Accounting - Term 3 - Week 9

Imagine Thandi runs a spaza shop in Khayelitsha. She wants to know if her business is doing well enough to survive load-shedding and rising costs. Just looking at her bank balance won’t help—she needs to dig deeper. Financial ratios help her compare this year’s performance to last year’s, or even to Ahmed’s supermarket down the road. For example, if her gross profit on sales is dropping, she might be losing customers to competitors. Ratios like gross profit percentage, current ratio, and debt/equity ratio turn raw numbers into clear signals. The main rule: always compare ratios over time or against similar businesses. Many learners think one ratio alone tells the full story—this is a mistake. A business can have a high profit ratio but still struggle to pay debts. Always use a range of ratios for a complete picture.

Sipho, who owns a minibus taxi business in Polokwane, wants to know if his business is making enough profit. The gross profit percentage shows how much profit is made from sales after paying for goods. For example, if Sipho’s sales are R100 000 and his cost of sales is R60 000, his gross profit is R40 000. The gross profit percentage is (Gross Profit ÷ Sales) × 100 = (R40 000 ÷ R100 000) × 100 = 40%. This means for every rand earned, 40 cents is profit before expenses. The net profit percentage goes further, showing what’s left after all expenses. If net profit is R15 000, the net profit percentage is (R15 000 ÷ R100 000) × 100 = 15%. Don’t confuse gross and net profit—gross is before expenses, net is after.

Lerato’s hair salon in Mthatha faces a cash crunch when clients pay late. Liquidity ratios help her check if she can pay short-term debts. The current ratio compares current assets (like cash and inventory) to current liabilities (like creditors). If Lerato has R30 000 in current assets and R15 000 in current liabilities, her current ratio is R30 000 ÷ R15 000 = 2:1. This means she has R2 in assets for every R1 owed. The acid-test ratio is stricter—it excludes inventory, which can be hard to turn into cash quickly. If her quick assets (cash and receivables) are R10 000, the acid-test ratio is R10 000 ÷ R15 000 = 0.67:1. A ratio below 1:1 means she may struggle to pay debts on time. Many learners think a high current ratio is always good, but too high can mean money is tied up in slow-moving stock.

Ahmed’s supermarket in Durban took a loan to expand. The solvency ratio shows if the business can cover all its debts with its assets. If Ahmed’s total assets are R500 000 and total liabilities are R200 000, his solvency ratio is R500 000 ÷ R200 000 = 2.5:1. This means for every rand owed, there’s R2.50 in assets. A ratio above 2:1 is usually safe. The debt/equity ratio compares borrowed funds to owner’s equity. If Ahmed’s equity is R300 000, the debt/equity ratio is R200 000 ÷ R300 000 = 0.67:1. Lower ratios mean less risk. Some learners think a high solvency ratio always means good management, but it could also mean the business isn’t using credit to grow. Always consider the context.

Step 1: Identify sales and cost of sales. Thandi’s sales are R80 000, and her cost of sales is R50 000. Step 2: Calculate gross profit. Gross profit = Sales - Cost of sales = R80 000 - R50 000 = R30 000. Step 3: Calculate gross profit percentage. Gross profit percentage = (Gross profit ÷ Sales) × 100 = (R30 000 ÷ R80 000) × 100 = 37.5%. Step 4: Interpret the result. This means that for every rand Thandi earns from sales, 37.5 cents is gross profit before any other expenses are paid. Step 5: Sanity check. The percentage is less than 100%, which makes sense—costs can’t be negative, and profit must be a portion of sales. If the percentage was over 100%, it would mean her costs are negative, which is impossible. Final answer: Thandi’s gross profit percentage is 37.5%. This shows she is keeping a healthy portion of her sales as profit before expenses.

Step 1: List current assets and current liabilities. Sipho has R25 000 in cash, R10 000 in receivables, and R5 000 in inventory. His current liabilities are R20 000. Step 2: Add up current assets. Add cash (R25 000), receivables (R10 000), and inventory (R5 000) to get R40 000. Step 3: Calculate the current ratio. Current ratio = Current assets ÷ Current liabilities = R40 000 ÷ R20 000 = 2:1. Step 4: Interpret the result. Sipho has R2 in current assets for every R1 of current liabilities, meaning he should be able to pay his short-term debts easily. Step 5: Sanity check. If the ratio was below 1:1, he might struggle to pay debts. Here, the ratio is healthy. Final answer: Sipho’s current ratio is 2:1, showing good short-term financial health.

