3.5 - Assessing competitiveness

Question 1

Give and describe the gearing ratio

Answer 1

Non-current Liabilities / Capital Employed x 100

Capital employed = total assets - current liabilities
Capital Employed = Shareholders’ equity + Non-Current Liabilities
Capital Employed = Total equity + Non-Current Liabilities
Capital employed = Share capital + retained profit + non-current liabilities

• Shows how much investment in a business if financed by long term borrowing (non-current liabilities)
• Shows the long-term financial structure of the business

Ideally around 15 - 30% - suggests to investors business can be trusted to borrow and repay. Utilising oppotunities to fund growth (gain 1MA before market saturation)

Question 2

Give the formula for Return on Capital Employed and briefly explain

Answer 2

Operating profit / Capital employed x 100

Capital employed = total assets - current liabilities
* Higher = better

• 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

Question 3

Breifly describe methods of increasing the gearing rate

Answer 3

Gearing ratio = Non-current liabilities / capital employed x 100
Capital employed = Share capital + retained earnings + long-term liabilities
Increase non-current liabilities or decrease capital employed:

• Buying back ordinary shares to reduce share capital in relation to borrowing
• Issue more preference shares with limited loss of control
• Obtain more loans

Question 4

Briefly describe methods of reducing the gearing rate

Answer 4

A highly-geared business may take steps to lower its ratio by:

Decrease long term borrowing

• Repaying loans to lower interest costs for the business

Increase equity
* Retaining more profits to avoid further borrowing
* Increase profits, sell assets (raise internal finance)
* Issuing more ordinary shares to create further share capital

Question 5

Describe a highly geared business

Answer 5

Highly geared business (Greater than 50%)
* In a highly-geared business more than 50 per cent of its capital employed are long-term loans - high non-current liabilities
* 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 - likely to face difficulties in raising further loan capital

Low geared business
* A low-geared business has less than 50 per cent of its capital employed as long-term loans

Question 6

Describe a low geared business

Answer 6

Low geared business
* A low-geared business has less than 50 per cent of its capital employed as long-term loans - non-current liabilities
* The business may be missing out on the opportunity to access finance without the need to raise share capital and dilute existing shareholders’ control (if PLC?)
* 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 - may be missing out on funding growth to gain 1MA
* Low-greared business may use more retained profit to fund capital employed and thus pay less to shareholders, potentially making it harder to raise share capital in future

Question 7

Describe how to interpret Return on Capital Employed (RoCE)

Answer 7

Interpreting Return on Capital Employed (RoCE)
* RoCE measures how well a business generates profit from the funds invested in the business
* 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
* 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, previous years RoCE, RoCE of close competition
* 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

To increase the RoCE level a business can
* increase the level of profit generated without introducing new capital into the business - increase efficiency
* maintain the level of profit generated whilst reducing the amount of capital in the business

Question 8

What is capital employed (give formula)?

Answer 8

The total amount of capital invested in a business to operate
* Capital employed = Share capital + Retained Earnings + non-current liabilities
Note that non-curent liabilities may appear negative on balance sheet, but should be treated as positive in calculation

• Capital employed = Total equity + non-current liabilities
• Capital emplpoyed = net assets + non-current liabilities
• Total equity or shareholders equity = total assets - total liabilities
• Capital employed = total assets - current liabilities
• Capital employed = total equity - current liabilities
• Capital Employed = Shareholders’ Equity + Non-Current Liabilities

Question 9

What is meant by shareholders equity?

Answer 9

• Shareholder equity (SE) is a company’s net assets and it is equal to the total monetaty amount that would be returned to the shareholders if the company must be liquidated and all its debts are paid off.
• total assets - total liabilities

Question 10

Labour Productivity formula

Answer 10

Total output / no. of workers

Question 11

Labour turnover formula

Answer 11

Within a set time period:

number of employees leaving / average number of employees X 100

Question 12

Absenteeism formula

Answer 12

Within a set time period:

Number of work days lost through absence / total possible days worked X 100