YEAR 12 ACCOUNTING Ratio/Percentage Analysis Profitability

REVIEW When businesses analyse their financial statements by using ratios and percentages. They need to compare their results to: Benchmark Intra-business comparison (i.e. results from past years) Inter-business comparison (i.e. results from different businesses)

CLASSIFICATION OF RATIOS/PERCENTAGES Ratios/Percentages ProfitabilityLiquidityFinancial Stability We are looking at this today!!!

How to evaluate businesses’ results? Please follow the steps as follows: Calculate Percentages/Ratios Explain the meaning of the Percentage/Ratios Identify the trend Satisfactory Trend Look at the financial statements and formula and identify what has been changed? Why was there a change in the financial statements? Look at the financial statements and formula and identify what has been changed? Unsatisfactory Trend Why was there a change in the financial statements? Provide recommendation/s to overcome the unsatisfactory trend.

PROFITABILITY The word ‘Profitability’ means: The ability of a business to generate profit.

PERCENTAGES UNDER PROFITABILITY The following percentages are classified under Profitability: Gross Profit Percentage Mark Up Percentage Expenses Percentage Return on Average Equity (Percentage) Net Profit Percentage

Gross Profit Percentage Meaning – It means for every $1 of total net sales, XX cents of gross profit is earned to cover expenses. Example: Gross Profit % in 2005 was 55% It means for every $1 of total net sales in 2005, 55 cents of gross profit was earned to cover expenses. Gross Profit = Sales - COS

Gross Profit Percentage The following shows an extract of an Income Statements for Mr Lo’s Banana Cake store for the year ended 31 March: Sales$500,000$590,000 Cost of Goods Sold250,000300,000 Gross Profit Gross Profit Percentage

Let’s analyse the Gross Profit Percentage Does the Gross Profit Percentage show a satisfactory or unsatisfactory trend? SATISFACTORYUNSATISFACTORY If Gross Profit Percentage shows a satisfactory trend, it means the percentages over past years are INCREASING. QUESTION TIME: WHY DOES THE GP% SHOW A SATISFACTORY TREND?

Reason of Trend (surface level) The best way of explaining trends is by looking at the financial statements and the formula. What happened to gross profit in 2005 compared to Reason Gross Profit increased by $40,000, that pushed up the Gross Profit Percentage. The increase in sales is HIGHER than the increase in cost of sales. (Look at the formula) WHY?

The increase in Sales was caused by charging a higher mark-up on banana cakes OR more cakes were sold during the year. There was a slower increase in Cost of Sales which was caused by better control over the cost of sales (i.e. buying the inventory from a cheaper supplier, which cost us less and more profit could be earned.) Example, instead of buying a $2 banana cake, Mr Lo bought a $1.50 banana cake to resell, this means Mr Lo could earn extra $0.50. Reason of trend (deep level)

Summary – Gross Profit Percentage A change in Gross Profit % could be caused by: Change in Gross Profit Change in Sales Change in COS Change in mark-up Change in cost of inventory bought

Mark-up Percentage Meaning: It means for every $1 of the cost of a product, $xx of mark-up is added to get the selling price of $X.XX Example:If Mark-up percentage in 2005 was 45% It means for every $1 of the cost of a product, 45 cents of mark-up was added to get the selling price of $1.45.

Mark-up Percentage Mark-up Percentage represents the amount of ‘profit’ added to the cost of a product. The higher the mark-up, the HIGHER the profit that can be earned. The lower the mark-up, the LOWER the profit that can be earned.

Calculation The following shows an extract of Income Statements for Mr Lo’s Banana Cake store for the year ended 31 March: Sales$500,000$590,000 Cost of Sales250,000300,000 Gross Profit250,000290,000 Mark-up Percentage

Let’s Analyse the Mark-up Percentage Does the Mark-up Percentage show a satisfactory or unsatisfactory trend? SATISFACTORYUNSATISFACTORY If the Mark-up Percentage shows a satisfactory trend, it means the percentages over past years are INCREASING. QUESTION TIME: WHY DOES THE MU% SHOW A SATISFACTORY TREND?

