The use of accounting data and ratio analysis in strategic decision-making — practice questions

Liquidity: Current ratio falling toward 1.1 — tightening short-term position; investigate before aggressive expansion.

Profitability: GPM down 4pp — rising costs or price pressure; strategy must address cost control or repositioning.

Gearing: Sharp rise to 52% — more debt-funded growth; interest cover should be checked; vulnerable if profits slip.

Efficiency: Inventory days up — cash tied in stock; links to weaker liquidity.

Priority: Working capital improvement (inventory reduction, receivables collection) and halt further debt-funded expansion until margins and liquidity stabilise. Longer term: cost reduction or premium pricing to restore GPM.

Step 1: Calculate Capital Employed (Before) Formula: Capital Employed = Shareholder Funds + Non-current Liabilities Calculation: $60m +$40m = $100m$

Step 2: Calculate Ratios (Before)

• ROCE: (Operating Profit / Capital Employed) x 100 = ($20m /$100m) x 100 = 20%
• Gearing: (Non-current Liabilities / Capital Employed) x 100 = ($40m /$100m) x 100 = 40%

Step 3: Calculate Post-Investment Figures

• New Operating Profit: $20m +$12m = $32m$
• New Shareholder Funds: $60m +$20m (from retained profits) = $80m$
• New Non-current Liabilities: $40m +$30m (new loan) = $70m$
• New Capital Employed: $80m +$70m = $150m$

Step 4: Calculate Ratios (After)

• ROCE: ($32m /$150m) x 100 = 21.3%
• Gearing: ($70m /$150m) x 100 = 46.7%

Step 5: Strategic Advice

• Analysis: The investment is projected to increase ROCE from 20% to 21.3%, indicating it is a value-creating project that improves overall profitability relative to the capital base. However, the gearing ratio will rise from a moderate 40% to a slightly more risky 46.7%.
• Recommendation: The board should proceed with the investment. The improvement in ROCE suggests the strategy is financially sound and will enhance shareholder value. The increase in gearing is manageable and an acceptable trade-off for the higher returns. Further analysis of the projected impact on the interest cover ratio is recommended to fully assess the affordability of the new debt.