LEARNING UNIT
9
Analysis and interpretation of financial statements
Learning outcomes .............................................................................................................. 264
Key concepts........................................................................................................................ 264
9.1
Introduction ................................................................................................................. 265
9.2
The objective of financial statements analysis........................................................... 265
9.3
The application of financial statements analysis ....................................................... 266
9.4
The limitation of financial statements analysis........................................................... 270
9.5
Exercises and solutions.............................................................................................. 271
Self-assessment .................................................................................................................. 283
263
Learning outcomes
After studying this learning unit, you should be able to do the following:
•
Discuss the nature, scope and objectives of financial statement analysis.
•
Explain the need for financial statement analysis.
•
Define, calculate and interpret the following ratios:
•
−
Return on equity
−
Return on total assets
−
Gross profit percentage
−
Profit margin
−
Financial leverage and leverage effect
−
Current ratio
−
Acid test ratio
−
Trade receivables control collection period
−
Inventory turnover rate
−
Inventory-holding period
−
Debt-equity ratio
−
Times interest earned ratio
Discuss the limitations of financial statement analysis.
Key concepts
•
Financial statement analysis
•
Ratio analysis
•
Profitability ratios
•
Liquidity ratios
•
Solvency ratios
•
Limitations of financial statement analysis
264
9.1
Introduction
Financial statement analysis is characteristically associated with ratio analysis, defined as the
analysis of relationships among various financial statement items both at a point in time and
over time. When ratio analysis is performed, financial statements are used in a unique manner
to provide a different viewpoint about the business entity.
To complete a ratio analysis, the financial statements are used to calculate a set of ratios.
Each ratio emphasises a particular aspect of the statement of financial position and/or
statement of profit or loss and other comprehensive income. The calculated set of ratios are
then compared to industry averages or historical standards to assess the financial
performance and position of the business entity. The general rule is that ratios deviating
largely on either side from industry standards may necessitate further analysis on the aspects
affecting that particular ratio.
Ratios for any one year can be misleading because they are high or low for some temporary
reason. Therefore, it is also important to analyse trends in the ratios to assess changes in the
business entity’s performance over time. A trend analysis involves graphs of the various
ratios, where each graph consists of a particular ratio plotted against time, usually expressed
in years. Thread analysis of the ratios adds depth to the study because it looks at several
years and assist in distinguishing between isolated instances of suspicious ratios and the
pervasive deterioration of ratios that indicates trouble.
Time trends in a business entity’s ratios are useful, but it is often more useful to compare the
entity trends with industry trends. This comparison illustrates how well an entity has been
doing over time relative to its competitors and may assist in explaining trends in the entity’s
ratios. If the entity’s profit margin is declining over time, for example, the user of the analysis
would like to know whether this decline is mainly because of declining industry profit margins
or whether the entity is not competitive when compared with other entities operating in same
industry.
9.2
The objective of financial statement analysis
The objective of financial statement analysis is to assess the entity's performance and
financial position in relation to risk. The information gathered from the analysis of the
financial statements can be used to pinpoint areas in the entity that require further
investigation and to plan for the future.
The significance of financial statement analysis relates to a wide range of aspects pertaining
a business entity. The following are some of the aspects that may be gleaned from financial
statements analysis:
➢
➢
➢
➢
the earning capacity or profitability of a business entity
the operational efficiency and managerial effectiveness
the short-term as well as long-term solvency position of a business entity
identification of the reasons for change in profitability and financial position of a
business entity
➢ monitoring of trends within the business and across businesses
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➢ assisting in making forecasts about future prospects of the business
Basically, there are three groups of financial ratios that are commonly used to assess the
aspects mentioned above, namely profitability, liquidity, solvency. A fourth category, market
ratios, is also useful in assessing the entity but falls outside the scope of this module.
9.3
Application of financial statement analysis
Ratios are classified according to the information they provide. The following ratios are dealt
with in this module:
•
•
•
Profitability ratios
Liquidity ratios
Solvency ratios
9.3.1 Profitability ratios
The objective of a business entity is to earn a reasonable profit on the capital invested.
Profitability ratios measure the profits of the entity relative to sales, assets, or equity.
