Analysis of Financial Statements (Grade 10 NSC Matric Accounting): Revision Notes

Ratios

Financial ratios are powerful tools that help us understand how well a business is performing. Think of them as a way to measure the "health" of a business, similar to how a doctor uses vital signs to check your health. These ratios convert large amounts of financial information into simple numbers that can be easily compared and understood.

Steps in the analysis process

When analysing financial statements using ratios, you should follow a systematic approach to ensure accurate and meaningful results. Here's the process you need to follow:

This structured approach ensures that you don't just calculate numbers, but actually understand what they tell you about the business's financial position.

Profitability of the business

Profitability ratios help us understand how effective a business is at generating profit from its operations. These ratios show whether the business is making good use of its resources and whether it's managing its costs effectively.

Gross profit on sales and gross profit on cost of sales

The gross profit represents how much money remains after a business subtracts the cost of goods sold from its sales revenue during a specific period. It's the first level of profit and shows how well the business is managing its basic trading activities.

The amount of gross profit a business aims to achieve depends on two main factors:

• The type of business activity (retail, wholesale, service, etc.)
• The profit mark-up policy the business follows

This demonstrates an important principle: understanding this relationship is crucial for business planning and pricing strategies.

When a business maintains its mark-up policy consistently, you'll see the same percentages in the final Income Statement. For instance, if the business sold 240 articles during the year:

Item	Amount
Sales for the year (240 articles)	R900 000
Less: Cost of sales	R720 000
Gross profit	R180 000

Gross profit as a percentage of sales: $\frac{\text{R}180\,000}{\text{R}900\,000} \times 100 = 20\%$

Gross profit as a percentage of cost of sales: $\frac{\text{R}180\,000}{\text{R}720\,000} \times 100 = 25\%$

This example shows that there's no variation in the mark-up - the business is maintaining its pricing policy consistently.

Percentage gross profit on turnover

Formula:

$\frac{\text{Gross profit} \times 100}{\text{Turnover}}$

Where:

• Turnover = Sales – Debtors' Allowances
• Gross profit = Turnover – Cost of sales

This ratio expresses the gross profit earned during a financial year as a percentage of net sales (turnover). It's a vital measure of trading efficiency. If a business consistently adds the same percentage of profit to its cost price, this should be reflected in the gross profit percentage.

Percentage gross profit on cost of sales

Formula:

$\frac{\text{Gross profit} \times 100}{\text{Cost of sales}}$

This ratio presents gross profit as a percentage of the cost of sales, giving a different perspective on profitability. It's particularly useful for determining whether the purchasing policy and inventory storage practices are working effectively.

Percentage operating profit on turnover

Formula:

$\frac{\text{Operating profit} \times 100}{\text{Turnover}}$

This ratio shows operating profit as a percentage of turnover and is extremely useful for evaluating how well a business manages its operations. Operating profit is calculated after accounting for all income and expenses but before deducting interest charges.

The purpose of this ratio is to help management understand how efficiently expenses are being controlled. The key principle is simple: the lower the percentage, the better the business is managing its expenses.

When you compare this ratio with previous years, you can see whether expense management is improving or deteriorating. If the percentage is increasing, it means expenses are consuming a larger portion of sales, which is a warning sign that requires investigation.

Net profit on turnover

Formula:

$\frac{\text{Net profit} \times 100}{\text{Turnover}}$

The net profit ratio represents the final profit for a financial period as a percentage of sales. This is the "bottom line" - what remains after all expenses, including interest, have been deducted.

To properly evaluate this ratio, you must compare it with previous years' percentages. This comparison reveals whether expense management is improving or worsening. Remember: the higher the percentage, the better the business is managing its expenses and controlling costs.

Total expenses as a percentage of turnover

Formula:

$\frac{\text{Operating expenses} \times 100}{\text{Turnover}}$

This ratio shows what portion of sales revenue is consumed by operating expenses. It's directly related to cost control and efficiency.