Reason for Trend The best way of explaining trends is by looking at the financial statements and the formula. The reason for a decrease in Mark-up percentage is that: The rate of increase in Gross Profit (i.e. +$40,000) is HIGHER/LOWER than the rate of increase in Cost of Sales (i.e. +$50,000), this means overall lower mark-up is charged on the cost of a product. This is only part of the answer because we haven’t yet answered WHY?

Why COS increases? There are a few possible reasons that cause an increase in COS: CauseWhy It Changes COGS? Increase in the cost of inventory bought. This means the amount of Purchases will increase, hence COS increases. Error in Stock-takeUnder-count of inventory means we assume more inventory was sold during a year, hence COS increases.

How do we make mistakes during stock-take? Thinking Time: If you work in Foodtown, can you tell me what are the possible ways to count inventory incorrectly?

Possible mistakes during stock-take Miscounted items – i.e. instead of 32 cakes, someone counted 23 cakes. Not counting some items – i.e. a person may miss a aisle of inventory to count.

EXPENSE PERCENTAGE Meaning:For every $1 of net sales, xx cents is allocated for xxx expense. Example:If the Distribution Expense Percentage in 2005 was 20%. This means in 2005, for every $1 of total net sales, 20 cents was allocated for distribution expenses.

CHARACTERISTICS OF EXPENSE There are TWO types of expense: Variable Costs Fixed Costs

Variable Costs Costs that vary (change) in total directly and proportionately with changes in total sales. It means as total sales increase, the cost will increase proportionately. Examples: Advertising Commission Paid Delivery Expenses Cost ($) Total Sales

Fixed Costs Costs that remain the same regardless to the changes in total sales. This means the business still needs to pay the cost despite total sales increasing. Example of Fixed Costs: oRent oInsurance oDepreciation Cost ($) Total Sales

Calculation The following shows an extract of an Income Statement of Mr Lo’s Banana Cake store for the year ended 31 March: Sales$500,000$590,000 Distribution Exp55,000%59,000% Administrative Exp80,000%140,000% Finance Costs10,000%9,000%

Identify the Distribution Expense Percentage Trend The Distribution Expense Percentage shows a SATISFACTORY or UNSATISFACTORY trend. It is when the expense percentage shows a DECREASING trend. After we have identified the trend, we need to…

Explain the reason for the trend (surface level) The Distribution Expense percentage showed a satisfactory trend because Mr Lo controlled the distribution expenses well despite the increase in distribution expense. THIS IS ONLY PART OF THE ANSWER BECAUSE WE HAVEN’T YET ANSWERED WHY

Explain the reason of the trend (deep level) What’s included in the distribution expense?

Explain the reason for the trend (deep level) Possible reasons of better control over Distribution Expense: Finding cheaper advertising suppliers (i.e. instead of using expensive publishers, Mr Lo found cheaper publishers, such as Stationery Warehouse) Instead of choosing colour copying, Mr Lo chose black and white copying, which let Mr Lo photocopied flyers at a less cost.

Summary – Distribution Expenses Percentage Possible ways of controlling distribution expenses well: Choose a cheaper advertising supplier. Instead of promoting products on TV commercials, try to use local newspapers. Instead of having flyers to be colour-copied, try to have them in black and white copy, which allow the business to save costs. Only deliver goods to customers who live close to your shop (i.e. not to deliver products to customers who live far away).

Administrative Expenses Percentage Let’s analyse and evaluate Administrative Expenses Percentage together. Remember the following steps: Explain the meaning of the percentage Identify the trend Describe the cause/s of the trend (look at the formula and the financial statements) Explain the reason of the trend (providing an example) Recommendations (if the trend is unsatisfactory)

Summary – Administrative Expense Percentage Possible ways of having better control over Administrative Expenses: To reduce the cost on ‘controllable’ expenses, for example: turn the lights off after trade hours, choose a cheaper insurance policy, buy cheaper stationeries etc.