Profitability ratios describe an entity’s past profitability. Investors are usually supplied with
information to the effect that a business earned a certain percentage of profit on equity during
the previous year and therefore should earn the same or higher percentage during the current
year. However, because there is little evidence that past profitability results predict future
profitability, it is important that the reader of such information avoids attaching too much
importance to these numbers, as they are historical. They certainly tell a story about where
the business entity has been; not where it is going. Therefore, the importance of profitability
ratios is that it provides several different meanings relating to the success of an entity in
generating a return on capital employed. Ratios that measure profitability of a business
include:
•
•
•
•
•
Return on equity
Return on total assets
Gross profit percentage
Profit margin
Financial leverage and leverage effect
3.3.1.1 Return on equity
The return on equity is used to measure how profitable the investment of capital is for the
owners of the entity. Return on equity is a two-part ratio as in its calculation it brings together
the statement of profit or loss and other comprehensive income and the statement of financial
position, where the profit for the year (profit before tax) is compared to the total equity. The
derived ratio represents the total return on equity capital and shows the entity’s ability to turn
equity investments into profits. It measures the profits made for each rand from equity holders.
3.3.1.2 Return on total assets
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The return on total assets is a measure of how effectively an entity's assets are being used to
generate comprehensive income. This ratio indicates how well a business is performing by
comparing the profit before interest (and tax) to the capital a business has invested in
assets. The higher the return, the more productive and efficient management is in utilising
economic resources.
3.3.1.3 Gross profit percentage
The gross profit percentage is a measure of the gross profit earned on sales. The gross profit
margin considers the entity's cost of goods sold but does not include any selling costs. It shows
how much profit a business entity makes after paying off its cost of goods sold. In other words,
the ratio indicates the percentage of each rand of revenue that the entity retains as gross
profit. This ratio also shows how well management is able to control costs relating to sales
when the entity is compared with its competitors. The gross profit percentage is an important
yardstick as it indicates the percentage of profit that is left from sales to meet other operating
expenses after deducting the cost of sales. Without a good cushion of gross profit, a business
entity will struggle to pay for its operating expenses.
3.3.1.4 Profit margin
The profit margin expresses the percentage of every sales rand a business entity was able to
convert into net income. The profit margin ratio shows profit (before tax) for the year as a
percentage of sales. Flowing from gross profit, the profit margin is one of the important
measures of the overall results of a business entity, showing management’s ability to operate
an entity profitably by recovering the costs relating to sales, other expenses relating to
operating a business, and the interest payable on borrowed funds. This is also an important
measure of good management stewardship in containing the operating expenses to ensure
that a reasonable amount of profit is available to the owners as compensation for investing in
the entity.
3.3.1.5 Financial leverage and leverage effect
The financial leverage ratio and financial leverage effect are measures of the extent to which
an entity benefits from the use of debt in contrast to equity. Business entities that utilise debt
to finance their activities face more business risk than purely equity financed entities. Since
such entities are obligated to make regular interest payments to lenders, they are also more
operationally leveraged. The financial leverage ratio is an assessment of how a business
entity an entity is using borrowed funds. It measures whether a business is generating positive
returns on the borrowed funds, that is, returns that are higher than the cost thereof.
A financial leverage ratio of one is generally regarded as an acceptable standard, as that is a
break-even point between the cost on borrowed funds (interest) and the benefits (return) of
using borrowed funds. A leverage ratio that exceeds one indicates that an entity is generating
higher returns on the borrowed funds than the cost thereof. Conversely, a leverage ratio of
less than one indicates that the cost on borrowed funds exceeds the return thereon.
The exact impact of the profitability of borrowed funds on the entity can be measured by
calculating the financial leverage effect. The financial leverage effect is expressed as the
267
difference between the return on equity and return on assets. The analysis of the leverage
effect is important to equity investors as it provides an indication of the return that is
attributable to them from the use of borrowed funds. A positive result on the calculation of the
leverage effect is desirable as it will indicate that borrowed funds are used profitably to
increase the wealth of the equity investors (owners) of the business.
