© Pearson Education New Zealand 2007 Contents 1. Profitability – formulas and explanations 2. Interpreting profitability 3. Liquidity – formulas and explanations 4. Interpreting liquidity 5. Financial stability – formulas and explanations 6. Interpreting financial stability 7. Evaluating financial and non-financial information End © Pearson Education New Zealand 2007

1 Profitability – formulas and explanations NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 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. © Pearson Education New Zealand 2007

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. © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 Expense percentage The expense percentage tells us what proportion of each $1 of sales is paid on that particular expense. Formula expenses 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. © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 Net profit percentage The net profit percentage tells us what proportion of each $1 of sales is received by the retailer as net profit. Formula net 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. © Pearson Education New Zealand 2007

Return to 1 Profitability Percentage change Percentage change shows us the trend in in dollar amounts from year to year. Formula Year 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. Return to 1 Profitability © Pearson Education New Zealand 2007

Questions: Profitability - Formulas and explanations © Pearson Education New Zealand 2007

Answers a) 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 100 Sales 1 24.67% Return to Interpreting Profitability Questions © Pearson Education New Zealand 2007

Answers b) 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. Return to 1 Profitability © Pearson Education New Zealand 2007

2 Interpreting profitability NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

Interpreting mark-up percentages Analysis measure percentage Mark-up % Satisfactory percentage / ratio Should compare favorably to industry norms. Cause of satisfactory percentage / ratio Good sales mix – combining low and high markup goods. Unsatisfactory 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. © Pearson Education New Zealand 2007

Interpreting gross profit percentages Analysis measure percentage Gross profit % Satisfactory percentage / ratio Providing sufficient gross profit to meet all of the business’s expenses. Cause of satisfactory percentage / ratio Sourcing lower-priced goods leading to a favorable mark up percentage. Unsatisfactory A gross profit % is deemed unsatisfactory if it is not providing a sufficient gross profit to help meet all business expenses. Cause of unsatisfactory percentage / ratio 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 %. © Pearson Education New Zealand 2007

Interpreting expense percentages Analysis measure percentage Expense % Satisfactory percentage / ratio The expense % should compare favorably to industry norms. Cause of satisfactory percentage / ratio Maintaining good control over expenses. Unsatisfactory If the expense % is increasing above industry norms OR any significant increase. [continues] © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 Cause of unsatisfactory percentage / ratio Distribution 1) Increased advertising 2) Increase sales wages 3) Hired new sales staff Administrative Increase in rates, electricity usage, office stationery costs etc. Finance Costs Refinanced at a higher interest rate / took out a new loan. How to improve unsatisfactory percentages / ratios Maintain better control over the expense %: 1) Reduce advertising 2) Don’t replace a staff member when they leave. Introduce electricity saving measures Buy less / lower quality office stationery etc. 1) Refinance at a lower interest rate 2) Pay off the loan. © Pearson Education New Zealand 2007

Interpreting net profit percentages Analysis measure percentage Net profit % Satisfactory percentage / ratio Providing a sufficient return to the owner. Cause of satisfactory percentage / ratio Favorable mark-up and gross profit %. Unsatisfactory A net profit % that is declining when compared to previous years or is an insufficient reward / risk return for the investment. Cause of unsatisfactory percentage / ratio 1) Mark-up % is not helping to contribute an adequate gross profit. 2) Inadequate control over the expenses. How to improve unsatisfactory percentages / ratios 1) Improve the mark-up %. 2) Decrease expense % by maintaining better control over expenses. Return to 2 Interpreting Profitability © Pearson Education New Zealand 2007

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 © Pearson Education New Zealand 2007

Answers 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 loan 6) 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. Return to 2 Interpreting profitability © Pearson Education New Zealand 2007

3 Liquidity – formulas and explanations NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

Liquidity: Current ratio Liquidity 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. © Pearson Education New Zealand 2007

Liquidity: Liquid ratio 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 liquid liabilities the retailer has $1.10 of liquid assets. This means that the retailer should be able to meet their immediate debts within the next 1–3 months. Return to 3 Liquidity © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 Questions: Liquidity © Pearson Education New Zealand 2007

