© pearson education new zealand 2007 contents 1. profitability – formulas and explanations 2....

© Pearson Education New Zealand 2007

Contents1. Profitability – formulas and explanations2. Interpreting profitability3. Liquidity – formulas and explanations4. Interpreting liquidity5. Financial stability – formulas and explanations6. Interpreting financial stability7. Evaluating financial and non-financial information

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1 Profitability – formulas and explanations

NOTES

QUESTIONS

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Mark-up percentage

The mark-up percentage tells us how much the retailer adds onto the cost of the goods in order to determine the selling price.

Formula gross profit x 100

cost of goods sold 1

A mark-up percentage of 50% tells us that the retailer will add 50 percent to the value of the good in order to reach the

selling price. E.g. a good costing $1 will be sold for $1.50.


Gross profit percentage

The gross profit percentage tells us what proportion of each $1 of sales is received by the retailer as gross profit.

Formula gross profit x 100 (net) sales 1

A gross profit percent of 40% tells us that for every $1 of sales

the retailer will receive 40 cents in gross profit.


Expense percentage

The expense percentage tells us what proportion of each $1 of sales is paid on that particular expense.

Formulaexpenses group x 100

(net) sales 1

A Distribution expense percentage of 8% means that for every $1 of sales, 8 cents is paid on distribution expenses.

An Administrative expense percentage of 6% means that for every $1 of sales, 6 cents is paid on administration expenses.

A Finance cost percentage of 5% means that for every $1 of sales, 5 cents is paid on finance costs.


Net profit percentage

The net profit percentage tells us what proportion of each $1 of sales is received by the retailer as net profit.

Formulanet profit x 100

(net) sales 1

A net profit percent of 12% tells us that for every $1 of sales the

retailer will receive 12 cents in net profit.


Percentage change

Return to 1 Profitability

Percentage change shows us the trend in in dollar amounts from year to year.

FormulaYear 2 – Year 1 x 100 Year 1

A percentage change in selling expenses of 20% tells the retailer that their selling expenses have increased by 20% when

comparing one year to another.


Questions: Profitability

- Formulas and explanations Bathroom Supplies I ncome Statement (extract) f or the year ended 31 March 2XX1

Revenue Sales 150 000 Cost of Sales 50 000 Gross Profi t 100 000 Less Expenses Distribution Expenses 27 000 Administrative Expenses 24 000 Finance Costs 12 000 Total Expenses 63 000 Net Profi t 37 000 Using the I ncome Statement extract above, a) complete the f ollowing profi tability measures (answers to 2 decimal places) and b) provide an explanation f or each measure: 1) Mark-up 2) Gross profi t percentage 3) Distribution expense percentage 4) Administrative expense percentage 5) Finance costs percentage 6) Net profi t percentage


Answersa) Bathroom Supplies – Profitability measures

Profitability Percentage

Formula Answer

Mark-up % 200%

Gross profit % Gross profit x 100 Sales 1 66.67%

Distribution expense % Distribution expense x 100 Sales 1 18%

Administrative expense % Administrative expense x 100 Sales 1 16%

Finance cost % Finance cost x 100 Sales 1 8%

Net profit % Net profit x 100Sales 1 24.67%

Return to Interpreting Profitability Questions


Answers

Return to 1 Profitability

1) The mark-up percentage of 200% tells us that Bathroom Supplies will add 200 percent to the value of the good in order to reach the selling price. E.g. a good costing $1 will be sold for $3.00.

2) The gross profit percentage of 66.67% tells us that that for every $1 of sales, Bathroom Supplies will receive 67.67 cents in gross profit.

3) The distribution expense percentage of 18% tells us that that for every $1 of sales, Bathroom Supplies will pay 18 cents on distribution expenses.

4) The administrative expense percentage of 16% tells us that that for every $1 of sales, Bathroom Supplies will pay 16 cents on administrative expenses.