9.3.2 Liquidity ratios
Liquidity ratios are used to provide information about the entity's ability to meet its short-term
(current) financial obligations with its current assets as they become due. These ratios are of
interest to short-term creditors of the entity. Ratios that measure the liquidity of a business
include:
•
•
•
•
•
•
Current ratio
Acid test ratio
Trade receivables collection period
Trade payables settlement period
Inventory turnover rate
Inventory-holding period
9.3.2.1 Current ratio
The current ratio measures the capability of a business to meet its short-term obligations that
are due within a year. The ratio contrasts current assets with current liabilities to assess the
extent to which current liabilities are covered by current assets. Relatively high current ratios
are interpreted as an indication that a business entity is liquid and in good position to meet its
current obligations, and vice versa. The current ratio supposedly measures liquidity because
it relates the business entity’s pending need for cash to the entity’s present cash and near
cash position.
9.3.2.2 Acid test ratio
The acid test ratio, otherwise known as the quick ratio, is the same as the current ratio except
that the current assets component excludes the inventory. Inventory is excluded because it
is deemed to be the least liquid item of the current assets. Like the current ratio, the acid test
ratio is meant to reflect the entity’s ability to pay its short-term obligations, and the higher the
acid test ratio, the more liquid the entity’s position.
9.3.2.3 Trade receivables collection period
The trade receivables collection period ratio represents the time lag between a credit sale and
receiving payment from the customer. As trade receivables relate to credit sales, the credit
sales figure is used to calculate the ratio. The closing and opening balances of trade
receivables are averaged and used in the calculation. This ratio is normally calculated in the
number of days that a business takes to collect cash from the trade receivables. This ratio
highlights both the collection efforts made by the business and the quality of trade receivables.
The shorter is the collection period of receivables, the better for a business entity.
268
9.3.2.4 Trade payables settlement period
The trade payables settlement period ratio represents the time lag between a credit purchase
and making payment to the supplier. As trade payables relate to credit purchases, credit
purchases figure should be used in calculating this ratio. The closing and opening balances
of trade payables are averaged and used in the calculation. Like other ratios, this ratio is
observed over a period of time and compared with the other businesses in the same industry.
In addition, the trade payables payment period is compared with the trade receivables
collection period to compare the pace of receiving and paying cash on trading activities.
9.3.2.5 Inventory turnover rate
The inventory turnover ratio is one of the yardsticks that are used to measure the efficiency
with which the entity’s inventory is being managed. It is a rough measure of how many times
per year the inventory level is replaced (turned over). It is calculated by dividing the cost of
sales by the average of closing and opening inventories. Generally, higher than average
inventory turnovers are suggestive of good inventory management. Low turnovers may result
from excessive inventory levels. On the other hand, abnormally high inventory turnovers may
indicate inventory levels so low that shortages of inventory will occur, and future sales
opportunities may be jeopardised.
9.3.2.6 Inventory-holding period
The inventory-holding period measures the number of days it takes to convert inventory into
sales. The inventory-holding period is calculated by multiplying the average inventory by the
number of days in a year (365) and dividing the result by the cost of sales for that period. The
higher this period, the higher the investment in inventory, which indicates that funds that could
be used to improve the entity’s ability to meet its short-term obligations are tied up in inventory.
9.3.3 Solvency ratios
Solvency ratios are used to measure the extent to which an entity can meet its long-term
obligations and remain solvent. An entity's financing is obtained from equity and the borrowing
of money. The greater the proportion of the loans (debt) regarding the equity, the greater the
risk will be for the entity and the financier. The following are two basic solvency ratios covered
in this module:
•
•
Debt-equity ratio
Times interest earned ratio
9.3.3.1 Debt-equity ratio
The debt-equity ratio is a leverage ratio that measures the weight of total debt and financial
liabilities against total equity. This ratio highlights how the entity’s capital structure is leaned
toward either debt or equity financing. The debt-equity ratio is calculated by dividing total longterm debt (non-current liabilities) by total equity. A higher debt-equity ratio indicates a levered
entity, which may be preferable for an entity that is stable with significant cash flow generation,
but not preferable for an entity that is in decline. Conversely, a lower ratio indicates an entity
269
that is less levered and closer to being fully equity financed. The appropriate debt to equity
ratio varies by industry.
