1. © Pearson Education New Zealand 2007
Contents
1. Profitability – formulas and explanations
2. Interpreting profitability
3. Liquidity – formulas and explanations
4. Interpreting liquidity
5. Financial stability – formulas and explanations
6. Interpreting financial stability
7. Evaluating financial and non-financial information
End
© Pearson Education New Zealand 2007

2. 1 Profitability – formulas and explanations
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

3. © Pearson Education New Zealand 2007
Mark-up percentage
The mark-up percentage tells us how much the retailer adds onto the cost of the goods in order to determine the selling price.
Formula
gross profit x 100
cost of goods sold
A mark-up percentage of 50% tells us that the retailer will add 50 percent to the value of the good in order to reach the selling price. E.g. a good costing $1 will be sold for $1.50.
© Pearson Education New Zealand 2007

4. Gross profit percentage
The gross profit percentage tells us what proportion of each $1 of sales is received by the retailer as gross profit.
Formula
gross profit x 100
(net) sales
A gross profit percent of 40% tells us that for every $1 of sales the retailer will receive 40 cents in gross profit.
© Pearson Education New Zealand 2007

5. © Pearson Education New Zealand 2007
Expense percentage
The expense percentage tells us what proportion of each $1 of sales is paid on that particular expense.
Formula
expenses group x 100
(net) sales
A Distribution expense percentage of 8% means that for every $1 of
sales, 8 cents is paid on distribution expenses.
An Administrative expense percentage of 6% means that for every $1
of sales, 6 cents is paid on administration expenses.
A Finance cost percentage of 5% means that for every $1
of sales, 5 cents is paid on finance costs.
© Pearson Education New Zealand 2007

6. © Pearson Education New Zealand 2007
Net profit percentage
The net profit percentage tells us what proportion of each $1 of sales is received by the retailer as net profit.
Formula
net profit x 100
(net) sales 1
A net profit percent of 12% tells us that for every $1 of sales the retailer will receive 12 cents in net profit.
© Pearson Education New Zealand 2007

7. Return to 1 Profitability
Percentage change
Percentage change shows us the trend in in dollar amounts from year to year.
Formula
Year 2 – Year 1 x 100
Year 1
A percentage change in selling expenses of 20% tells the retailer that their selling expenses have increased by 20% when comparing one year to another.
Return to 1 Profitability
© Pearson Education New Zealand 2007

8. Questions: Profitability - Formulas and explanations
© Pearson Education New Zealand 2007

9. Answers a) Bathroom Supplies – Profitability measures
Profitability Percentage
Formula
Answer
Mark-up %
200%
Gross profit %
Gross profit x 100
Sales
66.67%
Distribution expense %
Distribution expense x 100
Sales
18%
Administrative expense %
Administrative expense x 100
Sales
16%
Finance cost %
Finance cost x 100
Sales 8%
Net profit %
Net profit x 100
Sales
24.67%
Return to
Interpreting Profitability Questions
© Pearson Education New Zealand 2007

10. Answers b)
1) The mark-up percentage of 200% tells us that Bathroom Supplies will add 200 percent to the value of the good in order to reach the selling price. E.g. a good costing $1 will be sold for $3.00.
2) The gross profit percentage of 66.67% tells us that that for every $1 of sales, Bathroom Supplies will receive cents in gross profit.
3) The distribution expense percentage of 18% tells us that that for every $1 of sales, Bathroom Supplies will pay 18 cents on distribution expenses.
4) The administrative expense percentage of 16% tells us that that for every $1 of sales, Bathroom Supplies will pay 16 cents on administrative expenses.
5) The finance cost percentage of 8% tells us that that for every $1 of sales, Bathroom Supplies will pay 8 cents on finance costs.
6) The net profit percentage of 24.67% tells us that that for every $1 of sales, Bathroom Supplies will receive cents in net profit.
Return to 1 Profitability
© Pearson Education New Zealand 2007

11. 2 Interpreting profitability
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