The ratio should be compared with previous years and ideally should remain stable or decrease over time. A lower percentage indicates better expense management, meaning the business is spending less of its sales revenue on running costs.

Liquidity of the business

Liquidity ratios measure whether a business can meet its short-term financial obligations. These ratios answer the critical question: "Can the business pay its bills when they become due?" This is essential for day-to-day survival because even profitable businesses can fail if they cannot pay their debts on time.

Current ratio

Formula:

$\text{Current assets : Current liabilities}$

The current ratio measures how well the current assets of a business cover its current liabilities. It's always expressed as a ratio in the format x : 1, where current assets are divided by current liabilities.

This ratio is crucial for:

• Suppliers deciding whether to extend credit
• Banks considering loan applications
• Owners assessing the business's financial stability
• Managers planning cash flow

Acid test ratio

Formula:

$\text{(Current assets – Inventories) : Current liabilities}$

The acid test ratio is a more stringent measure of liquidity than the current ratio. It recognises a fundamental problem with using inventories to measure liquidity: inventories cannot always be quickly converted to cash.

The ratio is expressed as x : 1. A business is considered liquid if the ratio is greater than 1, meaning at least 1 : 1. For instance, if the ratio is 1.2 : 1, there is R1.20 of immediately available assets for each R1 of current liabilities.

Solvency of the business

Solvency ratio formula:

$\text{Total assets : Total liabilities}$

Where:

• Total assets = Tangible assets + Fixed deposit + Current assets
• Total liabilities = Non-current liabilities + Current liabilities

Solvency refers to the business's ability to meet its long-term obligations. Unlike liquidity, which focuses on short-term survival, solvency looks at the bigger picture: can the business continue operating in the long run?

Solvency is crucial for long-term planning and gives stakeholders confidence that the business will continue operating. Banks, long-term creditors, and potential investors pay close attention to this ratio when making decisions about the business.

Risk - the financial risk associated with the business

Debt/equity ratio formula:

$\text{Non-current liabilities : Owners' equity}$

Where:

Owners' equity = Capital balances of partners + Current account balances of partners

This ratio reveals how the business finances its operations. Capital can come from two sources:

1. Owners' investment (equity) - money provided by the business owners
2. Borrowed money (debt) - loans from banks or other lenders

Borrowing money comes at a cost - the business must pay interest. This creates financial risk because:

• Interest must be paid regardless of whether the business makes a profit
• If profits decline, loan repayments still need to be made
• This can create significant financial strain on the business

The debt/equity ratio shows readers of financial statements the extent to which borrowed capital finances the business, and therefore the level of risk involved.

When is it favourable to use borrowed capital?

Different debt/equity ratios indicate different risk levels:

Understanding gearing helps business owners make informed decisions about financing their operations and helps creditors assess the risk of lending money to the business.

The return on investment for the owners of the business

Formula:

$\frac{\text{Net profit} \times 100}{\text{Average owners' equity}}$

This ratio is particularly important for business owners because it measures how profitable their investment in the business is. It enables them to compare the return they're getting from the business with returns they could earn from alternative investments.

Before making decisions about whether to continue investing in the business or to sell it and invest elsewhere, owners should carefully consider several factors:

This ratio helps owners make informed decisions about whether to maintain, increase, or withdraw their investment in the business. It's a critical tool for evaluating whether the business is delivering adequate returns for the risk and effort involved.

Stakeholders interested in financial statements

Many different groups have an interest in a business's financial statements, each for different reasons:

• SARS (South African Revenue Service): Needs to verify that the business is paying the correct amount of tax
• Financial providers: Banks and other lenders use financial statements to assess whether the business can repay loans
• Unions: Worker organisations examine financial statements to understand the business's ability to pay salaries and benefits
• Employees: Individual workers want to know if their jobs are secure and if the business can afford salary increases
• Creditors: Suppliers need to determine whether the business can pay for goods and services purchased on credit

Remember!