5) The finance cost percentage of 8% tells us that that for every $1 of sales, Bathroom Supplies will pay 8 cents on finance costs.

6) The net profit percentage of 24.67% tells us that that for every $1 of sales, Bathroom Supplies will receive 24.67 cents in net profit.

b)


2 Interpreting profitability

NOTES

QUESTIONS

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Interpreting mark-up percentagesAnalysis measurepercentage

Mark-up %

Satisfactory percentage / ratio

Should compare favorably to industry norms.

Cause of satisfactorypercentage / ratio

Good sales mix – combining low and high markup goods.

Unsatisfactorypercentage / ratio

A mark-up % is deemed unsatisfactory if it is not providing a sufficient gross profit to help meet all business expenses.

Cause of unsatisfactory percentage / ratio

Cost of goods increasing but not passing this on to the customers.Reducing mark-up to encourage more sales.A change in sale mix to lower markup products.

How to improve unsatisfactory percentages / ratios

Increase the mark-up % (within reason considering competitors).Improve the sale mix towards higher mark-up goods.


Interpreting gross profit percentagesAnalysis measurepercentage

Gross profit %


Providing sufficient gross profit to meet all of the business’s expenses.


Sourcing lower-priced goods leading to a favorable mark up percentage.


A gross profit % is deemed unsatisfactory if it is not providing a sufficient gross profit to help meet all business expenses.


The mark-up % is insufficient to produce a gross profit that allows the business to meet all business’s expenses.

How to improve unsatisfactory percentages /ratios

Improve the mark-up %.


Interpreting expense percentagesAnalysis measurepercentage

Expense %


The expense % should compare favorably to industry norms.


Maintaining good control over expenses.


If the expense % is increasing above industry norms OR any significant increase.

[continues]



Distribution1) Increased advertising2) Increase sales wages3) Hired new sales staffAdministrativeIncrease in rates, electricity usage, office stationery costs etc.Finance CostsRefinanced at a higher interest rate / took out a new loan.


Maintain better control over the expense %:Distribution1) Reduce advertising2) Don’t replace a staff member when they leave.AdministrativeIntroduce electricity saving measuresBuy less / lower quality office stationery etc.Finance Costs1) Refinance at a lower interest rate 2) Pay off the loan.


Interpreting net profit percentages

Return to 2 Interpreting Profitability

Analysis measurepercentage

Net profit %


Providing a sufficient return to the owner.


Favorable mark-up and gross profit %.


A net profit % that is declining when compared to previous years or is an insufficient reward / risk return for the investment.


1) Mark-up % is not helping to contribute an adequate gross profit. 2) Inadequate control over the expenses.


1) Improve the mark-up %.2) Decrease expense % by maintaining better control over expenses.


Questions:Interpreting profitability

The owner of the Bathrooms Supplies store was pleased to see that their Gross

Profit in 2XX1 increased by $10, 000 from last year. State one possible reason for

this increase.

In 2XX0 the Distribution expense percentage was 15%,the Administrative expense percentage was 17%,the Finance cost percentage was 9%.1) Describe the trend of each of the expense percentages.2) State ONE unfavorable trend.3) Explain two possible causes for this expense percentage trend.4) How would you improve this expense percentage trend?5) State two ways of reducing the Administrative and Finance costs

percentages.6) Give one possible reason for the net profit increasing from last year.

To help you answer these questions, click to see the answers to the

previous section


Answers

Return to 2 Interpreting profitability

Possible reasons for the increase in Gross Profit include:The mark-up percentage was increased from last year A supplier has been found who supplies lower-priced goods leading to a favorable mark-up percentage. 1) The Distribution expense is trending upwards.

The Administrative expense is trending downwards.The Finance cost is trending downwards.