12. Interpreting mark-up percentages
Analysis measure
percentage
Mark-up %
Satisfactory percentage / ratio
Should compare favorably to industry norms.
Cause of satisfactory
percentage / ratio
Good sales mix – combining low and high markup goods.
Unsatisfactory
A mark-up % is deemed unsatisfactory if it is not providing a sufficient gross profit to help meet all business expenses.
Cause of unsatisfactory percentage / ratio
Cost of goods increasing but not passing this on to the customers.
Reducing mark-up to encourage more sales.
A change in sale mix to lower markup products.
How to improve unsatisfactory percentages / ratios
Increase the mark-up % (within reason considering competitors).
Improve the sale mix towards higher mark-up goods.
© Pearson Education New Zealand 2007

13. Interpreting gross profit percentages
Analysis measure
percentage
Gross profit %
Satisfactory percentage / ratio
Providing sufficient gross profit to meet all of the business’s expenses.
Cause of satisfactory
percentage / ratio
Sourcing lower-priced goods leading to a favorable mark up percentage.
Unsatisfactory
A gross profit % is deemed unsatisfactory if it is not providing a sufficient gross profit to help meet all business expenses.
Cause of unsatisfactory percentage / ratio
The mark-up % is insufficient to produce a gross profit that allows the business to meet all business’s expenses.
How to improve unsatisfactory percentages /ratios
Improve the mark-up %.
© Pearson Education New Zealand 2007

14. Interpreting expense percentages
Analysis measure
percentage
Expense %
Satisfactory percentage / ratio
The expense % should compare favorably to industry norms.
Cause of satisfactory
percentage / ratio
Maintaining good control over expenses.
Unsatisfactory
If the expense % is increasing above industry norms OR any significant increase.
[continues]
© Pearson Education New Zealand 2007

15. © Pearson Education New Zealand 2007
Cause of unsatisfactory percentage / ratio
Distribution
1) Increased advertising
2) Increase sales wages
3) Hired new sales staff
Administrative
Increase in rates, electricity usage, office stationery costs etc.
Finance Costs
Refinanced at a higher interest rate / took out a new loan.
How to improve unsatisfactory percentages / ratios
Maintain better control over the expense %:
1) Reduce advertising
2) Don’t replace a staff member when they leave.
Introduce electricity saving measures
Buy less / lower quality office stationery etc.
1) Refinance at a lower interest rate
2) Pay off the loan.
© Pearson Education New Zealand 2007

16. Interpreting net profit percentages
Analysis measure
percentage
Net profit %
Satisfactory percentage / ratio
Providing a sufficient return to the owner.
Cause of satisfactory
percentage / ratio
Favorable mark-up and gross profit %.
Unsatisfactory
A net profit % that is declining when compared to previous years or is an insufficient reward / risk return for the investment.
Cause of unsatisfactory percentage / ratio
1) Mark-up % is not helping to contribute an adequate gross profit.
2) Inadequate control over the expenses.
How to improve unsatisfactory percentages / ratios
1) Improve the mark-up %.
2) Decrease expense % by maintaining better control over
expenses.
Return to 2 Interpreting Profitability
© Pearson Education New Zealand 2007

17. Questions: Interpreting profitability
The owner of the Bathrooms Supplies store was pleased to see that their Gross
Profit in 2XX1 increased by $10, 000 from last year. State one possible reason for
this increase.
In 2XX0 the Distribution expense percentage was 15%,
the Administrative expense percentage was 17%,
the Finance cost percentage was 9%.
1) Describe the trend of each of the expense percentages.
2) State ONE unfavorable trend.
3) Explain two possible causes for this expense percentage trend.
4) How would you improve this expense percentage trend?
5) State two ways of reducing the Administrative and Finance costs percentages.
6) Give one possible reason for the net profit increasing from last year.
To help you answer these questions, click to see the answers to the
previous section
© Pearson Education New Zealand 2007