9.3.3.2 Times interest earned ratio
The times interest earned ratio measures the entity’s ability to meet its interest on debt
obligations on a periodic basis. This ratio can be calculated by dividing the entity’s profit before
interest (and tax) by interest expense. The ratio shows the number of times that an entity
could, theoretically, pay its interest expenses should it devote all of its profit before interest
(and tax) to interest payment. The times interest earned's main purpose is to help quantify the
entity’s probability of default on interest payment. This, in turn, helps determine relevant debt
parameters such as the appropriate interest rate to be charged or the amount of debt that a
company can safely absorb. Generally, the higher the times interest earned ratio, the better.
9.4
The limitations of financial statement analysis
Financial statement analysis is widely used by the entity’s management, its creditors, and
potential investors. It is an important technique, and anyone wishing to have a complete
understanding of managerial finance must have a good grasp of it. Nevertheless, financial
analysis has limitations and potential problems, including the following:
➢ Financial statements are prepared following the accrual basis of accounting and are
historical in nature. The figures presented on the current financial statements may
thus not be closely related to cash flows.
➢ Because of alternative accounting treatments, comparisons among entities within
the same industries, may be difficult. Furthermore, one entity’s accounting
procedures may change over time, making trend analysis less reliable.
➢ Large entities have multiple divisions operating in multiple industries. Compilation of
the industry averages may therefore be difficult, and the benchmarking can be
inaccurate.
➢ Inflationary periods can significantly distort an entity’s recorded values relative to the
actual market values. Inventory costs and depreciation charges may affect the
calculation of profits. Inflation can distort the comparison of ratios for several entities,
or one entity’s ratios over time.
➢ Financial ratios can be used to assess whether the performance of an entity is
satisfactory, by comparing it with other entities operating in the same industry, and
by comparing current period results with those achieved in the previous accounting
periods. However, ratios do not always provide explanations for observed changes,
and further inquiry is sometimes needed. Therefore, the interpretation of calculated
ratios requires a certain level of knowledge about the entity and the industry in which
the entity operates to arrive at an informed decision.
The above limitations do not make the ratio analysis less useful but highlight problems that
analysts should be aware of when interpreting the ratios. Ratio analysis conducted in a blunt
manner can be dangerous, but if used carefully, it can provide useful insight into an entity’s
performance and financial position.
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9.6
Exercises and solutions
Work through the exercises, noting how the different ratios are calculated and the very basic
interpretation of the ratios when comparing them with those for the previous year.
EXERCISE 9.1
The following information pertains to Usuthu CC.
USUTHU CC
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 28 FEBRUARY 20.15
20.15
20.14
R
R
Revenue
360 000
307 500
Cost of sales
(270 000)
(225 000)
Inventory (1 March 20.14)
66 000
58 000
Purchases
273 000
233 000
339 000
291 000
Inventory (28 February 20.15)
(69 000)
(66 000)
Gross profit
Other income
Interest income
90 000
1 000
1 000
82 500
1 000
1 000
Distribution, administrative and other expenses
Administration expenses
Depreciation
Remuneration: Accounting officer
Finance costs
Interest on long-term loan
91 000
(69 000)
45 000
9 000
15 000
(15 000)
(15 000)
83 500
(61 000)
43 000
8 000
10 000
10 000
10 000
Profit before tax
Income tax expense
Profit for the year
Other comprehensive income for the year
Total comprehensive income for the year
7 000
(2 000)
5 000
5 000
12 500
(3 600)
8 900
8 900
271
EXERCISE 9.1 (continued)
USUTHU CC
STATEMENT OF CHANGES IN NET INVESTMENT OF MEMBERS FOR THE YEAR
ENDED 28 FEBRUARY 20.15
Members'
Retained
contriTotal
earnings
butions
R
R
R
Balances at 1 March 20.14
100 000
19 000
119 000
Members' contributions
23 000
23 000
Total comprehensive income for the year
5 000
5 000
123 000
24 000
147 000
USUTHU CC
STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 20.15
20.15
R
ASSETS
Non-current assets
115 000
Property, plant and equipment
107 000
Fixed deposit
8 000
Current assets
137 000
Inventories
69 000
Trade receivables
68 000
20.14
R
100 000
92 000
8 000
123 000
66 000
57 000
Total assets
252 000
223 000
EQUITY AND LIABILITIES
Total equity
Members' contributions
Retained earnings
Total liabilities
Non-current liabilities
Long-term borrowings
Current liabilities
Trade payables
Bank overdraft
147 000
123 000
24 000
105 000
50 000
50 000
55 000
41 000
14 000
119 000
100 000
19 000
104 000
50 000
50 000
54 000
36 000
18 000
Total equity and liabilities
252 000
223 000
Additional information
1.
