Accounting - Term 4 - Week 3

Imagine Thandi runs a spaza shop in Khayelitsha. She wants to know if her business is healthy, but just looking at her bank balance isn’t enough. Accountants use financial ratios to get a clearer picture, just like a doctor uses blood pressure to check your health. For example, the gross profit percentage shows how much profit Thandi makes from every rand of sales after paying for stock. If her sales are R10 000 and her cost of sales is R7 000, her gross profit is R3 000. The gross profit percentage is (3 000 ÷ 10 000) × 100 = 30%. This means for every R1 she sells, she keeps 30c as gross profit. Ratios help compare businesses of different sizes, and spot problems early. Many learners think ratios are just numbers, but they tell a story about the business.

Sipho’s tuck shop in Polokwane made a big profit last month, but he’s struggling to pay his suppliers. This is where the difference between profitability and liquidity matters. Profitability ratios, like gross profit percentage, show how well a business turns sales into profit. Liquidity ratios, like the current ratio and acid-test ratio, show if the business can pay its short-term debts. For example, if Sipho’s current assets are R12 000 and his current liabilities are R8 000, his current ratio is 12 000 ÷ 8 000 = 1,5:1. This means for every R1 he owes, he has R1,50 in assets to pay. A common misconception is that a profitable business is always liquid, but that’s not true. A business can make a profit but still run out of cash if customers don’t pay on time.

Lerato owns a small bakery in Mthatha. Her financial statements show: Current assets R15 000, Inventory R5 000, Current liabilities R10 000. To calculate the acid-test ratio, first subtract inventory from current assets: 15 000 – 5 000 = R10 000. Then divide by current liabilities: 10 000 ÷ 10 000 = 1,0:1. This ratio tells us if Lerato can pay her debts without selling any stock. If the ratio is below 1:1, she might struggle to pay bills quickly. Many learners forget to subtract inventory when calculating the acid-test ratio, but this step is crucial because inventory is not always easy to turn into cash quickly. Always check the formula and the numbers you use.

Ahmed manages a cellphone shop in Durban. His gross profit percentage is 40%, current ratio is 2:1, and acid-test ratio is 1,2:1. What does this mean? A gross profit percentage of 40% is strong—he keeps 40c profit from every rand of sales after paying for stock. A current ratio of 2:1 means he has twice as many current assets as current liabilities, so he can pay his short-term debts easily. The acid-test ratio of 1,2:1 shows he can pay most debts even without selling inventory. If these ratios were much lower, Ahmed might struggle to pay suppliers or cover emergencies. In the NSC exam, you’ll be asked not just to calculate, but to explain what these ratios reveal about a business’s health.

Step 1: Write down the formula: Gross profit percentage = (Gross profit ÷ Sales) × 100. Step 2: Find the numbers. Suppose Thandi’s Spaza Shop has sales of R20 000 and cost of sales of R14 000. Step 3: Calculate gross profit: 20 000 – 14 000 = R6 000. Step 4: Plug into the formula: (6 000 ÷ 20 000) × 100 = 30%. Step 5: Sanity check: 6 000 is 30% of 20 000, so the answer makes sense. Final answer: Thandi’s gross profit percentage is 30%. This means for every R1 of sales, Thandi keeps 30c as gross profit. This is a typical figure for a small retail business in South Africa, showing she is managing her cost of sales well. Always double-check your calculation and ensure you are using the correct formula, as many learners mix up the numerator and denominator.

Step 1: Write the formula: Current ratio = Current assets ÷ Current liabilities. Step 2: Suppose Sipho’s Tuck Shop has current assets of R8 000 and current liabilities of R4 000. Step 3: Calculate: 8 000 ÷ 4 000 = 2:1. Step 4: Interpretation: For every R1 Sipho owes, he has R2 in assets to pay. This is a healthy liquidity position, as it means he should be able to pay his short-term debts comfortably. Step 5: Sanity check: If assets are double the liabilities, the ratio should be 2:1. Final answer: Sipho’s current ratio is 2:1. This is above the generally accepted minimum of 1:1, so creditors would feel confident that Sipho can pay his debts.

