The Standard requires: AchievementAchievement with Merit Achievement with Excellence Analyse financial information. Analyse a range of financial information. Analyse a wide range of financial information. Interpret information and make recommendation(s). Interpret a range of information and make recommendation(s). Interpret a wide range of information and make justified recommendation(s).
A wide range would typically involve nearly all of explanatory notes 3 and 6. A recommendation details a strategy that will improve an identified weakness. A justified recommendation explains how the recommendation will improve the identified weakness.
Analyse financial information means calculate analysis measures selected from: measures of profitability mark-up percentage gross profit percentage expenses percentages net profit percentage return on equity percentage rate of return on total assets percentage measures of liquidity working capital current ratio/working capital ratio liquid ratio/quick asset ratio measures of financial stability equity ratio measures of management effectiveness inventory turnover age of accounts receivable.
Interpret information includes: explain the analysis ratios explain possible reasons for trends explain possible consequences of a continued trend provide links between analysis measures and other information provide links between related analysis measures validly comment on an entitys financial performance, and/or financial position, and/or cash flows, using comparative figures (including industry averages) and results of analysis compare the financial and/or non-financial information relating to the business, or to two sole proprietor businesses.
Teaching Points Assessment Criteria Word Possible meaning/requirement of the word(s) Analyse Calculate analysis measures Interpret Explain the analysis ratios, possible reasons for trends, possible consequences of a continued trend Provide links between analysis measures and other information; between related analysis measures Comment on the validity of an entitys financial performance, and/or financial position, and/or cash flows, using comparative figures (including industry averages) and results of analysis Compare the financial and/or non-financial information relating to the business, or to two sole proprietor businesses. Recommendation A strategy that will improve an identified weakness Justified recommendation An explanation of how the recommendation(s) will improve the identified weakness – gives a clear transaction that would improve the percentage/ratio and linked this transaction clearly to the accounts affected
Three Components of Business Health Profitability StabilityLiquidity Profitability –Am I making enough Net Profit considering the efforts I am putting in and the money that I have tied up in business capital? Liquidity –Can I pay my bills as they fall due? Stability –Can I weather the storm if there is an expected or unexpected downturn in profitability and/or liquidity?
Gross Profit Percentage Formula: Gross Profit x 100 Net Sales What does it tell us? e.g. 30% means for every $1 of Sales there is 30c of gross profit. This tells us how much of our sales are returned as gross profit (the higher, the better) as expenses need to be covered. How to Improve it? Improve mark-up percentage; get a cheaper supplier
Mark up % Formula: Gross Profit x 100 COGS What does it tell us? This tells us the amount that is added to the cost price to get the selling price. - example on next page How to Improve it? Increase mark-up percentage. Change in sales mix (A sales mix is a change in quantity sold of both high & low mark up goods). If Mark Up% increases, Gross Profit % increases or vice versa
Example of Mark Up % Watches (mark up % of 50%) Earrings (15%) Watches that cost $100 will sell for $150 Earrings that cost $5 will sell for $5.75 Sales Yr 1:20 Watches 3 Earrings Sales Yr 2L3 Watches 17 Earrings Year 2 will have a smaller profit because the business has sold less expensive items (watches) and more cheaper items (earrings). A business mark-up percentage depends on competitors mark up
Expense percentages Formula: Expense Group x 100 Net Sales What does it tell us? Example: Distribution cost percentage of 10%. This means for every $1 of sales, 10c goes towards paying distribution costs. This tells us the proportion of sales revenue that is spent on paying expenses. It indicates how well expenses are being controlled. How to Improve it? Maintain better control over expenses.- Name the expense or expense group that needs better control. Use a specific example.
Net Profit % Formula: Net Profit x 100 Net Sales What does it tell us? e.g. 12% this means for every $1 of revenue, 12c is profit. This tells us how much of sales is returned as net profit. How to Improve it? Decrease expense % by maintaining better control over expenses. Increase GP% by increasing mark up%
Return on Equity (ROE or ROI) Formula: Net Profit x 100 Average OE What does it tell us? This measures the return on the owners investment in the business. The return must be sufficient to compensate the owner for the risk taken by investing in the business. This return needs to be compared to alternative investment opportunities. e.g. interest rates, industry average return, return in other companies. How to Improve it? Increase net profit
Return on Total Assets (ROTA) Formula: Net Profit + Interest x 100 Average Total Assets What does it tell us? This measures how productive the assets we used are in earning profit for the business. The business wants this to be as high possible. e.g. Old assets = Repairs/Maintenance increased = NP decreased = Return on Assets decreased How to Improve it? Improve Net Profit by maintaining better control over expenses especially repairs & maintenance. Sell idle (unused) or obsolete (old) non-current assets.
