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Question solutions

Learning Unit 2:

Interpreting financial results

Question 2.1

(i) The following analyses can help us determine which business makes the highest net profit in rand

value:

Shortened statement of comprehensive income of Business A:

Sales revenue (142 x R 400) R 56 800

Cost of sales (142 x R 200) (R 28 400)

Gross profit R 28 400

Weekly overhead expenses (R 18 500)

Net profit before interest and R 9 900

Shortened statement of comprehensive income of Business B:

Sales revenue (75 x R 1 500) R 112 500

Cost of sales (75 x R 1 000) (R 75 000)



Net profit before interest and tax R 16 500

Financial Management 1 A Degree

Financial Management 1 A Degree Question Solutions Learning Unit 2


Shortened statement of comprehensive income of Business C:

Sales revenue (15 x R 8 000) R 120 000

Cost of sales (15 x R 4 500) (R 67 500)



Net profit before interest and R 12 500

Thus: Business B is the most profitable in rand value, because it makes the highest net profit

(R 16 500) during an average sales week.

(ii) The gross profit percentage for each business can be calculated as follows:

Gross profit / Sales x 100

Thus:

Gross profit % for Business A: 28 400 / 56 800 x 100 = 50 %

Gross profit % for Business B: 37 500 / 112 500 x 100 = 33 1/3 %

Gross profit % for Business C: 52 500 / 120 000 x 100 = 43.75 %

Thus: Business A has the highest gross profit percentage

(iii) The net profit percentage for each business can be calculated as follows:

Net profit / Sales x 100

Thus:

Net profit % for Business A: 9 900 / 56 800 x 100 = 17.43 %

Net profit % for Business B: 16 500 / 112 500 x 100 = 14.67 %

Net profit % for Business C: 12 500 / 120 000 x 100 = 10.42 %

Thus: Business A has the highest net profit percentage



(iv)

Clearance sales profitability analysis for Business A:

Shortened statement of comprehensive income for a normal sales week (142 units):

Shortened statement of

comprehensive income if 210 units are sold:

Sales revenue (142 x R 400) R 56 800 Sales revenue (210 x R 300) R 63 000

Cost of sales (142 x R 200) (R 28 400) Cost of sales (210 x R 200) (R 42 000)

Gross profit R 28 400 Gross profit R 21 000

Weekly overhead expenses (R 18 500) Weekly overhead expenses (R 15 000)

Net profit before interest and tax R 9 900 Net profit before interest and tax R 16 000

Clearance sales profitability analysis for Business B:




Sales revenue (75 x R 1 500) R 112 500 Sales revenue (130 x R 1 125) R 146 250

Cost of sales (75 x R 1 000) (R 75 000) Cost of sales (130 x R 1 000) R 130 000


Weekly overhead expenses (R 21 000) Weekly overhead expenses R 21 000

Net profit before interest and tax R 16 500 Net loss (R 4 750)

Clearance sales profitability analysis for Business C:





Cost of sales (15 x R 4 500) (R 67 500) Cost of sales (21 x R 4 500) (R 94 500)


Weekly overhead expenses (R 40 000) Weekly overhead expenses (R 40 000)

Net profit before interest and tax R 12 500 Net loss (R 8 500)



Conclusion:

The clearance sale was not profitable for any of the businesses. Both Business B and C made a loss

during the clearance sale week, while Business A made a lower than usual net profit.

Question 2.2

(i)

Business A Business B Business C

Selling price per unit, excluding VAT R 400 R 1 500 R 8 000

Cost price per unit, excluding VAT R 200 R 1 000 R 4 500

Gross profit per unit R 200 R 500 R 3 500

(ii) Clearance sales profitability analysis for Business A:

Shortened statement of comprehensive income for normal sales months:

Shortened statement of comprehensive income if 5 % discount is offered by the supplier:

Sales revenue (142 x R 400) R 56 800 Sales revenue (142 x R 400) R 56 800

Cost of sales (142 x R 200) (R 28 400) Cost of sales (142 x R 190) (R 26 980)


Monthly overhead expenses (R 18 500) Monthly overhead expenses (R 18 500)


Thus, the monthly net profit before interest and tax increases by R 1 420 on average.

