Actions to improve performance and position

Welcome to the "Fix-it" Chapter!

In your F2 studies, you have learned how to construct financial statements and analyze them using ratios. But in the real world, a Management Accountant’s role does not stop at stating that a margin is declining or gearing is rising. You are expected to answer the key question: "How do we fix it?"

This chapter focuses on the actions an entity can take to improve its financial performance (profitability and operating efficiency) and its financial position (liquidity, working capital, and capital structure). We will break down these business decisions into structured, practical steps.

1. Improving Profitability and Operating Performance

Profitability is commonly assessed through margins, such as Gross Profit Margin and Operating Profit Margin. Management has two primary levers to improve these metrics: Revenue and Costs.

A. Revenue Actions

To enhance revenue and gross margins, an entity can evaluate:
• Pricing Strategy: Increasing selling prices where product demand is price-inelastic. If demand is price-elastic, selective discounting or volume rebates may increase total revenue by significantly expanding sales volumes.
• Product Mix Rationalisation: Discontinuing or redesigning low-margin products and focusing marketing on high-margin offerings.
• Market Expansion: Entering new geographic markets or untapped customer segments to drive revenue scale.

B. Cost Management

Controlling costs directly protects profit margins without necessarily requiring higher sales:
• Cost of Sales Reductions: Renegotiating procurement contracts, finding alternative raw material sources without compromising quality, and reducing production scrap and waste.
• Operating Expense Control: Streamlining administrative functions, automating repetitive processes, and consolidating facility overheads.
• Caution on Cost-Cutting: Indiscriminate cost reduction (such as slashing maintenance, R&D, or customer service) harms operational capability and degrades long-term brand equity.

2. Managing Working Capital and Liquidity

An entity can be profitable yet still fail if it runs out of cash. Working capital management focuses on optimising the cash operating cycle across inventory, receivables, and payables.

A. Inventory Management

Excessive inventory ties up liquidity and increases holding costs and obsolescence risk.
• Action: Adopt Just-In-Time (JIT) production and lean inventory techniques to minimise buffer stocks.
• Action: Implement improved demand forecasting to prevent over-purchasing and eliminate slow-moving stock lines.

B. Receivables Management

Extended credit periods strain operating cash flows.
• Action: Offer early settlement discounts (e.g., 2% discount for payment within 10 days) where the cost of the discount is lower than short-term borrowing costs.
• Action: Tighten credit-granting procedures and enforce strict credit limits.
• Action: Consider invoice discounting or debt factoring to accelerate cash receipts.

C. Trade Payables Management

• Action: Negotiate extended credit terms with suppliers to preserve operating cash balances.
• Caution: Delaying supplier payments excessively risks losing supplier goodwill, sacrificing settlement discounts, and incurring penalties or interrupted supply.

3. Improving Asset Utilisation

Asset Turnover measures how efficiently an entity generates revenue from its capital employed. To improve asset turnover and Return on Capital Employed (ROCE), management must ensure assets work productively.

• Disposal of Surplus or Idle Assets: Selling underutilised plant, machinery, or redundant properties provides an immediate cash injection and reduces total capital employed (the denominator in ROCE).
• Outsourcing Non-Core Operations: Subcontracting capital-intensive manufacturing or logistics functions can reduce fixed asset investment.
• Improving Capacity Utilisation: Implementing preventative maintenance schedules and multi-shift operations increases output without requiring additional non-current asset expenditure.

4. Managing Gearing and Financial Position

Gearing evaluates the financial risk of an entity by comparing long-term debt to total capital structure. High gearing exposes the entity to interest rate volatility and mandatory debt service obligations.

Actions to Reduce Gearing and Strengthen Position:

• Equity Financing: Undertake a rights issue or public share offering to generate proceeds earmarked specifically for debt retirement.
• Retained Earnings: Adjust dividend policy to retain a greater portion of annual profits within the business to fund capital investments and amortise debt.
• Debt Restructuring: Replace short-term expensive borrowings with structured longer-term facilities, or issue convertible debt where lower initial coupon rates apply and eventual conversion replaces debt with equity.
• Balancing the Tax Shield: While lower debt reduces default risk, debt interest is tax-deductible (providing a tax shield). Management must balance bankruptcy risk against the lower post-tax cost of debt to achieve an optimal capital structure.

5. Using Predictive and Prescriptive Ratios to Drive Actions

Under the Gartner Data Analytics maturity model, management interpretation moves from merely describing the past to actively driving corrective actions:

• Descriptive & Diagnostic: Historical ratios identify what happened (e.g., gross margin fell by 4%) and why it happened (e.g., raw material costs increased).
• Predictive Ratios: Use forward-looking statistical and financial models to forecast what will happen. For example, predictive solvency models (such as the Altman Z-score) use combinations of working capital, retained earnings, profitability, and gearing ratios to forecast the likelihood of corporate distress or debt covenant breach over the next 12 to 24 months.
• Prescriptive Ratios: Specify what specific actions must be taken to achieve desired performance targets or avoid predicted outcomes. For instance, management models sensitivity scenarios: "To prevent our interest cover from falling below our banking covenant of 3.0x, operating profit must increase by 8%, requiring an immediate inventory reduction of \$500,000 and price increases of 2%."

6. Common Strategic Pitfalls

• Short-Termism: Artificially boosting current-year profits by cutting essential research and staff training undermines future market competitiveness.
• Quality Compromise: Aggressive cost-cutting on raw materials can lead to high product return rates, warranty claims, and customer attrition.
• Over-Reliance on Single Indicators: Improving a single balance sheet ratio in isolation (e.g., slashing inventory to boost asset turnover) can cause stock-outs that damage sales and operating margin.

7. Summary of Key Formulas for Context

Key ratios used to evaluate these actions include:
• Operating Profit Margin: \( \frac{\text{Operating Profit}}{\text{Revenue}} \times 100 \)
• Asset Turnover: \( \frac{\text{Revenue}}{\text{Capital Employed}} \)
• Receivables Days: \( \frac{\text{Trade Receivables}}{\text{Credit Sales}} \times 365 \)
• Financial Gearing: \( \frac{\text{Total Debt}}{\text{Total Equity} + \text{Total Debt}} \times 100 \)
• Interest Cover: \( \frac{\text{Operating Profit}}{\text{Finance Costs}} \)