Chapter 10

Notes to teachers
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Basic Ratio Analysis

Most students would not have difficulty calculating the various accounting ratios. What they usually find difficult is interpreting the results of the ratios. You can teach them the following manner of writing comments: (i) Indicate by how much the ratio has increased or decreased. (ii) Give possible reasons for the change in the ratio. (iii) Explain the implications for the profitability or liquidity of the business entity. (iv) Suggest ways to improve results.

You should note that the limitations of ratio analysis are not required in the Compulsory Part.

Q1 Q2 Q3

Profitability refers to the ability to make profits. Profitability ratios include gross profit ratio, net profit ratio and return on capital employed. (Any two) The owner would be most interested in this ratio. It is because he has contributed capital and thus wants to know whether his capital has been efficiently employed to generate profits. (a) Cost of goods sold = $70,000 + $10,000 $8,000 = $72,000 Gross profit = $120,000 $72,000 = $48,000 Gross profit ratio =
$48,000 = 0.4 or 40% $120,000

Net profit = $48,000 $30,000 = $18,000 Net profit ratio = (b) Gross profit ratio (c) The net profit ratio is a better indicator of the profitability of a business, because all costs and expenses have been deducted to arrive at the net profit figure.
$18,000 = 0.15 or 15% $120,000

Q4

(a) (i) Capital as at 31 March 2009 = $110,000 + $18,000 $8,000 = $120,000 Return on capital employed =
$18,000 = 0.15 or 15% $120,000

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(ii) Average capital =

($110,000 + $120,000) = $115,000 2 $18,000 = 0.157 or 15.7% $115,000

Return on capital employed =

(b) The return on capital employed will drop.

Q5 Q6 Q7 Q8

Liquidity refers to the ability to pay short-term liabilities when due. Liquidity ratios include current ratio and quick ratio. If the current ratio is too high, there may be too many current assets lying idle. This means the current assets are not being used efficiently to generate revenues and profits for the business. The firm may have difficulty meeting its short-term obligations. (a) Current assets = $31,000 + $20,000 + $12,000 = $63,000 Current liabilities = $21,000 Current ratio = Quick ratio = (b) Current ratio (c) The quick ratio is a stricter measure of the liquidity of a business, because it includes only those current assets which are very liquid.
$63,000 = 3 :1 $21,000

($63,000 $31,000) = 1.52 : 1 $21,000

A1

Owners: They need to know whether their businesses are run efficiently and effectively in order to decide whether they should increase/decrease investments in those businesses. Managers: They need to maintain high profitability and ensure short-term liabilities can be paid on time. Lenders (such as banks): They need to know whether the borrowers will be able to repay interest and loan principal on time. Potential investors: They need to know whether a company is run efficiently and effectively in order to decide whether it is worth investing in it. Inland Revenue Department: They need to know how much profit a company has made in order to determine the amount of profits tax it has to pay. (Any reasonable answers)

A2

(a) It is because services firms do not have sales or cost of goods sold. Thus, there is no need to calculate the gross profit or the gross profit ratio. (b) Net profit = Gross profit + Other revenues Expenses As expenses are usually higher than other revenues, this causes the net profit to be lower than the gross profit. With the same amount of sales, the net profit ratio is thus smaller than the gross profit ratio.

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A3

The gross profit ratio may rise because: sales have increased by a greater percentage than the cost of goods sold. the selling prices of goods have been raised. there has been a favourable change in the sales mix. For example, the proportion of goods sold with higher margins is greater than that sold with lower margins. there has been less wastage of goods, which reduces the cost of goods sold. (Any reasonable answers) (a) The management should: increase selling prices of goods find cheaper supplies of goods reduce wastage of goods (Any reasonable answers) (b) The management should: find other sources of revenues reduce expenses (Any reasonable answers)

A4

A5

Managers would make use of the profitability ratios to see whether the profitability of the firm has improved or deteriorated, and find ways to improve it. For example, if the gross profit ratio has dropped, managers may increase prices or find ways to reduce the cost of goods sold. (Any reasonable answers) Managers would make use of the liquidity ratios to see whether the liquidity of the firm has improved or deteriorated, and find ways to improve it. For example, if the quick ratio has dropped to a very low level, managers may find ways to increase the level of cash or other liquid assets. If the quick ratio is too high, managers may find ways to use current assets efficiently to generate revenues and profits for the business. (Any reasonable answers) (a) The one which has a higher gross profit ratio, net profit ratio or return on capital employed (whichever is applicable) is more profitable. (b) The one which has a reasonably higher current ratio or quick ratio (whichever is applicable) is more liquid. (c) Choose the one which is considered more profitable and sufficiently liquid.