Clearance sales profitability analysis for Business B:


comprehensive income for normal

sales months:

Shortened statement of comprehensive income

if 5% discount is offered by the supplier:


Cost of sales (75 x R 1 000) (R 75 000) Cost of sales (75 x R 950) (R 71 250)







Clearance sales profitability analysis for Business C:


comprehensive income for normal

sales months:

Shortened statement of comprehensive income

if 5% discount is offered by the supplier:


Cost of sales (15 x R 4 500) (R 67 500) Cost of sales (15 x R 4 275) (R 64 125)





Question 2.3

The following will be classified as operating expenses:

Wages and salaries Advertising

Insurance Telephone

Repairs and maintenance Bad debts

Water and electricity Stationery



Question 2.4

(i) Statement of comprehensive income of Kgomotso Enterprises for the year ended 28 February 20.1

R R

Sales (411 000 – 3 000) 408 000

Less: Cost of sales (160 000)

Gross profit 248 000

Plus: Other operating income 3 400

Settlement discount received 3 400

Gross income 251 400

Less: Operating expenses (223 180)

Wages and salaries 88 000

Water and electricity 32 970

Insurance 10 600

Advertising 9 700

Packing materials 3 460

Rent paid 54 000

Vehicles expenses 17 260

Stationery 4 590

Settlement discount granted 2 600

Operating profit 28 220

Add: Interest income 230

Profit before interest expense 28 450

Less: Interest on overdraft (780)

Profit before tax 27 670



(ii) Kgomotso Enterprises

Budgeted Income statement for the year ended 28 February 20.2

R R

Sales (408 000 + 10 %) 448 800

Less: Cost of sales (160 000 – 8 %) (147 200)






Wages and salaries (88 000 – 10 %) 79 200

Water and electricity (32 970 – 10 %) 29 673

Insurance (R 10 600 – 10 %) 9 540

Advertising (R 9 700 – 10 %) 8 730

Packing materials (3 460 – 10 %) 3 114

Rent paid (R 54 000 – 10 %) 48 600

Vehicles expenses (R 17 260 – 10 %) 15 534

Stationery (R 4 590 – 10 %) 4 131

Settlement discount granted (R 2 600 – 10 %) 2 340


Add: Interest income 230

Profit before interest and tax 104 368

Less: Interest on overdraft (780 – 20 %) (624)




Question 2.5

Statement of comprehensive income of Dorcas (Pty) Ltd for the year ended 31 August 20.1:

R R

Sales 940 000




Rent received 84 000




Wages and salaries 15 000

Insurance 5 000

Telephone 15 000

Repairs and maintenance 8 000

Advertising 7 000

Stationery 3 000

Packing materials 9 000


Add: Interest income 16 000

Profit before interest expense 582 000

Less: Interest expense (12 000)


Less: Taxation expense (R 570 000 x 28%) (159 600)

Profit after tax 410 400

Less: Dividends expense (250 000 x 0.08) (20 000)

Retained income 390 400



Question 2.6

(i) (a) Sales increased by R 120 000 or by 20 % in 20.2.

(b) 200 000 / 600 000 x 100 = 33 1/3 %

(c) 206 000 / 720 000 x 100 = 28.61 %

(ii) A negative effect, because it will decrease profits. Instead of selling inventory it will have to be

written off.

(iii) (a) R 150 000 + 30 000 + 5 000 + 500 = R 185 500

(b) R 185 500 – 15 500 – 13 200 – 25 000 – 2 500 – 6 000 = R 123 300 (iv) Perpetual / continuous inventory system; or Periodic inventory system

Question 2.7

(i)

(a) There was an increase of R 150 000 in the sales total.

(b) R 278 000 – 115 000 = R 33 000 difference

(c) The net profit has increased by R 57 000.

