the impact of other business strategies on ratio results

10.4 Finance and Accounting Strategy – Accounting Data and Ratios

Objective

To understand how the choice and implementation of other business strategies (marketing, operations, HR, R&D, finance, CSR, etc.) affect the results of key financial ratios, and how accounting data are used to make strategic decisions in line with the Cambridge IGCSE/A‑Level syllabus 10.4.1 & 10.4.2.

1. Why Ratios Matter

• Ratios translate raw accounting figures into concise indicators of profitability, liquidity, efficiency, solvency and market perception.
• They are used by managers, investors, creditors and other stakeholders to assess the health of a business and to evaluate the impact of strategic choices.
• Ratios also help link day‑to‑day operational decisions to the wider corporate objectives (financial performance, sustainability, stakeholder value).

2. Core Ratio Categories

Category	What it measures	Typical strategic use
Profitability Ratios	Ability to generate profit from sales or assets.	Pricing, product‑mix, cost‑control, R&D investment decisions.
Liquidity Ratios	Short‑term ability to meet obligations.	Working‑capital policies, credit terms, cash‑management.
Efficiency (Activity) Ratios	How effectively resources are used.	Inventory management, production methods, supply‑chain design.
Solvency (Gearing) Ratios	Long‑term financial stability and capital structure.	Financing choices, dividend policy, capital‑intensive projects.
Market Ratios	Investor expectations and share performance.	Share buy‑backs, equity issuance, earnings growth strategies.

3. Strategic Decision‑Making Process (10.4.1)

The syllabus expects a clear, cyclical process that links accounting data to strategic choices. The steps below incorporate corporate objectives, benchmarking, target‑setting and monitoring.

1. Define the strategic issue and corporate objectives – e.g. “increase market share while maintaining a sustainable carbon footprint”.
2. Select the most relevant ratios – choose ratios that directly reflect the issue (e.g. Gross Profit Margin for pricing, Current Ratio for cash‑flow risk, Debt‑to‑Equity for sustainability‑linked financing).
3. Benchmark the ratios
   • Internal trend analysis – compare with the firm’s own figures for the past 3‑5 years.
   • Industry averages – use published sector data or competitor reports.
   • Ratio‑trend techniques – calculate year‑on‑year % change, moving averages or compound annual growth rates (CAGR) to smooth out seasonality.
4. Set SMART ratio targets (Specific, Measurable, Achievable, Relevant, Time‑bound). Example: “Raise Gross Profit Margin from 38 % to 42 % within 24 months while keeping the Debt‑to‑Equity ratio below 0.6”.
5. Generate and evaluate strategic options – use the impact of each option on the chosen ratios (e.g. new pricing policy, lean production, debt financing).
6. Implement the chosen strategy – record the resulting transactions in the accounting system.
7. Monitor and review – recalculate ratios each reporting period, compare with targets and benchmarks, and adjust the strategy as required.

4. Key Ratios, Formulas and Strategic Influences

Ratio	Formula	Strategic Areas That Influence the Ratio
Gross Profit Margin (GPM)	$$\text{GPM}= \frac{\text{Gross Profit}}{\text{Revenue}}\times100$$	Pricing strategy (premium vs. discount) Product‑mix decisions Supplier negotiations & cost of goods sold
Net Profit Margin (NPM)	$$\text{NPM}= \frac{\text{Net Profit}}{\text{Revenue}}\times100$$	Cost‑control programmes (lean, automation) Marketing spend vs. sales lift R&D investment and future product profitability
Current Ratio (CR)	$$\text{CR}= \frac{\text{Current Assets}}{\text{Current Liabilities}}$$	Inventory policies (stock levels, JIT) Credit policy & receivables collection Cash‑management and short‑term financing
Quick (Acid‑Test) Ratio (QR)	$$\text{QR}= \frac{\text{Cash}+\text{Marketable Securities}+\text{Receivables}}{\text{Current Liabilities}}$$	Inventory reduction programmes Just‑in‑time production Customer credit terms & factoring arrangements
Inventory Turnover (IT)	$$\text{IT}= \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$$	Product‑lifecycle management Supply‑chain responsiveness Promotional campaigns that create demand spikes
Receivables Collection Period (RCP)	$$\text{RCP}= \frac{\text{Average Receivables}}{\text{Revenue}}\times365$$	Credit‑terms policy CRM effectiveness and early‑payment discounts Use of factoring or invoice‑finance
Debt‑to‑Equity Ratio (DER)	$$\text{DER}= \frac{\text{Total Debt}}{\text{Total Equity}}$$	Financing strategy (debt vs. equity) Dividend policy (retained earnings affect equity) Capital‑intensive expansion projects
Return on Capital Employed (ROCE)	$$\text{ROCE}= \frac{\text{Operating Profit}}{\text{Capital Employed}}\times100$$	Asset utilisation (capacity, automation) Strategic acquisitions or divestments Cost‑reduction programmes that raise operating profit
Earnings per Share (EPS)	$$\text{EPS}= \frac{\text{Net Profit}-\text{Dividends on Preference Shares}}{\text{Weighted Average Shares Outstanding}}$$	Share buy‑back programmes (reduce share count) Growth strategy (revenue expansion vs. share dilution) Dividend policy (retained earnings vs. payouts)