Step 1: Note total liabilities and owner’s equity. Ahmed’s total liabilities are R120 000, and his owner’s equity is R180 000. Step 2: Calculate the debt/equity ratio. Debt/equity ratio = Total liabilities ÷ Owner’s equity = R120 000 ÷ R180 000 = 0.67:1. Step 3: Interpret the result. This means for every R1 of owner’s equity, Ahmed has 67 cents of debt. Lower ratios mean the business is less risky because it relies more on owner’s funds than borrowed money. Step 4: Sanity check. The ratio is less than 1, so equity is higher than debt, which is generally safer for long-term stability. If the ratio was above 2:1, the business would be highly geared and more at risk if profits fall. Final answer: Ahmed’s debt/equity ratio is 0.67:1, indicating a safe balance between debt and equity.

Question: Lerato’s salon made sales of R60 000. Her net profit was R9 000. What is her net profit percentage? Let’s think: Net profit percentage = (Net profit ÷ Sales) × 100. This tells us how much of every rand of sales is left after all expenses. Worked response: (R9 000 ÷ R60 000) × 100 = 15%. This means for every rand Lerato earns, 15 cents is left as net profit after all expenses. Your turn: If her net profit was R12 000 on sales of R80 000, what is the net profit percentage? Answer: (R12 000 ÷ R80 000) × 100 = 15%. Lerato’s net profit percentage remains 15%.

Question: Sipho’s current ratio is 2:1. His friend Musa’s is 1.2:1. Who is more liquid? Let’s think: A higher current ratio means more ability to pay short-term debts. Liquidity is about having enough assets to cover what you owe soon. Worked response: Sipho’s ratio is higher, so his business is more liquid. He has more current assets for every rand of current liabilities compared to Musa. Your turn: If Musa’s ratio was 0.8:1, what would that mean? Answer: Musa may struggle to pay his short-term debts because his current assets are less than his current liabilities.

Question: Ahmed’s supermarket has assets of R600 000 and liabilities of R300 000. What is his solvency ratio? Let’s think: Solvency ratio = Total assets ÷ Total liabilities. This shows if the business can cover all its debts if needed. Worked response: R600 000 ÷ R300 000 = 2:1. This means Ahmed has R2 in assets for every R1 of liabilities, which is a safe position. Your turn: If his liabilities were R400 000, what would the ratio be? Answer: R600 000 ÷ R400 000 = 1.5:1. This is still safe, but less so than before.

1. List two profitability ratios and briefly describe what each measures in a business. 2. State the formula for the current ratio and explain what it tells you about a business’s finances. 3. Name one reason why a business needs to check its solvency ratio, and give an example of what a low solvency ratio could mean.

1. Calculate the gross profit percentage if sales are R120 000 and cost of sales is R90 000. 2. Determine the acid-test ratio if current assets are R40 000, inventory is R15 000, and current liabilities are R20 000. 3. Explain what a current ratio of 0.9:1 means for a business and what action the business might need to take to improve it.

1. Compare two businesses: Business A has a net profit percentage of 18%, Business B has 12%. Who is more profitable, and why? 2. Analyse: If a business’s debt/equity ratio increases from 0.5:1 to 1.2:1, what does this suggest about its use of borrowed funds and risk? 3. Calculate the solvency ratio for a business with assets of R750 000 and liabilities of R250 000. Explain what this result means for the business’s long-term financial health.

• Gross profit percentage
• Current ratio
• Debt/equity ratio
• Net profit percentage

Answer: Current ratio

Current ratio compares current assets to current liabilities. Gross profit and net profit percentages measure profitability, not liquidity. Debt/equity ratio is about long-term risk, not short-term payments.

• 25% of sales is profit after all expenses
• 25% of sales is profit before expenses
• 25% of assets are profitable
• 25% of liabilities are paid

Answer: 25% of sales is profit before expenses

Gross profit is calculated before expenses. Many confuse it with net profit, which is after expenses. The other options do not relate to gross profit at all.

• The business can easily pay all debts
• The business may struggle to pay short-term debts
• The business is highly profitable
• The business has no liabilities

Answer: The business may struggle to pay short-term debts

An acid-test ratio below 1:1 means quick assets are less than current liabilities, so the business might not be able to pay its debts without selling inventory. This is a warning sign for liquidity. Many learners think any ratio above zero is fine, but below 1:1 is risky.

• Total assets ÷ Owner’s equity
• Total liabilities ÷ Owner’s equity
• Current assets ÷ Current liabilities
• Gross profit ÷ Sales

Answer: Total liabilities ÷ Owner’s equity

Debt/equity ratio compares total liabilities (borrowed funds) to owner’s equity. This shows how much the business relies on debt compared to the owner’s investment. The other formulas are for solvency, liquidity, or profitability ratios.

• The business has three times more current assets than current liabilities
• The business is not profitable