18. Answers Possible reasons for the increase in Gross Profit include:
The mark-up percentage was increased from last year
A supplier has been found who supplies lower-priced goods leading to a favorable mark-up percentage.
1) The Distribution expense is trending upwards.
The Administrative expense is trending downwards.
The Finance cost is trending downwards.
2) The Distribution expense is an unfavourable trend.
3) The Distribution expense may have increased due to increased advertising, increase sales wages or through the hiring of new sales staff.
4) Two ways to improve the Distribution expense percentage would be to reduce advertising or not to replace a staff member when they leave.
5) Two ways of reducing the Administrative expense percentage would be to introduce electricity saving measures, and to buy less / lower quality office stationery etc.
Two ways of reducing the Finance cost percentage would be to refinance at a lower interest rate or to pay off the loan
6) A possible reason for the Net profit percentage increasing would be because there has been an increase in the mark-up percentage and / or there has been better control over the Administrative and Finance cost expense percentages.
Return to
2 Interpreting profitability
© Pearson Education New Zealand 2007

19. 3 Liquidity – formulas and explanations
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

20. Liquidity: Current ratio
Liquidity shows how much cash the business has on hand to meet their regular payments.
Current ratio
The current ratio shows the ability of the retailer to meet their debts in the next 12 months/ accounting period
Formula
current ratio = current assets : current liabilities
The current ratio needs to be greater than 1:1. A current ratio of 1.30:1 tells us that for every $1 of current liabilities the retailer has $1.30 of current assets. This means that the retailer should be able to meet their debts during the next 12 months.
© Pearson Education New Zealand 2007

21. Liquidity: Liquid ratio
The liquid ratio shows the ability of the retailer to meet their immediate debts in the next 1–3 months.
Formula
Liquid ratio = current assets – (inventory + prepayments)
current liabilities – secured bank overdraft
Once again the liquid ratio needs to be greater than 1:1.
A liquid ratio of 1.10:1 tells us that for every $1 of liquid
liabilities the retailer has $1.10 of liquid assets. This means
that the retailer should be able to meet their immediate debts
within the next 1–3 months.
Return to
3 Liquidity
© Pearson Education New Zealand 2007

22. © Pearson Education New Zealand 2007
Questions: Liquidity
© Pearson Education New Zealand 2007

23. Answers 1) a) Musical Notes – Liquidity measures Liquidity ratio
Formula
Answer
Current ratio
Current assets
Current liabilities
1.22 : 1
Liquid ratio
Current assets – Inventory + Prepayments
Current liabilities – Secured overdraft
0.80 : 1
Return to
Interpreting liquidity Question
© Pearson Education New Zealand 2007

24. © Pearson Education New Zealand 2007b)
i) A current ratio of 1.22:1 tells us that for every $1 of current liabilities, Musical Notes has $1.22 of current assets. This means that the retailer should be able to meet their debts within the next 12 months.
ii) A liquid ratio of 0.8:1 tells us that for every $1 of liquid liabilities, Musical Notes has $1.22 of liquid assets. This means that Musical Notes may not be able to meet their immediate debts within the next 1–3 months.
Return to 3 Liquidity
© Pearson Education New Zealand 2007

25. 4 Interpreting liquidity
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

26. Interpreting the current ratio
Analysis measure
percentage / ratio
Current ratio
Satisfactory percentage / ratio
Must be greater than 1:1.
Cause of satisfactory
1) Good credit control so low bad debts
2) Good stock control.
Unsatisfactory
percentage ratio
Any ratio below 1:1 or above 2 :1.
Cause of unsatisfactory percentage / ratio
1)High accounts receivable – problem of bad debts.
2)Too much inventory – may become obsolete.
Ratio above 2:1
1) Too much cash is being held in low interest earning accounts.
2) Surplus cash should be invested in higher yield term deposits.
How to improve unsatisfactory percentages / ratios
1) Owner invests more capital in the form of cash.
2) Decrease drawings.
3) Borrow long term.
© Pearson Education New Zealand 2007