(d) Cost of sales for 20.1: R 700 000 – 280 000 = R 420 000

Cost of sales for 20.2: R 850 000 – 350 000 = R 500 000

(ii) Theft, breakages, obsolete stock, stock rotation, literal shrinking, natural disasters (in the absence

of comprehensive insurance), administrative errors.

(iii)

(a) R 540 000 – 300 000 = R 240 000

(b) R 300 000 + 60 000 = R 360 000

(c) R 360 000 – 160 000 = R 200 000

(iv)

Tighten up your security inside your shop. Install surveillance equipment such as closed-

circuit TV‟s.

Keep accurate records of all stock movements

Provide adequate and secure storage facilities

Ensure that the correct products and quantities are shipped to customers



(v) Abbreviated statement of comprehensive income assuming no glasses were broken:

R R

Sales [(R 50 + 80 % of R 50) x 42] 3 780


Opening inventory (40 x R 50) 2 000

+ Purchases (60 x R 50) 3 000

5 000

- Closing inventory (58 x R 50) (2 900)

Gross profit 1 680

Abbreviated statement of comprehensive income assuming three glasses were broken:

R R

Sales [(R 50 + 80 % of R 50) x 42] 3 780


Opening inventory (40 x R 50) 2 000

+ Purchases (60 x R 50) 3 000

5 000

- Closing inventory (55 x R 50) (2 750)

Gross profit 1 530

The breakage will decrease Jason‟s profit with R 150 for March 20.9.

Question 2.8

(i)

Name of ratio Comparative / benchmark figures: Ratio results for the years ended 31 August…

Gross profit percentage

The average gross margin for the industry is 40 %.

20.7 20.6 20.5

45.55 % 42.14 % 40.20 %

Calculation: Comments:

338 880 / 744 000 x 100 = 45.55 %

Trend is favourable

Returns are higher than the industry average.




Net profit

percentage

The average net margin for the industry as a whole is 15 %.

20.7 20.6 20.5

10.83 % 11.02 % 11.25 %


80 542.96 / 744 000 x 100 = 10.83 %

Trend is unfavourable.

Net profit returns are lower than that of the industry.

It seems as if soaring overhead costs are a problem for the business. These costs have to be reduced.


Return on average

owner‟s equity

Return on average owner‟s equity for the industry as whole is 20.5 %.

20.7 20.6 20.5

13.04 % 18.10 % 18.43 %


80 542.96 / [ (582 514.80 + 653 137.76)/2 ] x 100 = 13.04 %

Trend is unfavourable.

Same issues as with the net profit percentage.


Current ratio

Standard norm of 2:1. 20.7 20.6 20.5

2.84 : 1 2.41 : 1 2.39 : 1


47 035.96 : 16 552.20

= 2.84 : 1

Trend is favourable

Compares favourably with the standard norm of 2:1

Business liquidity is sound; short-term debts are adequately covered.


Acid test / Quick ratio

Standard norm of 1:1 20.7 20.6 20.5

1.28 : 1 1.22 : 1 1.17 : 1


(47 035.96 - 25 890): 16 552.20

= 1.28 : 1

Trend is favourable.

Compares favourably with the standard norm of 1:1

Business liquidity is sound; short-term debts are adequately covered. Business is not overly dependent on inventory to cover current liabilities.




Debtors collection

period

The average debtors collection period for the industry as a whole is 31 days.

20.7 20.6 20.5

19.43 days 27.55 days 35.66 days


[ (21 145.96 + 22 424.82) / 2 x 365 ] /

(55 % of 744 000) = 19.43 days

Trend is favourable, tremendous improvement!

19 days for collection is excellent.

Considerable better than the industry benchmark.


Creditors settlement

period

The average creditors settlement period for the industry as a whole is 35 days.

20.7 20.6 20.5

32.44 days 29.00 days 29.15 days


[ (12 261.80 + 18 222.48) / 2 x 365 ] /

171 500 = 32.44 days

Trend is generally unfavourable.