Finance Cost Percentage Let’s analyse and evaluate Finance Cost Percentage together. Remember the following steps: Explain the meaning of the percentage Identify the trend Describe the cause/s of the trend (look at the formula and the financial statements) Explain the reason of the trend (providing an example) Recommendations (if the trend is unsatisfactory)

Summary – Finance Cost Percentage Possible ways of having better control over Finance Costs: Repay non-current liabilities earlier if sufficient funds are available, which reduce the amount of interest paid; Instead of borrowing non-current liabilities, try to have owner contribute the business’s funds, which reduce the amount of non-current liabilities so hence less interest to be paid. Finance Costs = INTEREST only

Summary – Expense Percentage A change in XXX Expense % could be caused by: Change in Expenses Has the business controlled its expenses well?

Net Profit Percentage Net Profit = Gross Profit – Expenses (trading) Income – Expenses (service) Meaning:For every $1 of net sales, xx cents of net profit is earned. Example: Net Profit % in 2005 was 5% It means for every $1 of total net sales in 2005, 5 cents of net profit was earned.

Calculation Sales$500,000$650,000 Cost of Goods Sold(250,000)(300,000) Gross Profit250,000350,000 Distribution Expenses(55,000)(59,000) Administrative Expenses(80,000)(140,000) Finance Costs(10,000)(9,000) NET PROFIT Net Profit Percentage

Identify the trend The Net Profit Percentage showed a SATISFACTORY / UNSATISFACTORY trend. Next step is to look at WHY?

Describe the reason of the trend Although gross profit shows an increasing trend. A significant increase in expenses (especially Administrative expenses) Pushes down the growth rate of net profit hence causing net profit percentage decreases. Net Profit Percentage

Why the Net Profit Percentage shows such trend? Increase in a Administrative Expense is caused by loose control over administrative expenses such as: Purchase of expensive stationeries OR Increase in office workers wages OR Did not turn off power after office hours OR Chose expensive insurance premium etc.

How to improve unsatisfactory Net Profit % trend Write 2 – 3 sentences for a recommendation to Mr Lo on how to improve the unsatisfactory Net Profit % trend.

Summary – Net Profit Percentage A change in Net Profit % could be caused by: Change in Net Profit Change in Gross Profit Change in Expenses Change in mark-up How well does the business control the expenses Change in COS

Return on Average Equity (%) This percentage tells the owner of a business how ‘profitable’ their investment is in terms of the level of return (net profit). Average Equity: (Opening Equity + Closing Equity)/2 Meaning:It means for every $1 of equity invested by the owner, xx cents of net profit will be received by the owner.

Example If the Return on Average Equity Percentage in 2005 was 15%, it means in 2005, for every $1 of average equity, the owner would receive 15 cents of net profit as a return.

Calculation The following shows the extract of balance sheet of Mr Lo’s Banana Cake Store Capital – 1 April50,000125,000 Plus: Net Profit105,000142, ,000267,000 Less: Drawings30,00050,000 Capital – 31 March125,000197,000 Return on Average Equity %

Thinking Time How do you work out whether Mr Lo is making a good return? What should you compare this calculation to?

Comparison of Results Return on Average Equity Percentage must be compared to returns (express in %) from other investments in order to provide detailed investment information. Other types of investment may include: Interest rate on term deposit Dividend rate on investments in shares Interest rate on investments in debentures

Comparison of Result The Return on Average Equity shows a BETTER / WORSE result comparing to returns from other investments, such as Term Deposit (i.e. 6%)

Identify the trend The Return on Average Equity Percentage showed a SATISFACTORY / UNSATISFACTORY trend. Next step is to look at WHY?

Reason of the trend The financial statement showed that (what had happened in the financial statements): Average capital had increased (because Mr Lo invested extra capital, such as cash into the business) regardless to the increase in drawings. Net Profit had decreased (due to significant increase in administrative expenses, such as not turning off lights after office hours)

Recommendations What can we do to overcome this unsatisfactory trend? To decrease the amount of Capital? Is this a good idea? To increase Net Profit? Is this a good idea? How to?