27. Interpreting the liquid ratio
Analysis measure
percentage / ratio
Liquid ratio
Satisfactory percentage / ratio
Must be greater than 1:1
Cause of satisfactory
1) Good credit control so low bad debts
2) Good stock control
3) Limited drawings
Unsatisfactory
Any ratio below 1:1
Cause of unsatisfactory percentage / ratio
1) High accounts receivable – problem of bad debts.
2) Too much inventory – may become obsolete.
3) Decrease drawings
How to improve unsatisfactory percentages / ratios
1) Improve credit control measures to reduce bad debts
2) Owner invest more capital in the form of cash.
3) Decrease drawings.
4) Have a sale on obsolete stock to reduce stock levels
Return to
4 Interpreting liquidity
© Pearson Education New Zealand 2007

28. Question: Interpreting the liquid ratio
1) State three ways the owner of Musical Notes could improve their liquidity ratio and explain how these measures will impact on components of the liquidity ratio.
Go to previous section to get the data for this question
© Pearson Education New Zealand 2007

29. Answers
Ways the owner of Musical Notes can improve their liquidity are
1) to improve credit control measures to reduce bad debts. This means that Musical Notes are careful as to whom they allow to purchase on credit, thus giving them a greater chance of receiving all outstanding money.
2) Owner invests more capital in the form of cash. This increases the bank asset (or decreases the bank overdraft) thus improving the liquid ratio.
3) Decrease drawings. This action will improve the bank balance and thus improve the liquid ratio.
4) Have a sale on obsolete stock to reduce stock levels. This will raise the level of cash in the bank and thus improve the liquid ratio.
Return to 4 Interpreting
liquidity
© Pearson Education New Zealand 2007

30. 5 Financial stability – formulas and explanations
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

31. © Pearson Education New Zealand 2007
Financial stability
Financial stability shows how much of the business is owned by the owner and how much is owned by outsiders as well as the return the owner receives from running their business.
© Pearson Education New Zealand 2007

32. © Pearson Education New Zealand 2007
Equity ratio
The equity ratio shows how much of the business has been financed by the owner.
Formula
Equity ratio = Owners equity (closing)
Total assets
An owner’s equity ratio of 0.65:1 tells us that for every $1 of assets, the owner has financed 65 cents. If this ratio falls below 0.5:1 this means that outside liabilities such as banks own a greater proportion of the business than the owner. This could have dire consequences for the owner of the business.
© Pearson Education New Zealand 2007

33. Return on owner’s equity
The return on owner’s equity measures the return on the
owner’s investment in their business. The return on the
owner’s investment must be sufficient to warrant the owner
taking the risk of investing in the business.
Formula
return on owner’s equity = net profit x
average owner’s equity
In order to find the average owner’s equity, the opening capital
is added to the closing capital and then divided by 2.
Return to
5 Financial stability
© Pearson Education New Zealand 2007

34. Questions: Financial stability
© Pearson Education New Zealand 2007

35. Answers a) The Coffee Shop – Financial stability measures
Financial Stability Ratio & Percentage
Formula
Answer 2XX1
Answer 2XX2
Equity Ratio
Equity (closing)
Total assets
0.55:1
0.56:1
Return on average owner’s equity
____Net profit_____
Average owner’s equity
32.43%
40%
Return to
Interpreting financial stability Questions
© Pearson Education New Zealand 2007

36. © Pearson Education New Zealand 2007b)
1) In 2XX1 the owner’s equity ratio of 0.55 : 1 tells us that the owner of The Coffee Shop has financed 55 cents for every $1 of assets.
In 2XX2 the owner’s equity ratio of 0.56 : 1 tells us that the owner of The Coffee Shop has financed 56 cents for every $1 of assets in 2XX2.
2) In 2XX1 a return on average owner’s equity of 32.43% tells us that the owner of The Coffee Shop is receiving a 32.43% return on their investment.
In 2XX2 the owner’s equity ratio of 0.56 : 1 tells us that the owner of The Coffee Shop is receiving a 40% return on their investment.
Return to 5
Financial stability
© Pearson Education New Zealand 2007

37. 6 Interpreting financial stability
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