Increased liquidity due to improved debtors collection period is not really utilised to improve the creditors settlement period.

Ratio is good based on general norms and compared with industry averages.


Trade inventory turnover

Average inventory turns for the industry = 11.5 times a year.

20.7 20.6 20.5

11.88 times 11.70 times 11.60 times


405 120 / [(25 890 + 42 300) / 2]

= 11.88 times

Trend is favourable.

The business inventory turns are in excess of the industries‟ as a whole. Also attributes to improved liquidity position.

Overall comment:

The business seems to be quite efficient and liquid. The only cause for concern is the unfavourable

trend in the profitability ratios. Notice that the gross margin shows an upward trend, but that the net

margin shows a downward trend. This means that the business is experiencing difficulties to keep their

overheads down.

(i) There are many advantages of preparing final accounts and financial statements. If this is not

done, the following will happen:

The business will not have reliable information which it can present to its stakeholders.

The business might run into trouble with the authorities, since taxes are determined on the

basis of the net profit as calculated in the profit and loss account, as adjusted.

Management and investors will not be able to calculate reliable ratios in order to ascertain

in which areas the business is under- or overspending or in which areas the business

needs to improve their efficiency.



Income and expense accounts will not close off at year-end which will create serious

bottlenecks from an operational as well as a compliance point of view. To „fix‟ this problem

in the future will be an arduous task.

(ii) Gross profit is the „trading profit‟, i.e. the pure profit derived by subtracting cost of sales from net

sales. It is the profit earned in the business that is available to cover overheads. Think of “gross”

as “before deductions”. When we refer to a payslip, gross salary is before deductions. The same

argument can be used here. The gross profit is the profit before deducing the running expenses.

After we have deducted the total running expenses from the gross profit, we arrive at the „bottom

line‟ (i.e. the net worth that has been added to the owner‟s equity). We call this amount the net

profit. Net profit is derived by deducting total expenses (including cost of sales) from total income

(including sales).

Business people often say that „profit is an opinion, but cash is a fact‟. It is important to realise

that profits do not refer to cash flows. It doesn‟t mean that a business has money in the bank if it

has earned a lot of profit. A business could be very strong financially in terms of its balance sheet

and income statement, but could still be on the verge of sequestration. The easiest way to explain

this is to make reference to credit sales. Suppose a business were to sell all their goods on credit

to debtors. Debtors will be debited and sales (and Output VAT) will be credited. The income is

therefore „earned‟ although it has not been turned into cash as yet. The liquidity trap emerges

when the business is unable to turn these profits into cash (i.e. they struggle to collect the

outstanding amounts from debtors). This is the reason why a third financial statement, namely a

„cash flow statement‟ needs to be drawn up to explain how purchases and receipts were

converted into cash. It is also the reason why ratios like debtors collection periods and creditors

settlement periods are so important.

(iii) The most prevalent strength of this business is its liquidity. The business does very well in

collecting debtors‟ outstanding accounts, and cash flow seems to be sound, although the

business runs a small overdraft from time to time. The business is also quite profitable in the

trading account. Gross margins are favourable as compared to those of their competitors. The

obvious weaknesses of the business are controlling overheads and other costs. Although the

gross margins are profitable, the net margin and return on equity are lagging behind the rest of

the industry.

(iv) There may be several ways to improve the efficiency of a business. Here are the five sure ways

to improve the efficiency of your business.

Tracking your marketing and MAKING improvements

Basically, every time you contact your prospect or customer, you are involved in the marketing

process. The marketing process may be considered as a three step process, namely

advertisement, sales and the closing process. As a business owner, you must always find ways

to move the prospect acquired as a lead from your advertisement to the sales process and then

from sales to the closing process quickly.



Automation

Automation has helped both small and large businesses in improving the efficiency of their

business. Data entry, bookkeeping, customer service, E-mail marketing and fulfillment are some

operations that can be easily automated.

