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

Gearing measures how much of a firm's capital is financed by debt rather than equity (1); high gearing means the firm relies heavily on borrowing and carries greater financial risk (1).

Comparing a firm's ratios with a competitor's lets managers judge relative performance rather than absolute figures. For example, a 10% ROCE might seem strong, but if a rival achieves 15% it shows the firm is using its capital less efficiently than the competition. This is useful because it highlights areas where the firm is falling behind, helping it target improvements and set realistic benchmarks.

The first effect is on the gearing ratio. Borrowing increases debt relative to equity, so gearing rises. This means the company relies more heavily on borrowed funds, increasing its financial risk: if profits fall or interest rates rise, the fixed interest still has to be paid, which could threaten the firm in a downturn.

The second effect is on profitability ratios. Loan interest is a finance cost that reduces net profit, so the net profit margin and ROCE may fall in the short term. Until the investment funded by the debt starts generating extra profit, the firm looks less profitable on paper.

Choosing debt over equity therefore raises gearing and squeezes profitability now, but it avoids diluting existing shareholders' ownership — a trade-off the company must weigh against the stability of its profits.

Every strategy works through the accounts, so it leaves a mark on the ratios — which is why managers use ratios both to plan strategy and to monitor whether it is working.

A cost-cutting or efficiency strategy lowers costs, so it tends to raise the net profit margin and ROCE. If the cuts also reduce capital employed (for example by outsourcing and shedding fixed assets), ROCE can rise further, though quality could suffer if cuts go too far.

A growth strategy has more mixed effects. Expansion ties up cash in extra stock, equipment and debtors before sales are collected, so the current ratio can fall and the firm risks overtrading. Margins may dip while new capacity is paid for, then improve later through economies of scale. If the growth is debt-funded, gearing rises too.

A financing strategy is decisive for gearing: raising debt increases gearing and interest costs, while issuing equity lowers gearing but dilutes ownership. A dividend strategy shifts the dividend ratios — a higher payout lifts yield but cuts cover and retained profit.

Therefore ratios are a sensitive indicator of strategy: managers can predict the likely ratio effects before acting, and track the actual results afterwards to judge success. However, because the figures are historical, the ratios confirm the impact only after time has passed.

Ratio analysis has clear value for strategic decisions. It turns raw figures into meaningful comparisons — profitability, liquidity, gearing and efficiency — and lets managers see the firm's performance over time and against competitors. This gives a major decision (such as expansion or a change in financing) a rigorous, evidence-based foundation, helps set measurable targets, and lets managers predict the likely ratio effects of a strategy and monitor whether it is delivering. For a decision that turns on financial questions — can we afford this, is gearing safe, are we more profitable than rivals? — ratio analysis is exactly the right tool.

However, relying mainly on ratio analysis is risky. The ratios are based on published accounts that are historical, so they describe the past and may mislead about a fast-changing future. Figures can be window-dressed, and the ratios ignore all qualitative factors — brand strength, staff morale, customer loyalty, management quality and the external (PEST) environment — which often determine whether a strategy succeeds. Inter-firm comparisons can be unfair because firms use different accounting policies and operate in different contexts, and a single ratio read in isolation can mislead (a high current ratio may mean strong liquidity or idle cash). A decision driven purely by the numbers could look sound on paper yet fail in the market.

Judgement (criterion). How far the firm should rely on ratio analysis depends on how financial the decision is and how stable the environment is. For a decision that is essentially about finance, in a stable market, ratio analysis is the most important input. For a decision that depends on market trends, brand or competition, the ratios are necessary but not sufficient and qualitative analysis matters more. On balance, the business should use ratio analysis as the quantitative backbone of its decision — but interpret each ratio in context, read the ratios together, and combine them with qualitative judgement, rather than relying on them alone. Ratios are best treated as prompts for further investigation, not as final verdicts.

A financing strategy — choosing between debt and equity, and how much profit to distribute — has a direct, visible impact on the ratios, especially gearing, profitability and the dividend ratios. It is therefore tempting to judge the strategy mainly by these effects, but how far that is wise depends on the firm's situation.

The case for judging by ratio impact. The ratios capture the financial consequences of the decision precisely. Raising debt increases gearing and interest costs and so raises financial risk; issuing equity lowers gearing but dilutes ownership; a generous dividend lifts yield but cuts cover and retained profit. Because these effects determine the firm's risk, return and capacity to reinvest, monitoring them is essential — a firm that ignores its rising gearing could over-borrow and fail in a downturn. Ratios also let the firm benchmark its financing against rivals and over time, giving an objective basis for the decision and a way to track its results.

The case against judging mainly by ratio impact. First, the ratios are historical and quantitative: they show the past effect of financing, not whether the strategy will suit the firm's future needs. Second, the 'right' level of gearing depends on qualitative judgement the ratios cannot supply — chiefly the stability of profits: a firm with steady cash flows can safely carry high gearing that would be dangerous for a volatile one. Third, financing decisions must serve the wider strategy: debt may be the right choice to fund a high-return expansion even though it worsens gearing in the short term, so a strategy that simply 'keeps the ratios looking good' could starve the firm of growth. Fourth, stakeholder reactions — shareholders' attitude to dilution and risk, lenders' willingness to lend — matter beyond what the ratios show. Judging the strategy only by its ratio impact would miss these.

Weighing it up (criterion). The importance of ratio impact depends on how risk-sensitive the firm is and how its profits behave. For a firm with volatile profits or already-high gearing, the ratio impact (especially on gearing and interest cover) is critical and should weigh heavily, because the danger of financial distress is real. For a firm with stable profits pursuing a strong growth opportunity, the ratio impact matters less than whether the financing supports the strategy, and a temporary worsening of gearing may be acceptable.

Judgement. Ratio impact is an essential consideration in judging a financing strategy — gearing, profitability and dividend ratios reveal the risk and return the firm is taking on, and ignoring them can be fatal. But it should not be the main basis in every case: the strategy must ultimately be judged by whether it provides the right finance for the firm's objectives at an acceptable level of risk, given the stability of its profits and the views of its stakeholders. The most defensible conclusion is that the ratios should be a key constraint and monitor on the financing strategy — heavily weighted where profits are volatile or gearing is high — but the strategy is best judged by how well it serves the firm's wider plans, not by the ratios alone.