38. Interpreting the equity ratio
Analysis measure
percentage / ratio
Equity ratio
Satisfactory percentage / ratio
Must be greater than 50% but not greater than around 80% in order to take advantage of borrowed funds.
Cause of satisfactory
The owner has invested more into their business than creditors / outsiders.
Unsatisfactory
Below 50%.
Cause of Unsatisfactory percentage / ratio
The owner does not have enough capital invested into the business. Creditors own more of the business than the owner.
How to improve Unsatisfactory percentages / ratios
The owner
1) invests more capital
2) pays off some liabilities.
© Pearson Education New Zealand 2007

39. Interpreting the return on average equity
Analysis measure
percentage / ratio
Return on equity
Satisfactory percentage / ratio
This return needs to favourably compare to last year’s return and to alternative investment opportunities, e.g. industry averages, return in other businesses, interest rates.
Cause of satisfactory
A satisfactory net profit.
Unsatisfactory
This return does not compare favourably to last years return or to other alternative investments.
Cause of unsatisfactory percentage / ratio
Unsatisfactory net profit.
How to improve unsatisfactory percentages / ratios
Better control over business expenses.
Return to
6 Interpreting financial stability
© Pearson Education New Zealand 2007

40. Questions: Interpreting financial stability
1) Describe the trend of the equity ratio for The Coffee Shop.
2) Explain possible reasons for the equity ratio trend.
3) What would the owner of The Coffee Shop compare their rate of return on average owner’s equity to?
To answer these questions, click to see the answers to the
Financial Stability questions
© Pearson Education New Zealand 2007

41. Answers 1) The equity ratio for The Coffee Shop is increasing.
2) Reasons for an increasing equity ratio is that the owner has invested more capital or they have paid off some of their liabilities such as a loan.
3) The owner of The Coffee Shop would compare their rate of return on average owner’s equity with last year’s return, other similar types of businesses and other investment rates such as banks.
Return to
6 Interpreting financial stability
© Pearson Education New Zealand 2007

42. 7 Evaluating financial and non-financial information
NOTES
QUESTIONS
Back to Contents
© Pearson Education New Zealand 2007

43. Evaluating financial and non-financial information
Sole proprietors are faced with evaluating information and making and justifying recommendations as well as stating any consequences that flow from their decisions. This process allows them to make an informed decision that is based on financial and non financial information.
Return to 7 Evaluating financial and non-financial information
© Pearson Education New Zealand 2007

44. Questions: Evaluating financial and non-financial information
1) What is the best option for Daniel?
2) State one non-financial reason for choosing your preferred option
3) State one financial reason for choosing your preferred option.
4) State one consequence for Daniel if he chooses your preferred option
5) State the option you did not chose for Daniel
6) State one financial reason for not choosing this option.
© Pearson Education New Zealand 2007

45. © Pearson Education New Zealand 2007
Answers
1) What is the best option for Daniel?
Either apprentice builder or apprentice plumber.
2) One non-financial reason for choosing your preferred option:
Apprentice builder
Daniel can gain a variety of building skills.
Apprentice plumber
Good working hours from 9 to 5 five days a week.
3) One financial reason for choosing your preferred option:
Long term wage prospects are excellent.
Guaranteed income of $ increasing to $ within 5 years.
© Pearson Education New Zealand 2007

46. 4) One consequence for Daniel if he chooses your preferred option:
Apprentice builder
He would be working long hours six days a week which would mean less leisure time / He would gain a variety of building skills which would mean that he could work for himself in the future.
Apprentice plumber
As there is presently a glut of plumbers, if Daniel doesn’t work hard he may find that he is unable to keep his apprenticeship.
5) The option you did not chose for Daniel:
Apprentice plumber or Apprentice builder
6) One financial reason for not choosing this option:
There is a salary cap of $ which is not that enticing when compared to other jobs and salaries offered.
In the short term, the minimum wage of $10.25 per hour is not a very good reward for all of the hard work put into being a builder’s apprentice.
Return to
7 Evaluating financial and
non-financial information
© Pearson Education New Zealand 2007