A6

A7

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Profitability refers to the ability to make profits, while liquidity refers to the ability to pay short-term liabilities when they are due. (a) (b)
$31,800 100% = 47.4% $67,110 $3,300 100% = 4.9% $67,110

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(c) (d) (e)

$3,300 100% = 3.3% $101,300 $113,120 = 1.6 : 1 $71,820 ($113,120 $15,010) = 1.4 : 1 $71,820

Profitability: May Furniture was under-performing as its gross profit ratio, net profit ratio and the return on capital employed were all lower than industry averages. Liquidity: May Furniture was also under-performing as its current ratio and quick ratio were both lower than industry averages. However, if we simply compare the quick ratios, it seems that May Furniture had sufficient liquidity to meet its short-term liabilities.

The loan application might not be approved because: May Furniture was under-performing the industry in terms of profitability and liquidity. May Furniture had been run for a month only. It is not certain whether the business would keep earning profits or remaining sufficiently liquid in future. Other factors to consider: the amount of loan applied the duration of the loan whether collateral is provided the purpose of the loan (Any reasonable answers)

ASSESSMENT

MCQ
1 C 6 A 11 D 2 A 7 B 12 B 3 D 8 C 4 A 9 B 5 C 10 D

Exercises
13
(a) Gross profit ratio = (b) Net profit ratio =
$72,500 = 0.2 or 20% $362,500 $36,250 = 0.1 or 10% $362,500 ($29,600 + $5,000 + $1,100 + $550) $36,250 = = 0.1 or 10% $362,500 $362,500

(c) Expenses-sales ratio = 112

14

(a) (i) Current ratio =

Current assets Current liabilities

Current assets: Inventory as at 30.6.2006 Accounts receivable Cash in hand Current liabilities: Accounts payable Bank overdraft
$135,300 = 2 :1 $67,650

$ 45,000 90,000 300 135,300 28,800 38,850 67,650

Current ratio = (ii) Quick ratio =

$90,300 = 1.33 : 1 $67,650

(iii) Net sales: $377,685 $17,685 = $360,000

$ Cost of goods sold: Inventory as at 30.6.2005 Add Purchases Less Returns outwards Less Inventory as at 30.6.2006 218,568 (8,568) $ 75,000 210,000 285,000 (45,000) 240,000

Net sales $360,000 Cost of goods sold $240,000 = Gross profit $120,000 Gross profit ratio =
$120,000 = 0.3333 or 33.33% $360,000

(iv) Gross profit $120,000 Administrative expenses $19,250 = $100,750 Net profit ratio =
$100,750 = 0.2799 or 27.99% $360,000

(b) T  he profitability of T Zhous business is satisfactory, as both the gross profit ratio and the net profit ratio are fairly high.  he liquidity of T Zhous business is also satisfactory, as both the current ratio and the quick ratio are T greater than 1 : 1 but not too high.

15X (a) (i) Gross profit as a percentage of sales:

$400,000 Gross profit = = 0.25 or 25% $1,600,000 Sales

(ii) Net profit as a percentage of sales:

$320,000 Net profit = = 0.2 or 20% $1,600,000 Sales

(iii) Net profit as a percentage of total capital employed:

$320,000 Net profit = = 0.27 or 27% Capital employed $1,180,000

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(iv) Current ratio:

$200,000 Current assets = = 2 :1 Current liabilities $100,000

(v) Acid test ratio:

Accounts receivable and bank $80,000 + $20,000 = = 1 :1 Current liabilities $100,000

(b) A  lthough K Kung and B Kau have the same gross profit as a percentage of sales, B Kaus net profit as a percentage of sales is markedly lower. This implies that B Kau has far higher expenses than K Kung. For the same amount of total capital employed, K Kung is getting more return on it than B Kau, 27%  compared with 12 1 2 %. This indicates that K Kungs efficiency in utilising net assets to earn a profit is much higher than that of B Kau. B Kaus liquidity is lower than that of K Kung. It is more obvious when we compare their acid test  ratios. They show that B Kau has less ability to meet debts in the short-term than K Kung. But this does not necessarily mean that B Kaus liquidity position is in danger. To determine whether the liquidity of a firm is sufficient to meet its debts in the short term, it is necessary to find out the usual ratios in their industry. K Kung is by far the more successful business. It has kept expenses at a lower level. It is also in a better  liquidity position and more able to meet its short-term debts. B Kau, on the other hand, is in a worse position on each factor. It is not only less profitable, but it is also  in a less liquid position to meet its short-term debts as they fall due.

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(a) (i) (ii) (iii) (iv) (v)

Keith
$200,000 = 4 :1 $50,000 $100,000 = 2 :1 $50,000 $72,000 = 0.2 or 20% $360,000 $43,200 = 0.12 or 12% $360,000 $43,200 = 0.13 or 13% $335,000

Nelson Current ratio Quick ratio Gross profit as a percentage of sales Net profit as a percentage of sales Rate of return on capital employed (based on average capital)
$130,000 = 2 :1 $65,000 $66,000 = 1.02 : 1 $65,000 $62,500 = 0.25 or 25% $250,000 $35,000 = 0.14 or 14% $250,000 $35,000 = 0.14 or 14% $247,500

(b) Nelson gives a higher return on owners capital. Keiths current ratio is higher than Nelsons. This indicates that Keith is in a better liquidity position.  he gross profit percentage of Nelson is five percentage points higher than that of Keith. This may be T due to better purchasing and selling methods. The expenses of Nelson are also lower than those of Keith. Tight control of expenses will lead to higher profitability. Therefore, Nelsons net profit ratio is two percentage points higher than that of Keith.

