13. Financial statements analysis

Question 1

What is profitability?

Answer 1

It is the ability of a business to generate excess income to cover its expenses.

Question 2

Which ratios measures profitability?

Answer 2

Ratios that measures profitability:

1. Gross profit margin
2. Mark-up on cost
3. Profit margin
4. Return on equity

Question 3

Formulae for gross profit margin. What the figure tells?

Answer 3

GP/ Net sales revenue x 100%

It measures how much gross profit business earns (e.g 20% means $0.20) for every dollar of net sales revenue.

Question 4

Formulae for mark-up of cost. What does the figure tell?

Answer 4

GP/ cost of sales x 100%

It measures how much gross profit the business earns (e.g 20% means $0.20) for every dollar of cost of sales

Question 5

Formulae for profit margin. What does the figure tell?

Answer 5

Profit for the year/net sales revenue x 100%

It measures how much profit for the year the business earns (e.g 20% means $0.20) for every dollar of net sales revenue.

Question 6

Formulae for return on equity. What does the figure tell?

Answer 6

Profit for the year/average equity x 100%

It measures how much profit for the year the owner / investor earns (e.g 20% means $0.20) for every dollar of capital invested.

Question 7

How to improve profit of the business?

Answer 7

1. Sell goods at a higher price
2. Buy goods at lower cost price by
   a. buying goods in bulk to obtain trade discount,
   b. buying from supplier who offer lower price , without compromising on quality
3. increase source of other income
   a. sublet excess space to another business to earn rental income
   b. pay early to take advantage of cash discounts.
4. Reduce operating expenses

Question 8

What is liquidity?

Answer 8

It is the ability of a business to convert current assets into cash to pay current liabilities.

Question 9

Which ratios measures liquidity?

Answer 9

Ratios that measures liquidity:

1. Working capital
2. Working capital ratio (Current ratio)
3. Quick ratio (acid-test ratio)

Question 10

Formulae for working capital? What the figure tells?

Answer 10

Working capital = current asset – current liabilities

It measures the whether business has enough current assets to cover its current liabilities.

Question 11

Formulae for current ratio. What does the figure tell? What is the industry benchmark?

Answer 11

Current assets/ current liabilities

It tell how much current asset a business has to settle every dollar of current liabilities.

Industry benchmark is 2.

Question 12

Formulae for quick ratio. What does the figure tell? What is the industry benchmark?

Answer 12

Current assets – inventory – prepaid expenses/ current liabilities

It tell how much quick asset a business has to settle every dollar of current liabilities.

Industry benchmark is 1.

Question 13

What are some of the problems faced by the business if there is insufficient working capital (liquidity)?

Answer 13

• Insufficient money to pay for daily expenses such as rent, utilities, salaries, etc.
• Insufficient money to buy goods by cash. Suppliers are not willing to sell goods or services to the business and the business has no goods or services to offer to customers.
• Unable to take advantage of cash discounts because of inability to pay promptly.
• Trade payables may force the business to close down.

Question 14

What actions can a business take to improve liquidity working capital?

Answer 14

• Sell off surplus non-current assets
• Owner(s) bring in additional capital in the form of cash/deposits in the bank account.
• Issue more shares
• Borrow money from the bank.

Question 15

What business should not keep excessive inventory?

Answer 15

• Incurring additional expenses for storage and managing the inventory.
• Increase the risk of inventory needed to be sold at great discount to clear stock. Hence making loss.
• Expired inventory.
• Cash in used up to buy inventory instead of using cash for more profitable areas

Question 16

Which ratios measures efficiency of inventory management?

Answer 16

Ratios that measures efficiency of inventory management:

1. Rate of Inventory turnover
2. Days sales in inventory

Question 17

Formulae for rates of inventory turnover? What does the figure tell?

Answer 17

Inventory turnover = Cost of sales / Average Inventory

It indicates the number of times in a year the business replenish its inventory.

Question 18

Formulae for days sales in inventory? What does the figure tell?

Answer 18

Days sales in inventory
= Average Inventory / cost of sales x 365

It indicates the number of days business takes to sell its inventory.

Question 19

How to improve efficiency in inventory management?

Answer 19

1. Sell inventory faster
   a. Reduce selling price for slow-moving goods
   b. Provide trade discounts to encourage customers to buy in bulk and regularly.
   c. Attract more customers through marketing campaigns.
2. Keep sufficient inventory on hand
   • Use technological tools to improve the accuracy of predictions about customer demand in order to know when and how much inventory to buy.

Question 20

Which ratios measures efficiency of trade receivables management?

Answer 20

Ratios that measures efficiency of trade receivables management:

1. Rate of trade receivables turnover
2. Trade receivables collection period

Question 21

Formulae for rates of trade receivables turnover? What does the figure tell?

Answer 21

Trade receivables turnover =
(net credit sales revenue)/(average net trade receivables)

It indicates the number of times in a year the trade receivables settle their debts.

Question 22

Formulae for days sales in inventory? What does the figure tell?

Answer 22

Days sales in inventory
= (average net TR)/(net credit sales revenue) x 365 days

It indicates the number of days business takes to collect payments from the trade receivables.

Question 23

How to improve efficiency in trade receivable management

Answer 23

1. Improve credit granting processes
   a. Monitor collection patterns closely
   b. Ensure credit is granted to customers who are financially able.
2. Provide monetary incentives
   a. Offer cash discount to encourage credit customers to pay early.
3. Increase debts collection efforts
   a. Send regular reminders to credit customers who delay payment or refuse to pay
   b. Engage professional debts recovery agencies to collect payment from financially distressed credit customers.