Reducing costs

This may seem very obvious, but most often the business owners fail to track the cost while

focusing on increasing their sales/revenue. You could have a system to monitor both expenses

and income every week. You can reduce cost by eliminating a service that is no longer required

or locating vendors that can give you a better deal. The key is to be aware and create a system to

reduce cost.

Offer back-end products to your current customers

It is far easier to sell a product to a current customer than to acquire a new customer. You could

sell your own product or strike a deal with a business that sells to the same market as you do.

This can be a win-win lucrative situation for both the businesses.

Increase profit earned per customer

There are several ways to increase profit earned per customer. You could use the following two

methods.

Price increase - You could increase the price of your product and thereby increase profit. This

may seem difficult in the beginning, but you must take the bold step and do it anyway.

Offering package deals - You could combine two or more products/services, create packages and

sell with higher profit margin.

(v) The cost-to-income ratio shows the proportion of total costs of a business as opposed to their

total revenue. It should be a priority of the business to reduce the cost-to-income ratio at all times.

Increases in sales and reduction in costs are very important, but it is the ratio between costs and

income that will give a better indication of performance.

The methods to reduce costs and enhance income as outlined in question (v) above can be

applied to enhance the cost-to-income ratio. The key is to reduce costs and to increase income at

the same time.

Total cost = R 698 265.34 and total income = R 778 808. Thus, the cost-to-income ratio =

Total cost : Total income

R 698 265.34 : R 778 808

= 0.90 : 1



(vi) Liquidity refers to the cash flow in a business. It is of no use for a business to increase its

profitability, but at the same time struggle to collect outstanding debts from debtors. It is quite

possible for a business to increase their inventory turnover, but find it difficult to convert the sales

into cash. While profit is an opinion, cash is a fact. Ultimately, a highly profitable business which

is constantly cash-strapped is doomed to failure.

(vii) The following are limitations of ratio analyses:

One year's accounts are insufficient for proper analysis to be undertaken. The analysis of

trends, taken from, say, five years' of accounts, would give a better insight.

Differences in accounting policies between two companies will affect comparisons.

The use of historical costs brings about many distortions.

The use of industry inter-firm comparisons would make the ratios more capable of being

interpreted.

The plans of the companies for the future expressed in their budgets would be of more

interest than past figures.

The accounts from which the conclusions have been drawn are necessarily summarised.

Question 2.9

Name of ratio: Comparative figures: Ratio for the years ended 28/29 February ….

Gross profit percentage

The average gross margin for the industry is 51%.

2013 2012 2011

(calculated) (given) (given)

Formula:

50% 50% 61%

Gross profit X 100 Calculation:

Comments:

Total sales

The gross margin remained the same as the previous year (2012) for the business.

462 319.16 X 100

924 638.32

The gross margin is still 1% less than that of industry. This is an unfavourable trend.

= 50%




Net profit percentage

The average net margin for the industry is 45.00 %.

2013 2012 2011


Formula:

35.54 % 45.00 % 60.00 %

Net profit X 100 Calculation:

Comments:

Total sales The net margin has

unfavourably decreased by 9.46 % since 2012.

328 579.47 X 100

924 638.32 The net margin is also 9.46 % below the industry level. This is an unfavourable trend.

= 35.54 %


Return on average owner's equity

The return on average owner's equity for the industry is 62%.

2013 2012 2011


Formula:

26.48 % 57% 58%

Net profit X 100 Calculation:

Comments:

Average owner's equity The return on average owner‟s

equity has decreased unfavourably by 30.52 % since 2012.

328 579.47 X 100

[(1 097 212.82 + 1 384 183.57)/2] The return on average owner‟s

equity is unfavourably below the industry level with 35.52 %.

= 26.48 %




Current ratio

The current ratio for the industry is 2:1.

2013 2012 2011


Formula:

2.78:1 3:1 1.5:1

Current assets:Current liabilities Calculation:

Comments:

There was a decrease in the current ratio of the business since 2012. This is an unfavourable trend.

105 408.77 : 37 910.17

The current ratio is still

favourably above the industry norm of 2:1.

