Finance and accounting strategy

Business A2 · Finance and accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

Test this topic free All Business A2 topics

The idea

Accounting data is used to choose and to check strategy. The annual report contains the financial statements, notes to the accounts, the directors' and chairman's reports and the auditors' report. Each stakeholder reads it for a different reason: lenders look at gearing and liquidity, suppliers at liquidity, shareholders at profit and dividends.

Ratios are compared over time and against competitors, and every strategy changes them. A new loan raises gearing; a share issue lowers it. Growth financed before it earns profit lowers ROCE and earnings per share at first. A lower dividend cuts dividend yield but raises dividend cover.

Ratios have limits. They use past figures, firms use different accounting methods, and window dressing can flatter the accounts.

Rules to remember

Debt finance (a long-term loan) raises non-current liabilities and capital employed, so gearing rises.
Equity finance (a share issue) raises capital employed only, so gearing falls; more shares also lower earnings per share until profit grows.
earnings per share = profit for the year ÷ number of issued shares
A lower dividend: dividend yield falls, dividend cover rises and retained earnings (reserves) rise.
The auditors' report gives an independent opinion on whether the accounts give a true and fair view.
A ratio has meaning only when compared with earlier years, with similar firms or with a target.
Limitations of ratios: historical data, different accounting policies, window dressing, inflation, and no qualitative information.

Common mistake

Students add a new loan to non-current liabilities but forget to add it to capital employed as well. Both the top and the bottom of the gearing ratio change.

Worked example

A company has profit from operations of $1.6m, capital employed of $8m and non-current liabilities of $2m. It needs $2m for a new factory that will earn no profit this year. Compare a long-term loan with a share issue.

Now: gearing = 2 ÷ 8 × 100 = 25% and ROCE = 1.6 ÷ 8 × 100 = 20%.
Either way capital employed becomes 8 + 2 = $10m, so ROCE = 1.6 ÷ 10 × 100 = 16%.
With a loan: non-current liabilities = 2 + 2 = $4m, so gearing = 4 ÷ 10 × 100 = 40%.
With a share issue: non-current liabilities stay at $2m, so gearing = 2 ÷ 10 × 100 = 20%.

Answer: ROCE falls to 16% in both cases; gearing rises to 40% with the loan but falls to 20% with the share issue.

Ask about this

Type what you are stuck on. The helper finds the explanation, worked examples and the notes to read, free and instant.

Keep going

← Investment appraisal Take a Business A2 test