2) The Distribution expense is an unfavourable trend.3) The Distribution expense may have increased due to increased advertising, increase sales wages or through the hiring of new sales staff.4) Two ways to improve the Distribution expense percentage would be to reduce advertising or not to replace a staff member when they leave.5) Two ways of reducing the Administrative expense percentage would be to introduce electricity saving measures, and to buy less / lower quality office stationery etc.

Two ways of reducing the Finance cost percentage would be to refinance at a lower interest rate or to pay off the loan6) A possible reason for the Net profit percentage increasing would be because there has been an increase in the mark-up percentage and / or there has been

better control over the Administrative and Finance cost expense percentages.


3 Liquidity – formulas and explanations

NOTES

QUESTIONS

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Liquidity: Current ratioLiquidity shows how much cash the business has on hand to meet their regular payments.Current ratio The current ratio shows the ability of the retailer to meet their debts in the next 12 months/ accounting period

Formula current ratio = current assets : current liabilities

The current ratio needs to be greater than 1:1. A current ratio of 1.30:1 tells us that for every $1 of current liabilities the retailer has $1.30 of current assets. This means that the retailer should be able to meet their debts during the next 12 months.


Liquidity: Liquid ratio

Return to 3 Liquidity

The liquid ratio shows the ability of the retailer to meet their immediate debts in the next 1–3 months.

Formula Liquid ratio = current assets – (inventory + prepayments) current liabilities – secured bank overdraft

Once again the liquid ratio needs to be greater than 1:1. A liquid ratio of 1.10:1 tells us that for every $1 of liquidliabilities the retailer has $1.10 of liquid assets. This meansthat the retailer should be able to meet their immediate debtswithin the next 1–3 months.


Questions: Liquidity

Musical Notes Balance Sheet as at 31 March 2XXX

Current Assets

Bank 8 000 Accounts Receivable 4 000 I nventory 40 000

Prepayment 3 000 55 000 Non- Current Assets Property, Plant and Equipment (Note)

Total Carrying Amount 190 000 I ntangible Assets Goodwill 10 000 Total Assets 255 000

Less Liabilities Current Liabilities Accounts Payable 8 500

GST Payable 6 500 Bank Overdraf t (Secured) 30 000 45 000 Non Current Liabilities

Mortgage 130 000 Total Liabilities 175 000 Net Assets $ 80 000

1) Using the Balance Sheet extract above, a) complete the f ollowing liquidity measures (round to the nearest cent) and b) provide an explanation f or each measure:

Current ratio Liquid ratio


Answers

1) a) Musical Notes – Liquidity measures

Liquidity ratio FormulaAnswer

Current ratio Current assets Current liabilities 1.22 : 1

Liquid ratio Current assets – Inventory + Prepayments Current liabilities – Secured overdraft 0.80 : 1

Return to Interpreting liquidity Question


Return to 3 Liquidity

i) A current ratio of 1.22:1 tells us that for every $1 of current liabilities, Musical Notes has $1.22 of current assets. This means that the retailer should be able to meet their debts within the next 12 months.

ii) A liquid ratio of 0.8:1 tells us that for every $1 of liquid liabilities, Musical Notes has $1.22 of liquid assets. This means that Musical Notes may not be able to meet their immediate debts within the next 1–3 months.

b)


4 Interpreting liquidity

NOTES

QUESTIONS

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Interpreting the current ratio

Analysis measurepercentage / ratio

Current ratio


Must be greater than 1:1.


1) Good credit control so low bad debts2) Good stock control.

Unsatisfactorypercentage ratio

Any ratio below 1:1 or above 2 :1.


1)High accounts receivable – problem of bad debts.2)Too much inventory – may become obsolete.Ratio above 2:11) Too much cash is being held in low interest earning accounts. 2) Surplus cash should be invested in higher yield term deposits.


1) Owner invests more capital in the form of cash.2) Decrease drawings.3) Borrow long term.