= 2.78:1


Acid test/quick ratio

The acid test/quick ratio for the industry is 1:1.

2013 2012 2011


Formula:

1.44:1 1:1 0.5:1

(Current assets - inventory) : Current liabilities Calculation:

Comments:

There was a favourable increase in

the acid test ratio of the business since 2012.

(105 408.77 - 50 855.11) : 37

910.17

The acid test ratio of the business

is favourably above the industry norm of 1:1.

= 1.44:1



Name of ratio: Comparative figures: Ratio for the years ended 28/29 February

….

Average trade debtors collection period

The average trade debtors collection period for the industry is 28 days.

2013 2012 2011


Formula:

17.57 days 10 days 8 days

Average trade debtors x 365 Calculation:

Comments:

Credit sales There was an unfavourable increase of 7.57 days in the average trade debtors collection period since 2012.

[(28 155.24 + 32 362.34)/2 x 365]

924 638.32 x 68% The average trade debtors collection period of the business is still favourably below the industry period of 28 days.

= 17.57 days

Name of ratio: Comparative figures: Ratio for the years ended 28/29 February

….

Average trade creditors settlement period

The average trade creditors settlement period for the industry is 30 days.

2013 2012 2011


Formula:

51.82 days 15 days 15 days

Average trade creditors x 365 Calculation:

Comments:

Credit purchases The average trade creditors settlement period has increased unfavourably with 36.82 days since 2012.

[(21 054.01 + 21 266.68)/2 x 365]

462 319.16 x 52% x 62% The average trade creditors settlement period is 21.82 days more than that of industry. This is an unfavourable trend.

= 51.82 days




Average trade inventory turnover

The average trade inventory turnover for the industry is four times.

2013 2012 2011


Formula:

9.05 times 4 times 4 times

Cost of sales Calculation:

Comments:

Average inventory The average trade inventory turnover has

favourably increased by 5.05 times since 2012.

462319.16

[(51 363.66 + 50 855.11)/2] The average trade inventory turnover is

5.05 times more than the industry norm of four times. This is a favourable trend.

= 9.05 times

Question 2.10

Although the P/E ratio can provide a good approximation of how „expensive‟ a particular share is

relative to its underlying earnings stream, it is by no means a perfect gauge of a company's value. P/E

ratios have a number of drawbacks, including:

Earnings Manipulation

Companies often use a variety of accounting techniques to alter their reported net income. As a result,

the reported earnings figures we read about are often not entirely representative of a company's true

financial situation. Since net income is a critical component of a firm's P/E ratio, manipulated earnings

can lead to misleading P/E data.

Industry Differences

Different industries typically have different historical growth rates, risk levels, etc.; and hence different

average P/E ratios. Thus, shares that may appear cheap in one industry may look expensive when

stacked up against another. For this reason, it is typically more appropriate to compare a firm's P/E ratio

to those of other companies within the same sector.



Other Factors

It's important to remember that P/E ratios only take two items into account – a firm's current share price

and its net profit. As a result, P/E ratios completely ignore a variety of other important factors. One of

the most notable of these factors is a firm's projected future growth rate. Two shares could be identical

in every respect (including on a P/E basis), but if one company is growing at twice the rate of the other

firm, then the high-growth firm will likely make a better investment over the long haul. With this in mind,

many investors prefer to examine PEG ratios as opposed to traditional P/E ratios.

Volatility and Risk

P/E ratios also ignore such critical items as risk and volatility. Two firms may have identical P/E ratios,

but if one firm's revenue and earnings base is extremely reliable, yet the other firm's earnings are highly

uncertain, then the more reliable firm could make a better investment over the long haul. With the

above limitations in mind, when attempting to assess the value of a particular security, most

experienced investors choose to analyse P/E ratios in conjunction with a variety of other ratios,

including Price/Sales (P/S), Price/Cash Flow (P/CF), etc.

question solutions€¦ · question solutions learning unit 2: interpreting financial results...

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