Current Ratio Formula: Current Assets Current Liabilities = x : 1 What does it tell us? e.g. 2.5 : 1 means for every $1 of CL the firm has $2.5 of CA. This tells us our ability to repay short- term debts (debts that are due in the next accounting period – 1 year). Ratio should be at least 1:1. Problems of a high current ratio: High accounts receivable – Problem of bad debts, Too much inventory – may become obsolete (expired, out of fashion etc.), Too much cash -better invested in term deposit to earn interest. How to Improve it? Borrow long term Invest more capital in form of cash. Sell idle non-current assets for cash Decrease drawings.
Liquid Ratio Formula: What does it tell us? e.g. 1.52:1 means for every $1 of liquid liabilities, the business has $1.52 of liquid assets. This tells us the firms ability to repay immediate debts (debts that are due between 1- 3 months). Note: The Liquid ratio is the best indicator of liquidity. How to Improve it? Same as current ratio. Have clearance sale to sell obsolete inventory. CA-Inventory & Prepayment CL- Secured Bank OD = x :1
Equity Ratio (Gearing Ratio) Formula: Owners Equity = x : 1 Total Assets What does it tell us? e.g. 0.6:1 means for every $1 of assets the owner has financed 60c. This tells us how much of the business assets has been financed by the owner. The ratio needs to be greater than 0.5:1 If the ratio is less than 0.5:1, the creditors will force the business to sell the assets to repay them back. If the ratio is too high, this means the business is not making use of external funds (borrowing) to expand the business. How to Improve it? If the ratio is low, the owner must invest more capital. If the ratio is high, borrow more long term funds.
Inventory Turnover Formula: Cost of Goods Sold Average Inventory =_____times per year What does it tell us? e.g. 12 times per year means that the business is selling on average its entire stock 12 times per year. Tells us how long an average inventory is in the store before it is sold and how many times the business sells its entire inventory. The ideal inventory turnover depends on the type of business activity. e.g. a jeweller may have 1 or 2 stock turns a year, a greengrocer 200 stock turns a year and a baker will have to have a daily turnover period otherwise the stock is stale and worthless.
Each different business would have its own industry average. Goods with a higher mark-up% usually have a lower turnover. (interrelation). Lower mark-up made up for by greater sales, therefore a high stock turn Problems with a low inventory turnover: Money better invested elsewhere. Higher insurance premiums Store and warehousing costs Greater risk of deterioration/obsolescence (out of date) Stock items stolen How to improve the Inventory Turnover Review purchasing procedure (why are we buying too much?) Have clearance sale to sell off obsolete stock.
Formula: What does it tell us? Note: ALWAYS round to the next full day. (general rounding rule does not apply) e.g. 35.4 = 36 days; 35.8 = 36 days35.001 = 36 days Means that the business is collecting its accounts receivable on an average every 36 days. Indicates how many days our customers take on average to pay their debts. Should be an average 35-40 days or better. How to Improve it? Write off long overdue a/c as Bad debts. Perform credit checks. Encourage payment of accounts by offering discounts or charge interest for overdue accounts. Review credit collection policies. i.e. send regular statements. Age of Accounts Receivable Average Accounts Receivable X 365 Net credit sales + GST 1 Optimum Age of Accounts Receivable Ratio 35 – 40 days or LESS
Interpretation - What do all the numbers mean???
Profitability An increase in Mark Up Percentage will increase Gross Profit Percentage and vice versa. Mark Up Percentage is linked to both sales and inventory turnover. A decrease in mark up should lead to an increase in sales and an increase in inventory turnover as the sales volume has improved. An increase in Gross Profit Percentage should lead to an increase in Net Profit Percentage. If not, the firm needs to look at their expenses. A decrease in Expenses Percentage (better control over expenses) should lead to an increase in Net Profit Percentage.
Profitability Continued… A decrease in Net Profit Percentage is not necessarily detrimental for the firm if the net profit figure in the Income Statement has increased. A higher net profit figure means that the firm is more profitable even though it may have a lower Net Profit Percentage. An increase in net profit figure will usually lead to an increase in the return on owners equity. If the capital figure in the Statement of Financial Position (Balance Sheet) has increased, and Net Profit has remained constant the return on owners equity would decrease.
Liquidity/Management Effectiveness Current Ratio Liquid Ratio CausesRecommendation High Too much cash Age of Accounts Receivable slow Better invested in interest bearing accounts Write off bad debts, and check credit collection policies HighLow Decrease in Inventory turnover with the possibility of obsolete stock or overstocking Clearance sale of obsolete stock or Check procedures when purchasing stock or write off any obsolete stock LowHigh a large secured bank overdraft Check assets have been financed by non current liabilities (long term sources) Low Increase in unsecured bank overdraft Assets financed from short term rather than long term sources Owner invests cash or reduces amount of drawings Check assets have been financed by non current liabilities (long term sources)
Stability If the Equity ratio is low and the liquid ratio is low, the owner should invest more capital If the Equity ratio is high and the liquid ratio is low, the firm should borrow from long term sources e.g. increase mortgage