Interpreting the liquid ratio

Return to 4 Interpreting liquidity


Liquid ratio


Must be greater than 1:1


1) Good credit control so low bad debts2) Good stock control3) Limited drawings


Any ratio below 1:1


1) High accounts receivable – problem of bad debts.2) Too much inventory – may become obsolete.3) Decrease drawings


1) Improve credit control measures to reduce bad debts2) Owner invest more capital in the form of cash.3) Decrease drawings.4) Have a sale on obsolete stock to reduce stock levels


Question:Interpreting the liquid ratio

1) State three ways the owner of Musical Notes could improve their liquidity ratio and explain how these measures will impact on components of the liquidity ratio.

Go to previous section to get the data for this question


Answers

Return to 4 Interpreting liquidity

Ways the owner of Musical Notes can improve their liquidity are

1) to improve credit control measures to reduce bad debts. This means that Musical Notes are careful as to whom they allow to purchase on credit, thus giving them a greater chance of receiving all outstanding money. 2) Owner invests more capital in the form of cash. This increases the bank asset (or decreases the bank overdraft) thus improving the liquid ratio.3) Decrease drawings. This action will improve the bank balance and thus improve the liquid ratio.4) Have a sale on obsolete stock to reduce stock levels. This will raise the level of cash in the bank and thus improve the liquid ratio.


5 Financial stability – formulas and explanations

NOTES

QUESTIONS

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Financial stability

Financial stability shows how much of the business is owned by the owner and how much is owned by outsiders as well as the return the owner receives from running their business.


Equity ratio

The equity ratio shows how much of the business has been financed by the owner.

Formula

Equity ratio = Owners equity (closing) Total assets

An owner’s equity ratio of 0.65:1 tells us that for every $1 of assets, the owner has financed 65 cents. If this ratio falls below 0.5:1 this means that outside liabilities such as banks own a greater proportion of the business than the owner. This could have dire consequences for the owner of the business.


Return on owner’s equity

Return to 5 Financial stability

The return on owner’s equity measures the return on theowner’s investment in their business. The return on theowner’s investment must be sufficient to warrant the ownertaking the risk of investing in the business.

Formulareturn on owner’s equity = net profit x 100

average owner’s equity 1

In order to find the average owner’s equity, the opening capitalis added to the closing capital and then divided by 2.


Questions: Financial stability

The Coff ee Shop 2XX1 2XX2 $ $ Equity 55 000 70 000 Current Assets 20,000 25,000 Non-current Assets 80,000 100,000 Current Liabilities 7,000 11,000 Non-current Liabilities 60,000 40,000 Net Profi t 30 000 25 000 The Equity in 2XX0 was $65 000. Using the fi nancial inf ormation above, complete the f ollowing financial stability measures for 2XX1 and 2XX2 (to 2 decimal places), providing an explanation f or each measure: a) Equity ratio b) Return on average owner’s equity


Answers

a) The Coffee Shop – Financial stability measures

Financial Stability Ratio & Percentage

Formula Answer 2XX1

Answer 2XX2

Equity Ratio Equity (closing) Total assets 0.55:1 0.56:1

Return on average owner’s equity

____Net profit_____Average owner’s equity 32.43% 40%

Return to Interpreting financial stability

Questions


Return to 5 Financial stability

b)

1) In 2XX1 the owner’s equity ratio of 0.55 : 1 tells us that the owner of The Coffee Shop has financed 55 cents for every $1 of assets.

In 2XX2 the owner’s equity ratio of 0.56 : 1 tells us that the owner of The Coffee Shop has financed 56 cents for every $1 of assets in 2XX2.

2) In 2XX1 a return on average owner’s equity of 32.43% tells us that the owner of The Coffee Shop is receiving a 32.43% return on their investment.

In 2XX2 the owner’s equity ratio of 0.56 : 1 tells us that the owner of The Coffee Shop is receiving a 40% return on their investment.


6 Interpreting financial stability

NOTES

QUESTIONS

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Interpreting the equity ratio


Equity ratio


Must be greater than 50% but not greater than around 80% in order to take advantage of borrowed funds.