Credit sales amounted to R330 000 and R270 000 for years 20.15 and 20.14 respectively.
2.
All of the purchases for both years were on credit.
3.
The fixed deposit was acquired at the Second National Bank at 12,5% interest per annum.
The money was invested on 1 March 20.13 for five years.
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EXERCISE 9.1 (continued)
4.
The balance of trade receivables and trade payables in year 20.13 amounted to R55 000
and R34 000 respectively.
5.
The closing balance of inventory on 28 February 20.13 amounted to R63 000.
REQUIRED
Calculate and comment on the profitability, liquidity and solvency ratios of Usuthu CC.
SOLUTION 9.1
1.
PROFITABILITY
Return on equity:
20.15
Return on equity =
Profit before tax
20.14
R7 000
R12 500
× 100 :
× 100
R147 000
R119 000
= 4,76%
: = 10,50%
× 100 =
Total equity
There is a remarkable deterioration in the return on equity of 5,74% (10,5 – 4,76%) in 20.15.
Return on total assets:
20.15
20.14
Return
Profit before interest and tax
R22 000
R22 500
on total =
× 100 =
× 100 :
× 100
Total assets
R252 000
R223 000
assets
= 8,73%
: = 10,09%
 Profit before interest and tax:
2015: R(7 000 + 15 000) = R22 000
2014: R(15 500 + 10 000) = R22 500
There was a deterioration in the return on assets of 1,36% (10,09% – 8,73%) in 20.15.
Gross profit percentage:
Gross profit percentage =
Gross profit
Sales
× 100 =
20.15
R90 000
R360 000
= 25,00%
× 100 :
20.14
R82 500
R307 500
: = 26,83%
× 100
The gross profit margin deteriorated by 1,83% (26,83% – 25,00%) in 20.15, which is one of the reasons
why the other profitability ratios deteriorated.
Profit margin:
Profit margin =
Profit before tax
Sales
× 100 =
20.15
R7 000
R360 000
= 1,94%
× 100 :
20.14
R12 500
R307 500
: = 4,07%
× 100
273
The profit margin deteriorated by 2,13% (4,07% – 1,94%), which can be attributed to an increase in
expenses and the decrease in the gross profit percentage.
Financial leverage:
Return on equity
Financial leverage =
Return on assets
=
20.15
4,76%
8,73%
= 0,55
:
20.14
10,50%
10,09%
: = 1,04
The financial leverage declined to a very low level in 20.15, which is an indication of inefficient use of
borrowed funds during the year.
Leverage effect:
20.15
4,76%
(8,73%)
(3,97%)
Return on equity
Less: Return on assets
20.14
10,50%
(10,09%)
(0,41%)
The members of the corporation received a negative return of 3,97% on their investment in 20.15,
indicating that the borrowed money was not effectively used. The situation was better in 20.14 because
a positive return of 0.41% was received.
LIQUIDITY
Current ratio:
Current ratio =
Current assets
Current liabilities
=
20.15
R137 000
R55 000
= 2,49 : 1
:
20.14
R123 000
R54 000
: = 2,28 : 1
The current ratio of Usuthu CC indicates a healthy liquidity position. However, it is increasing and is
higher than the standard of 2:1, thus indicating a larger than necessary investment in current assets.
Acid test ratio:
Current assets less inventory
Current liabilities
=
=
20.15
R(137 000 – 100 000)
R55 000
1,24: 1
:
20.14
R(123 000 – 66 000)
:=
R54 000
1,06 : 1
The acid test ratio of Usuthu CC is good although it is higher than the standard of 1:1, which indicates
that the CC's current liabilities are well covered by current assets even after the exclusion of inventory.
That is an indication of a good liquidity position of the entity.