Answers 1) a) Musical Notes – Liquidity measures Liquidity ratio Formula Answer 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 © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 b) 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. Return to 3 Liquidity © Pearson Education New Zealand 2007

4 Interpreting liquidity NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

Interpreting the current ratio Analysis measure percentage / ratio Current ratio Satisfactory percentage / ratio Must be greater than 1:1. Cause of satisfactory 1) Good credit control so low bad debts 2) Good stock control. Unsatisfactory percentage ratio Any ratio below 1:1 or above 2 :1. Cause of unsatisfactory percentage / ratio 1)High accounts receivable – problem of bad debts. 2)Too much inventory – may become obsolete. Ratio above 2:1 1) Too much cash is being held in low interest earning accounts. 2) Surplus cash should be invested in higher yield term deposits. How to improve unsatisfactory percentages / ratios 1) Owner invests more capital in the form of cash. 2) Decrease drawings. 3) Borrow long term. © Pearson Education New Zealand 2007

Interpreting the liquid ratio Analysis measure percentage / ratio Liquid ratio Satisfactory percentage / ratio Must be greater than 1:1 Cause of satisfactory 1) Good credit control so low bad debts 2) Good stock control 3) Limited drawings Unsatisfactory Any ratio below 1:1 Cause of unsatisfactory percentage / ratio 1) High accounts receivable – problem of bad debts. 2) Too much inventory – may become obsolete. 3) Decrease drawings How to improve unsatisfactory percentages / ratios 1) Improve credit control measures to reduce bad debts 2) Owner invest more capital in the form of cash. 3) Decrease drawings. 4) Have a sale on obsolete stock to reduce stock levels Return to 4 Interpreting liquidity © Pearson Education New Zealand 2007

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 © Pearson Education New Zealand 2007

Answers 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. Return to 4 Interpreting liquidity © Pearson Education New Zealand 2007

5 Financial stability – formulas and explanations NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 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. © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 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. © Pearson Education New Zealand 2007

Return on owner’s equity The return on owner’s equity measures the return on the owner’s investment in their business. The return on the owner’s investment must be sufficient to warrant the owner taking the risk of investing in the business. Formula return on owner’s equity = net profit x 100 average owner’s equity 1 In order to find the average owner’s equity, the opening capital is added to the closing capital and then divided by 2. Return to 5 Financial stability © Pearson Education New Zealand 2007

Questions: Financial stability © Pearson Education New Zealand 2007

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 © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 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. Return to 5 Financial stability © Pearson Education New Zealand 2007

6 Interpreting financial stability NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

Interpreting the equity ratio Analysis measure percentage / ratio Equity ratio Satisfactory percentage / ratio Must be greater than 50% but not greater than around 80% in order to take advantage of borrowed funds. Cause of satisfactory The owner has invested more into their business than creditors / outsiders. Unsatisfactory 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 owner 1) invests more capital 2) pays off some liabilities. © Pearson Education New Zealand 2007

Interpreting the return on average equity Analysis measure percentage / ratio Return on equity Satisfactory percentage / ratio 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. Cause of satisfactory A satisfactory net profit. Unsatisfactory This return does not compare favourably to last years return or to other alternative investments. Cause of unsatisfactory percentage / ratio Unsatisfactory net profit. How to improve unsatisfactory percentages / ratios Better control over business expenses. Return to 6 Interpreting financial stability © Pearson Education New Zealand 2007

Questions: Interpreting financial stability 1) 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 © Pearson Education New Zealand 2007

Answers 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. Return to 6 Interpreting financial stability © Pearson Education New Zealand 2007

7 Evaluating financial and non-financial information NOTES QUESTIONS Back to Contents © Pearson Education New Zealand 2007

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. Return to 7 Evaluating financial and non-financial information © Pearson Education New Zealand 2007

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. © Pearson Education New Zealand 2007

© Pearson Education New Zealand 2007 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: Long term wage prospects are excellent. Guaranteed income of $25 000 increasing to $40 000 within 5 years. © Pearson Education New Zealand 2007

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 plumber As 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: There is a salary cap of $40 000 which is not that enticing when compared to other jobs and salaries offered. In 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. Return to 7 Evaluating financial and non-financial information © Pearson Education New Zealand 2007