= 1,211 units per employee ( 1 mark )

480 ,000
Labour Productivity last year =
365
= 1,315 units per employee ( 1 mark )

Step 2: Calculate the percentage increase between last year and this year

( new value − old value )

Percentage change = x 100
old value

( 1,315 − 1,211 )
Percentage change = x 100 ( 1 mark )

1,211

104
Percentage change = x 100 = 8. 59 % ( 1 mark )

1,211

Labour Turnover and Retention

Labour turnover measures the proportion of employees leaving a business during a specific time
period
It is expressed as a percentage and is calculated using the formula

Number of Staff Leaving

Labour Turnover = × 100
Average Number of Staff

A rising rate of labour turnover can signal internal human resource management problems such as

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Poor management leading to workers losing commitment

A poor recruitment and selection approach leading to staff leaving soon after starting their job Your notes
Low wage levels compared to those that could be earned elsewhere
External factors can also increase labour turnover in a business
A buoyant local economy where workers are attracted to employment opportunities elsewhere
Improved transport links that provide an opportunity for workers to seek work across a wider
geographical area
The Consequences of high Labour Turnover

Problems Opportunities

Increased recruitment and selection Workers with existing skills can be recruited to reduce
costs the need for training
Increased induction and training New ideas and creativity introduced to the business
costs
New perspective and approaches to problem-solving
Lower productivity levels as workers can improve business performance
settle into new roles

Worked Example
In 2022 Domus Construction Ltd employed an average of 7,200 workers, six per cent of whom
worked at the head office.
During 2022 fifty-four head office employees left the business.
Calculate the labour turnover of Domus Construction's head office in 2022. (3 marks)
Step 1: Calculate the number of head office workers
0.06 x 7,200 = 432 workers (1 mark)
Step 2: Apply the labour turnover formula

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Number of Staff Leaving

Labour Turnover = × 100
Average Number of Staff
Your notes
54
Labour Turnover =
432
= 0. 125 × 100 = 12 . 5 % ( 2 marks )

Labour Retention
Labour retention measures the proportion of employees remaining with a business during a specific
time period
It is expressed as a percentage and is calculated using the formula

Number of Staff Remaining

Labour Retention = × 100
Average Number of Staff

A high level of labour retention means that few staff are leaving the business during a given period

Worked Example
In 2022 the University of West Surrey employed an average of 4,240 employees, 265 of whom left
the university during the year.
Calculate the University of West Surrey's staff retention rate in 2022. (2 marks)
Step 1: Calculate the number of employees not leaving
4,240 - 265 = 3,975 (1 mark)
Step 2: Calculate the retention rate using the formula

Number of Staff Remaining

Labour Retention = × 100
Average Number of Staff
(1 mark)
3,975
Labour Retention = = 0. 9375 × 100 = 93 . 75 %
4,240

Absenteeism
The absenteeism rate is a measure of the proportion of staff were absent from work during a specific
period of time (e.g. a day, week or month)
It is expressed as a percentage and is calculated using the formula

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Number of staff absent

Absenteeism rate = × 100
Number of staff employed
Your notes
High levels of absenteeism can cause several problems for a business, including
Absence due to illness requires sick pay to be paid
Hiring temporary staff to cover for those absent increases costs
Output is likely to be temporarily reduced if staff are key to production process
Other staff may become demotivated if they have to constantly cover for absent workers
A wider culture of absenteeism may develop

Worked Example
On January 16th twenty-two of Belling Stoneworks Ltd's 189 employees were absent.
Calculate Belling Stoneworks Limited's absenteeism rate on January 16th. (2 marks)
Step 1: Substitute the values into the formula

Number of staff absent

Absenteeism rate = × 100
Number of staff employed

22
Absenteeism rate =
189
× 100 ( 1 mark )

22
Absenteeism rate =
189
× 100 ( 1 mark )

Human Resources Strategies to Improve Employee

Performance
Raising the labour productivity rate as well as reducing staff turnover and absenteeism rates are key
human resource management objectives
Increased labour productivity will lower the labour cost per unit and contribute to improved
competitiveness
More output will be produced so there is more output to sell - potentially increasing revenue

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Money is saved on recruitment, selection and training costs and a positive group spirit may
emerge
Strategies to Improve Employee Performance Your notes

Strategy Explanation

Offering financial rewards Examples of financial rewards include

Increased pay rates
Profit share schemes
Bonuses and Commissions
Performance-related pay
Attendance rewards
Loyalty bonuses
Paying workers more or sharing profits may increase commitment
and effort, leading to higher output and productivity
If financial rewards are greater than those of other employers, staff
are less likely to want to leave
Bonuses and commissions are only paid when they have been earned
or if targets have been met
Attendance and loyalty rewards may improve the intrinsic motivation
of workers as they feel valued

Offering employees Rewarding senior executives and managers with shares may increase
shares in the company their commitment to achieving objectives
Employees who own shares in the business may work harder and take
less time off as they have a financial stake in the success of the
business

Consultation Consultation involves managers obtaining the views of employees

when making decisions
Workers are likely to feel more involved within the business and may
be less likely to take days off work or leave the business

Empowerment Empowerment involves providing employees with autonomy and

responsibility to make their own decisions and work on their own

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behalf
Employee are encouraged to make use of their own knowledge and
experience and develop their own solutions Your notes
Workers must be properly trained and equipped with the necessary
resources to be properly empowered
Leaders need to be prepared to hand over authority and focus on
providing encouragement praise and feedback

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