Trade receivables collection period:
20.15
20.14
Average trade receivables
R62 500*
R56 000**
× 365 =
× 365 :
× 365
Credit sales
R330 000
R270 000
= 69,13 days
: = 75,70 days
* Average trade receivables: R(68 000 + 57 000) = R125 000 ÷ 2 = R62 500
** Average trade receivables: R(57 000 + 55 000) = R112 000 ÷ 2 = R56 000
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The collection period improved from 75,70 days in year 20.0 to 69,13 days in year 20.15. Debtors
currently settle their accounts 6,57 days earlier when compared with the year 20.14.
Trade payables settlement period:
20.15
Average trade payables
R38 500*
× 365 =
× 365 :
Credit purchases
R273 000
= 51,47 days
:
20.14
R35 000**
× 365
R233 000
= 54,83 days
* Average trade payables: R(41 000 + 36 000) = R77 000 ÷ 2 = R38 500
** Average trade payables: R(36 000 + 34 000) = R70 000 ÷ 2 = R35 000
Currently it takes Usuthu CC 51,47 days to settle its creditors' accounts. Compared with year 20.14, it
is a slight deterioration of the ratio as the number of days Usuthu CC is required to settle its creditors'
accounts 3,36 days earlier than it in year 20.14. Comparing this ratio with the trade receivables
collection period, Usuthu CC is in a less favourable position, as the time it takes the CC to receive its
money owed by its debtors is longer than the time the CC is required to settle its creditor's accounts.
Inventory turnover rate:
=
Cost of sales
Average inventory
=
20.15
R270 000
20.14
R225 000
:
R67 500*
R64 000**
= 4 times
: = 3,49 times
* Average inventory: R(69 000 + 66 000) = R135 000 ÷ 2 = R67 500
** Average inventory: R(66 000 + 63 000) = R129 000 ÷ 2 = R64 500
Usuthu CC recorded an improvement in the inventory turnover rate in year 20.15 when compared with
20.14. Improvement in this rate can be attributed to good management of inventory, which usually leads
to the saving of costs associated with holding inventory for longer periods.
Inventory-holding period:
Average inventory x 365
Cost of sales
=
20.15
R67 500* x 365
R270 000
20.14
R64 500* x 365
R225 000
=
91,25 days
104,63 days
* Refer to the calculation of inventory turnover rate
The inventory-holding period indicates the number of days that inventory is on hand, that is, the period
it takes the entity to sell its inventory. Usuthu CC recorded a decrease in the number of days it keeps
its inventory. This is an improvement in rate, which can be attributed, amongst other things, to improved
marketing strategies by the entity as inventory is sold quicker than it was in the previous year.
275
3
SOLVENCY
Debt-equity ratio:
Total debt
Total equity
× 100 =
20.15
R105 000
R147 000
× 100 :
= 71,43%
20.14
R104 000
R119 000
× 100
: = 87,39%
The level of debt in the entity's financial structure reported in year 20.15 is much less when compared
with year 20.14. This is an improvement in the ratio as high level of debt-equity ratio generally means
that the entity is aggressively financing its assets with debt than equity.
Times interest earned ratio:
Profit before interest
Interest expense
=
20.15
R22 000
R15 000
= 1,47 times
:
20.14
R22 500
R10 000
: = 2,25 times
The number of times interest payment is covered by the profit deteriorated in year 20.15 when
compared with year 20.14.
276
EXERCISE 9.2
The following information appeared in the accounting records of Ginger Limited:
GINGER LIMITED
BALANCES AS AT 28 FEBRUARY 20.15
Share capital
Retained earnings
Long-term loan: Globe Bank
Furniture and fittings (at carrying amount)
Inventories
Trade payables control
Trade receivables control
Bank
Income tax payable
Sales
Purchases
Administrative expenses
Interest on long-term loan
Ordinary dividend paid
20.15
R
100 000
30 000
100 000
120 000
100 000
110 000
88 000
33 000
1 000
400 000
320 000
50 000
10 000
5 000
20.14
R
100 000
10 000
100 000
140 000
80 000
99 000
66 000
25 000
2 000
360 000
290 000
45 000
10 000
2 000
Additional information
1.
The opening inventory for the year ending 20.14 amounted to R75 000.
Required
(a) Calculate all the profitability and liquidity ratios for both years of Ginger Limited and
comment on the financial position and results of the company's activities.
