Ok, we are at the last chapter of the POA O level syllabus at mypoateacher.blogspot , this being said, this is definitely not the lease important😀.
On the contrary, this chapter is sure to come out unless if something unexpected like Covid strikes again and this chapter may be eliminated out of O level which may not be a good thing 👎 Especially if you are sure score if you can understand this chapter reasonably well by its ratios and formulas. 💪✅💯
💨Having learnt on Income statement and the balance sheet elements, have you ever wondered, how users of these financial statements make compare and use to form meaningful information?
Yes, You are right, they use ratios. Ratio can show us the uptrend or downtrend of the business and they are able to convey information in the shortest time possible.
☝There are 3 categories of ratios to analyse a business: -
1. Profitability;
2. Liquidity; &
3. Efficiency
1. Profitability
A business needs profit to carry on its ongoing trade. If a business has no profit, there will not be adequate funds for daily operational uses such as paying to suppliers for trading business or paying employee salaries for a manufacturing firm let alone any funds for capital expenditure to purchase income generating assets.
💨Profit measure the ability of a business to earn revenue and manage expenses.
Gross profit = Net Sales Revenue - Cost of Goods sold , whereby
*Net sales revenue is Total Sales revenue - Total Sales returns
Compare the Sales and gross profit of company 001 & 002, jus by looking at the sales revenue, it may appear company 001 has a larger increase of revenue (i.e around $700 to $800 increase/yr) compared to $300 of company 002.
👦However, when you analyse the gross profit margin, what did you see??
👉Did you see that Company 001 Gross profit margin is on a downward trend while company 002 Gross profit margin is on a upward trend. An investor who only sees the revenue will invest in Company 001 while by using Gross profit ratio, an investor may instead invest in Company 002 as its expenses are well managed as the years goes by.
☝How to improve Gross profit or Gross profit margin?
Ans: Gross profit can be improved either by increasing sales
(i) Have trade discount to customers to increase bigger or bulk purchase
(ii) Purchase goods from a reliable supplier to lower sales returns from customers and thereby increasing Net Sales Revenue.
Or reducing Cost of Sales
(iii) Attempt to ask for discount from suppliers
(iv) Lower manufacturing overheads such as salaries and rental
☝How do you interpret a gross profit of 20% for a business?
It means of every $1 the business made, the cost of sales of producing this product of $1 is $0.80 and thereby gross profit is $0.20 ($1.00 - $0.80)
There are 3 other profitability ratios which you have to understand, the first being (i) Mark- up on cost
☝If the question say a product that is sold for $10/piece has a mark up of 20%, how much is the original costs?
Ans: For those who said $8.00, later you do 2 more POA questions haha, the answer is $8.33 ($10/ 120% X 100%) The base for this $10 is 120% not 100%, since it is an increase or an mark up of 20% on the original price.
💨The 2nd profitability ratio is the return on equity ratio
It means the amount of profit/return earn by the owner or investors for every dollar invested into the business.
💨The 3rd profitability ratio is the profit margin ratio
The profit margin is calculated by Profit / Total Net Sales revenue. similar to Gross profit margin, the same base of " Total Net Sales revenue"is used, the difference is that profit is used instead of gross profit. It take into accounts the variable overhead and the miscellaneous expenses such as depreciation expenses or non Cost of goods sold costs.
2. Liquidity
The next important category of ratio in this chapter is the liquidity ratio. Liquidity measures the ability of a business to meet its short term financial obligation, such as payment to supplier, salaries to employees, electricity bills or rental.
Profitability does not necessary means liquidity
💨This may sound like a tagline for a movie😆, but a business which is profitable may not have liquidity, the business could sold most of its products on credit causing alot of trade receivables but no cash.
The business may also have too many obligations such as loans whose interest are occupying a huge % of the cashflow of the business or simply holding too many illquid assets such as stocks or prepaying their suppliers early.
One measure of liquidity is working capital, it is computed by: -
Working Capital = Current asset - Current liab
Company 001 has an increasing Working capital over the 3 years while company 002 increased its working capital over Yr 1 to Yr 2 but decreased to $8,000 in year 3. This maybe due to Company 002 paying off its long terms liability loan which are not within the calculation and yet reducing the bank/cash in hand which result in a lower working capital of $8,000/-.
Next, we will touch on Working Capital Ratio,
The formula is given by Working Capital Ratio = Total Current Assets/ Total Current Liab
💨A working capital ratio of less than 1 means that the business current assets is lesser than its current liab. This is dangerous as it means that the business will not be able to meet its short term obligations such as paying to suppliers if need to.
☝While a Working Capital ratio of more than 1 means that it has more current asset than current liab. An widely acceptable working capital ratio is 2. Any working capital ratio of more than 2 might means that the business is not effectively using its cash or liquid assets to increase shareholders return or returns on equity.
💨 As we all know the components of current assets within the balance sheet -----> Cash in hand, bank, trade receivables, inventory and prepayment.
Of these items, the inventory and prepayment are the hardest or takes the longest to convert to cash when the need arises.
Henceforth, quick ratio is there to taking into effect of inventory & prepayment:-
Quick Ratio = Quick Asset/Total current liab
whereby Quick asset = Total current Assets - inventory - prepayments.
The quick ratio is a clearer calculation/ ratio of the liquidity of a business since most prepayments cannot be convert to cash while to encash the whole batch of inventory does certainly requires a substantial amount of time.
Comparing the Quick ratio of Company 001 & 002 , Company 001 quick ratio are on a 3 year downward trend while company 002 are on a 3 year upward trend. Company 001 quick ratio were higher than 002 in yr 1 but were lesser than 002 in Yr 2 & 3 whereby in Yr 3 company 002 had 2.13 times of current asset compared to current liab. Company 001 could need to reduce its loan by increasing Owners or shareholders fund or hold more promotion/sales to increase its sales revenue.
3. Inventory Management
💨Inventory are a double edged sword, holding too much of it will increase storage cost, insurance, possibility of inventory esp food turning bad or possibility of theft.
Holding too little inventory might means rejecting potential customers who require high volume of goods. A business holding too little inventory will also need to incur more ordering costs and freight costs. Furthermore, the business might not enjoy trade discount since the amount of goods ordered is too little.
A ratio used for inventory management is the inventory turnover rate.
Which is calculated by Cost of sales / Average inventory
Whereby Average inventory = (Opening inventory + Closing Inventory)/2
☝Inventory turnover rate can be increased by reducing average inventory while increasing costs of sales
such as :-
(i) Not purchasing excessive inventory, a good hunch would be to purchased based on budgeted which are foremost pegged to historical sales trends &
(ii) Selling more goods to increase cost of goods sold, having more sales promotion such as using mypoateacher.blogspot 😂 as an avenue for advertisements or other social media to increase sales
☝Test your understanding, Lets try one of the question on Financial statements analysis.