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17X (a) (i)

Sales Less Returns inwards Less

Income Statement for the year ended 31 December 2008

$ $ $ 519,000 (12,000) 507,000

Cost of goods sold: Opening inventory Purchases Less Returns outwards

39,000 288,000 (6,000) 282,000 321,000 (41,000)

Less Closing inventory Gross profit Discounts received Less Expenses: Wages Sundry expenses Discounts allowed Rent, rates and insurance Net profit

(280,000) 227,000 9,000 236,000

97,200 5,600 11,000 29,500

(143,300) 92,700

(ii)
Non-current assets Fixtures and fittings Current assets Inventory Accounts receivable Bank Current liabilities Accounts payable Net current assets Financed by: Capital as at 1 January 2008 Add Net profit Less Drawings Less

Balance Sheet as at 31 December 2008

$ $ 92,000

41,000 38,500 21,600 101,100 (31,000) 70,100 162,100 149,400 92,700 242,100 (80,000) 162,100

(b) (i) Gross profit ratio = (ii) Net profit ratio =

$227,000 = 0.4477 or 44.77% $507,000

$92,700 = 0.1828 or 18.28% $507,000

(iii) Current assets = $101,100 Current liabilities = $31,000 Current ratio = 3.26 : 1 (iv) Acid test ratio = 1.94 : 1 (c) T  he firm seems to have sufficient liquidity. Its current ratio is much greater than 2 : 1, and even the acid test ratio is above 1 : 1.

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18X

Income Statements for the year ended 31 December 2006

Business S $ $ 672,000 (560,000) 112,000 56,000 21,000 (77,000) 35,000 Business T $ $ 1,067,500 (854,000) 213,500 84,000 49,000 (133,000) 80,500

Sales Less Cost of goods sold Gross profit Less Administrative expenses Selling and distribution expenses Net profit

(a) (i) Gross profit ratio (ii) Net profit ratio (iii) Return on capital employed (based on average capital)

Business S
$112,000 = 0.17 or 17% $672,000 $35,000 = 0.05 or 5% $672,000 $35,000 = 0.12 or 12% $297,500

Business T
$213,500 = 0.2 or 20% $1,067,500 $80,500 = 0.08 or 8% $1,067,500 $80,500 = 0.15 or 15% $530,250

(b) (i) We need to know the current assets and current liabilities in detail. (ii) Are they in similar types of business? What type of business is each of them in? Is there competition from other businesses? It is preferable to have several years of accounts to gauge trends. What is the quality of the staff? Would they continue to work for Du? What are the norms of the industry with regard to the above-mentioned accounting ratios? (Any relevant answers) 2001
$9,000 = 6% $150,000 $18,000 = 20% $90,000 $9,000 = 10% $90,000 $37,500 =2 $18,750 $22,500 = 1.2 $18,750

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(a) B Cheung (i) Return on capital employed (ii) Gross profit ratio (iii) Net profit ratio (iv) Current ratio (v) Quick assets ratio

2000
$45,000 = 36% $125,000 $60,000 = 40% $150,000 $45,000 = 30% $150,000 $45,500 = 2.4 $18,750 $30,000 = 1.6 $18,750

(b)  The liquidity and profitability of the company for 2001 were not as good as those for 2000. The return on capital employed, gross profit ratio and net profit ratio of 2001 were all lower than those for 2000. It appears that selling prices were reduced and/or the costs of goods sold were increased substantially in 2001.

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Also, the current ratio and quick assets ratio decreased, indicating that the companys ability to meet its current liabilities has weakened, although these ratios are still acceptable.

20X (a) H Man

(i) Return on capital employed (ii) Gross profit ratio (iii) Net profit ratio (iv) Current ratio (v) Quick assets ratio

2008
$180,000 = 8% $2,250,000 $360,000 = 20% $1,800,000 $180,000 = 10% $1,800,000 $750,000 = 2 :1 $375,000 $450,000 = 1.2 : 1 $375,000

2007
$900,000 = 45% $2,000,000 $1,200,000 = 40% $3,000,000 $900,000 = 30% $3,000,000 $900,000 = 2.4 : 1 $375,000 $600,000 = 1.6 : 1 $375,000

(b) The financial position and results of the company for 2008 were not as good as those for 2007. The return on capital employed, gross profit ratio and net profit ratio of 2008 were all lower than those for 2007. It appears that selling prices were reduced substantially in 2008. Also, the current ratio and quick assets ratio decreased, indicating that the companys ability to meet its current liabilities has weakened, although these ratios are still acceptable.

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