(b) Briefly discuss the implications of a higher debt-equity ratio.
(c) Calculate and comment briefly on the solvency position of Ginger Limited for the years
ended 2019 and 2018.
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SOLUTION 9.2:
(a)
PROFITABILITY RATIOS
Gross profit percentage:
Gross profit percentage =
Gross profit
Sales
× 100 =
20.15
R100 000
R400 000
= 25,00%
× 100 :
20.14
R75 000
R360 000
: = 20,83%
× 100
The 20.15 gross profit percentage has improved when compared with 20.14. Any change in the gross
profit percentage is associated with elements that affect the gross profit, that is, mark-up, sales mix,
inventory levels, and different forms of discounts.
Profit margin:
Profit before tax
Sales
× 100 =
20.15
R40 000
R400 000
= 10,00%
× 100 :
20.14
R20 000
R360 000
: = 5,56%
× 100
An improvement in the profit margin is recorded in 20.15 when compared with 20.14. An improvement
in the profit margin can, amongst others, be attributed to efficient management of distribution,
administrative and other operating expenses.
Return on assets (ROA):
Profit before interest
Total assets
× 100 =
20.15
R50 000
R341 000
= 14,66%
× 100 :
20.14
R30 000
R311 000
: = 9,65%
× 100
The return on assets improved in the year 20.15. This indicates that the entity was more profitable in
20.15 when compared with 20.14. This can be traced to the entity's ability to utilise assets efficiently to
generate profits.
Return on equity (ROE)
Profit before tax
Total equity
× 100 =
20.15
R40 000
R130 000
= 30,77%
× 100 :
20.14
R20 000
R110 000
: = 18,18%
× 100
A significant increase in the return on equity of the entity is recorded in year 20.15. Generally, increases
in the return on equity ratio are attributed to decreases in expenses, increases in profit mark-ups, and
decreases in equity. The increase in this ratio can also be linked to an increase in profit.
278
SOLUTION 9.2 (continued)
Financial leverage:
Return on equity
Return on assets
=
20.15
30,77%
14,66%
= 2,10
20.14
18,18%
:
9,65%
: = 1,88
The company's financial leverage improved in 2019 when compared with 2018.
Leverage effect:
Return on equity
Less: Return on total assets
20.15
20.14
30,77%
:
(14,66%)
18,18%
(9,65%)
16,11%
8,53%
:
The leverage effect of Ginger Limited indicates that the owners (shareholders) received more on their
investment than they would have if they had financed everything themselves.
LIQUIDITY RATIOS
Current ratio:
Current assets
=
20.15
R221 000
R111 000
= 1,99 : 1
Current liabilities
:
20.14
R171 000
R101 000
: = 1,69 : 1
The company's current ratio increased by 17,75% over the year, which is an ideal result for the
company. This means that each R1 of the current liabilities is covered by R1,99 of current assets or a
margin of 99%.
Acid test ratio:
Current assets less inventory
Current liabilities
=
=
20.15
R(221 000 – 100 000)
R111 000
1,09: 1
:
20.14
R(171 000 – 80 000)
R101 000
: = 0,9 : 1
The company's acid test ratio improved by more than 100%, which is good coverage of current liabilities.
It means that each R1 of current liabilities is covered by R1,09 of "quick" assets. This also indicates
that the cash flow position of the company is favourable.
Trade receivables collection period:
20.15
20.14
Average trade receivables
R70 000*
R60 000**
× 365 =
× 365 :
× 365
Credit sales
R400 000
R360 000
= 64 days
: = 61 days
* R(80 000 + 60 000) ÷ 2 = R70 000
** R60 000 (In the absence of prior year amount)
279
SOLUTION 9.2 (continued)
The company's credit control weakened as debtors' amounts were outstanding for a longer period in
20.15 than in 20.14. Ginger Limited decreased its collection period by 4,92%, which was accompanied
by 11,11% in sales. This means that the company extended its credit terms to boost sales.