5. How Specific Business Strategies Shift Ratio Outcomes

1. Marketing Strategy
   • Higher advertising spend can boost revenue → improves GPM & NPM, but if financed by short‑term borrowing it may lower the Current Ratio.
   • Premium‑segment focus raises average selling price → lifts GPM and NPM.
   • Promotional discounts increase sales volume but may compress margins if not matched by cost reductions.
2. Operations / Production Strategy
   • Lean manufacturing reduces inventory → higher Inventory Turnover, higher Quick Ratio.
   • Automation adds depreciation expense → may reduce NPM in the short term but improves ROCE through higher operating profit.
   • Out‑sourcing non‑core activities can lower operating costs (NPM ↑) but increase reliance on suppliers (potential impact on liquidity).
3. Human Resources Strategy
   • Training and skill development raise productivity → higher Operating Profit → higher ROCE.
   • Higher wages increase operating costs → pressure on NPM unless offset by higher output or price premiums.
   • Performance‑related pay links employee incentives to profit targets, reinforcing profitability ratios.
4. Research & Development Strategy
   • Capitalising qualifying R&D costs increases the asset base → raises Capital Employed, potentially lowering ROCE unless the project generates proportionally higher operating profit.
   • Successful innovation lifts revenue and GPM, improving NPM and EPS.
   • Long‑term R&D projects may depress short‑term profitability, a factor to consider when setting ratio targets.
5. Financial Strategy
   • Debt financing for expansion raises DER but can improve ROCE if the borrowed funds generate returns above the cost of debt.
   • Dividend policy directly affects retained earnings → equity level → DER and solvency ratios.
   • Share buy‑backs reduce the number of shares outstanding → EPS rises, potentially boosting market ratios.
6. Corporate‑Social‑Responsibility / Sustainability Strategy
   • Investment in green technology may increase capital expenditure (lower short‑term liquidity) but improve long‑term ROCE and brand‑related market ratios.
   • Ethical sourcing can raise COGS → lower GPM, yet may enhance brand value and justify a premium price.

6. Ratio Trend & Benchmarking Techniques

• Internal trend analysis – calculate year‑on‑year % change or CAGR for each ratio over the last 3‑5 periods.
• Moving averages – smooth seasonal fluctuations (e.g., 3‑year moving average of the Current Ratio).
• Industry benchmarking – compare the firm’s ratios with published sector averages or key competitors.
• Variance analysis – express the difference between actual and target ratios as a % of the target.
• Ratio‑ratio analysis – examine the relationship between two ratios (e.g., ROCE vs. DER) to spot trade‑offs.

7. Setting and Reviewing Ratio Targets (SMART)

1. Specific – state exactly which ratio is to be improved and why (e.g., “increase Inventory Turnover to reduce holding costs”).
2. Measurable – define the numerical target (e.g., “from 4.2 to 5.5 turns per year”).
3. Achievable – ensure the target reflects realistic operational changes.
4. Relevant – link the target to corporate objectives such as profitability, sustainability or market share.
5. Time‑bound – set a clear deadline (e.g., “by the end of FY 2027”).

After each reporting period, compare actual results with the SMART target, analyse any variance and decide whether to maintain, modify or replace the underlying strategy.

8. Limitations and Qualitative Considerations (10.4.2)

9. Using the Annual Report (10.4.3)

The annual report is the primary source of the accounting data needed for ratio analysis. Key sections and their relevance are:

• Chair’s/MD’s Statement – outlines strategic direction and future objectives.
• Business Review (MD’s Report) – commentary on performance, market conditions and operational changes that explain ratio movements.
• Financial Statements – profit & loss account, balance sheet and cash‑flow statement provide the raw numbers.
• Notes to the Accounts – detail accounting policies, breakdown of line items, contingent liabilities – essential for adjusting ratios.
• Auditor’s Report – assurance on the reliability of the figures.
• CSR / Sustainability Report – qualitative information that can affect market perception and, indirectly, market ratios.

10. Worked Example

Company XYZ introduces a new pricing strategy that raises the average selling price by 8 % while keeping cost of goods sold unchanged.

Item	Before Strategy (£’000)	After Strategy (£’000)
Revenue	5,000	5,400
Cost of Goods Sold	3,000	3,000
Operating Expenses	1,200	1,260 (5 % increase due to higher marketing spend)
Net Profit	800	1,140

Calculate the change in Gross Profit Margin and Net Profit Margin.

Gross Profit Margin before:

$$\text{GPM}_{\text{before}} = \frac{5{,}000-3{,}000}{5{,}000}\times100 = 40\%$$

Gross Profit Margin after:

$$\text{GPM}_{\text{after}} = \frac{5{,}400-3{,}000}{5{,}400}\times100 \approx 44.44\%$$

Net Profit Margin before:

$$\text{NPM}_{\text{before}} = \frac{800}{5{,}000}\times100 = 16\%$$

Net Profit Margin after:

$$\text{NPM}_{\text{after}} = \frac{1{,}140}{5{,}400}\times100 \approx 21.11\%$$

Interpretation – The pricing change lifts both gross and net margins. The 5 % rise in marketing expense partially offsets the profit gain, illustrating the trade‑off between revenue‑driving strategies and cost control.

11. Checklist for Exam Answers (10.4.2)

• Read the question carefully – identify which ratio(s) are required and the strategic context.
• State the formula(s) clearly (use LaTeX if possible).
• Link each element of the numerator and denominator to a specific business strategy (e.g., “higher advertising spend appears in operating expenses, affecting Net Profit”).
• Explain the direction of impact (increase or decrease) and the underlying reason.
• Discuss any secondary effects (e.g., “higher debt improves ROCE but raises DER”).
• Reference benchmarking or target‑setting where relevant – show awareness of internal trends or industry averages.
• Conclude by tying the ratio change back to the company’s overall objectives (profitability, sustainability, market position, etc.).

12. Suggested Diagram

Flowchart illustrating how Marketing, Operations, HR, R&D, Financial and CSR strategies feed into specific ratios, which in turn inform strategic decision‑making, target‑setting and performance monitoring.