The owner has invested more into their business than creditors / outsiders.


Below 50%.

Cause of Unsatisfactory percentage / ratio

The owner does not have enough capital invested into the business. Creditors own more of the business than the owner.

How to improve Unsatisfactory percentages / ratios

The owner1) invests more capital2) pays off some liabilities.


Interpreting the return on average equity

Return to 6 Interpreting financial stability


Return on equity


This return needs to favourably compare to last year’s return and to alternative investment opportunities, e.g. industry averages, return in other businesses, interest rates.


A satisfactory net profit.


This return does not compare favourably to last years return or to other alternative investments.


Unsatisfactory net profit.


Better control over business expenses.


Questions:Interpreting financial stability1) Describe the trend of the equity ratio for The Coffee Shop.

2) Explain possible reasons for the equity ratio trend.

3) What would the owner of The Coffee Shop compare their rate of return on average owner’s equity to?

To answer these questions, click to see the answers to the

Financial Stability questions


Answers

Return to 6 Interpreting financial stability

1) The equity ratio for The Coffee Shop is increasing.

2) Reasons for an increasing equity ratio is that the owner has invested more capital or they have paid off some of their liabilities such as a loan.

3) The owner of The Coffee Shop would compare their rate of return on average owner’s equity with last year’s return, other similar types of businesses and other investment rates such as banks.


7 Evaluating financial andnon-financial information

NOTES

QUESTIONS

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Evaluating financial and non-financial information

Return to 7 Evaluating financial and non-financial information

Sole proprietors are faced with evaluating information and making and justifying recommendations as well as stating any consequences that flow from their decisions. This process allows them to make an informed decision that is based on financial and non financial information.


Questions: Evaluating financial and non-financial information

1) What is the best option for Daniel?2) State one non-financial reason for choosing your preferred option 3) State one financial reason for choosing your preferred option.4) State one consequence for Daniel if he chooses your preferred option 5) State the option you did not chose for Daniel 6) State one financial reason for not choosing this option.

Daniel Hall is thinking about a career af ter he leaves school. He is considering being an apprentice builder or plumber.

Apprentice Builder: Apprentice Plumber * Long work hours six days a week * Minimum wage of $10.25 per hour but long term wage prospects are excellent * Gain a variety of building skills * The current building boom is expected to last f or 10 years * Daniel has contacts with a building business that has a good reputation

* Work five days a week f rom 9 to 5 * Paid a salary of $25 000 per year and can go up to $40 000 within 5 years * There is a glut of plumbers at present although long term prospects are good * Daniel has no plumbing contacts


Answers

1) What is the best option for Daniel? Either apprentice builder or apprentice plumber.

2) One non-financial reason for choosing your preferred option: Apprentice builder

Daniel can gain a variety of building skills. Apprentice plumber

Good working hours from 9 to 5 five days a week.

3) One financial reason for choosing your preferred option: Apprentice builder

Long term wage prospects are excellent. Apprentice plumber

Guaranteed income of $25 000 increasing to $40 000 within 5 years.


Return to 7 Evaluating financial and non-financial information

4) One consequence for Daniel if he chooses your preferred option: Apprentice builder He would be working long hours six days a week which would mean less leisure time / He would gain a variety of building skills which would mean that he could work for himself in the future.

Apprentice plumberAs there is presently a glut of plumbers, if Daniel doesn’t work

hard he may find that he is unable to keep his apprenticeship.

5) The option you did not chose for Daniel: Apprentice plumber or Apprentice builder

6) One financial reason for not choosing this option:Apprentice plumber There is a salary cap of $40 000 which is not that enticing when compared to other jobs and salaries offered.Apprentice builderIn the short term, the minimum wage of $10.25 per hour is not

a very good reward for all of the hard work put into being a builder’s apprentice.

© pearson education new zealand 2007 contents 1. profitability – formulas and explanations 2....

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