Trade payables settlement period:
20.15
20.14
Average trade payables
R95 000*
R90 000**
× 365 =
× 365 :
× 365
Credit purchases
R320 000
R290 000
= 108 days
: = 113 days
* R(100 000 + 90 000) ÷ 2 = R95 000
** R90 000 (In the absence of prior year amount)
Ginger Limited paid its creditors sooner in 20.15 than in 20.14. When compared with the trade
receivables collection period, the trade payables settlement period is still favourable to the company's
cash flow. The company will receive payments from its debtors sooner than it would be required to
settle its creditors' accounts.
Inventory turnover rate:
=
Cost of sales
Average inventory
=
20.15
R300 000
20.14
R285 000
:
R90 000*
R77 500**
= 3,3 times : = 3,7 times
* R(100 000 + 80 000) ÷ 2 = R90 000
** R(80 000 + 75 000) ÷ 2 = R77 500
The inventory moved a bit slower in 20.15 when compared with 20.14. Lower inventory turnover ratio
is considered a negative indicator of ineffective inventory management. However, a lower inventory
turnover ratio will not always mean bad inventory management performance. It may in some instances
indicate adequate inventory levels, which may result in an increase in sales.
(b)
Implications of a higher debt-equity ratio:
The debt-equity ratio is the ratio of total debt (liabilities) to total equity. This ratio indicates the extent to
which debt is covered by owners' equity. A higher debt-equity ratio indicates excessive financial risk.
Whilst a higher debt-equity ratio may be unattractive because of the high level of risk, a very low ratio
would also be unattractive because it may indicate forgone opportunity to earn higher returns from
borrowed funds.
(c)
SOLVENCY POSITION
Debt-equity ratio:
Total debt
Total equity
280
× 100 =
20.15
R211 000
R130 000
= 162,31%
× 100 :
20.14
R201 000
R110 000
: = 182,73%
× 100
Times interest earned ratio:
Profit before interest
Interest expense
=
20.15
R50 000
R10 000
= 5 times
:
20.14
R30 000
R10 000
: = 3 times
The extent of debt financing is too high. This indicates that Ginger Limited uses higher levels of debt to
finance its growth. This indicates that the company's assets are largely funded through debt financing.
However, whilst the level of debt is astronomically high, the company can generate good returns for the
owners (shareholders), as indicated by the leverage effect. The company can also generate adequate
profits to settle interest payments.
CALCULATIONS


Gross profit
Sales
Cost of sales
Opening inventory
Purchases
Closing inventory
20.15
R
400 000
(300 000)
80 000
320 000
(100 000)
20.14
R
360 000
(285 000)
75 000
290 000
(80 000)
Gross profit
100 000
75 000
R
100 000
(50 000)
50 000
(10 000)
40 000
R
75 000
(45 000)
30 000
(10 000)
20 000
Profit for the year before interest and tax
Gross profit
Administrative expenses
Profit before interest
Interest expense
Profit before tax


Total assets
Non-current assets
Furniture and fittings
Current assets
Inventories
Trade receivables
Bank
R
120 000
120 000
221 000
100 000
88 000
33 000
R
140 000
140 000
171 000
80 000
66 000
25 000
Total assets
341 000
311 000
R
100 000
30 000
130 000
R
100 000
10 000
110 000
R
110 000
1 000
111 000
R
99 000
2 000
101 000
Equity
Share capital
Retained earnings

Current liabilities
Trade payables
Bank overdraft
Current liabilities
281
SOLUTION 9.2 (continued)

Total debt
Long-term loan
Trade payables
Income tax payable
282
R
100 000
110 000
1 000
211 000
R
100 000
99 000
2 000
201 000
Self-assessment
After having worked through this learning unit, are you able to do the following?
Yes
•
Discuss the nature, scope and objectives of financial statement analysis.
•
Understand the need for financial statement analysis.
•
Define, calculate and interpret the following ratios:
•
−
Return on equity
−
Return on total assets
−
Gross profit percentage
−
Profit margin
−
Financial leverage and leverage effect
−
Current ratio
−
Acid test ratio
−
Trade receivables collection period
−
Trade payables settlement period
−
Inventory turnover rate
−
Inventory-holding period
−
Debt-equity ratio
−
Times interest earned
No
Discuss the limitations of financial statement analysis.
If you answered "yes" to all of the assessment criteria, you can now focus on revision
of the study material for the exams. If your answer was "no" to any of the criteria, revise
those sections concerned before commencing with the revision of the study material.
283