Step 1: Write the formula: Acid-test ratio = (Current assets – Inventory) ÷ Current liabilities. Step 2: Suppose Lerato’s Bakery has current assets of R15 000, inventory of R5 000, and current liabilities of R10 000. Step 3: Subtract inventory: 15 000 – 5 000 = R10 000. Step 4: Divide by current liabilities: 10 000 ÷ 10 000 = 1,0:1. Step 5: Sanity check: If assets (excluding inventory) equal liabilities, the ratio is 1:1. Final answer: Lerato’s acid-test ratio is 1,0:1. This means Lerato can pay all her short-term debts even if she cannot sell her inventory immediately. This is important for businesses that may have slow-moving stock. Remember, the acid-test ratio is a stricter test of liquidity than the current ratio.

Question: Ahmed’s Cellphone Shop made sales of R25 000 and had a cost of sales of R18 000. What is his gross profit percentage? Let’s think: First, find gross profit: 25 000 – 18 000 = R7 000. Next, use the formula: (7 000 ÷ 25 000) × 100 = 28%. Model answer: Ahmed’s gross profit percentage is 28%. This means for every rand of sales, Ahmed keeps 28c as gross profit. Now you try: Busi’s Boutique had sales of R30 000 and cost of sales of R21 000. What is her gross profit percentage? Answer: (30 000 – 21 000) ÷ 30 000 × 100 = 9 000 ÷ 30 000 × 100 = 30%. Busi’s gross profit percentage is 30%. This is a good sign for her business, as it shows she is controlling her cost of sales well.

Question: Thandi’s Spaza Shop has current assets of R9 000 and current liabilities of R6 000. What is her current ratio? Let’s think: Use the formula: 9 000 ÷ 6 000 = 1,5:1. Model answer: Thandi’s current ratio is 1,5:1. This means for every R1 she owes, she has R1,50 in current assets to pay. Now you try: Sipho’s Tuck Shop has current assets of R5 000 and current liabilities of R2 500. What is his current ratio? Answer: 5 000 ÷ 2 500 = 2:1. Sipho’s ratio is strong, showing he is in a good position to pay his short-term debts.

Question: Lerato’s Bakery has current assets of R12 000, inventory of R4 000, and current liabilities of R8 000. What is her acid-test ratio? Let’s think: Subtract inventory from current assets: 12 000 – 4 000 = 8 000. Then divide by current liabilities: 8 000 ÷ 8 000 = 1:1. Model answer: Lerato’s acid-test ratio is 1:1. This means she can pay her current debts even without selling any inventory. Now you try: Ahmed’s Cellphone Shop has current assets of R10 000, inventory of R2 000, and current liabilities of R5 000. What is his acid-test ratio? Answer: (10 000 – 2 000) ÷ 5 000 = 8 000 ÷ 5 000 = 1,6:1. Ahmed’s business is in a strong liquidity position.

1. Write the formula for gross profit percentage in words and symbols. 2. List two examples of current assets you might find in a South African spaza shop or tuck shop. 3. State in one sentence the difference between the current ratio and the acid-test ratio, focusing on what is excluded from the acid-test ratio.

1. Calculate the gross profit percentage for a business with sales of R40 000 and cost of sales of R28 000. Show all your steps. 2. Calculate the current ratio if current assets are R15 000 and current liabilities are R10 000. Explain what this means for the business. 3. Calculate the acid-test ratio for a business with current assets of R18 000, inventory of R6 000, and current liabilities of R12 000. Then state whether this is a safe liquidity position.

1. Interpret what a current ratio of 0,8:1 means for a business in Soweto and suggest one action the owner could take to improve it. 2. Compare the liquidity of two businesses: Business A with an acid-test ratio of 1,5:1 and Business B with 0,9:1. Explain which is safer for creditors and why. 3. Solve: A business in Durban has current assets of R20 000, inventory of R8 000, and current liabilities of R10 000. Calculate both the current ratio and acid-test ratio, and explain what these results mean for the business’s ability to pay debts.

• (Gross profit ÷ Sales) × 100
• (Sales ÷ Gross profit) × 100
• (Gross profit ÷ Cost of sales) × 100
• (Cost of sales ÷ Sales) × 100

Answer: (Gross profit ÷ Sales) × 100

The correct formula is gross profit divided by sales, then multiplied by 100. Many confuse the order or use cost of sales incorrectly.

• 2:1
• 0,5:1
• 1:2
• 1:1

Answer: 2:1

Divide assets by liabilities: 12 000 ÷ 6 000 = 2:1. Some learners reverse the numbers.

• Inventory
• Debtors
• Bank balance
• Cash on hand

Answer: Inventory

Inventory is excluded because it is not easily converted to cash. Many mistakenly include it.

• The business keeps 25c profit from every R1 of sales after cost of sales.
• The business spends 25% of sales on stock.
• The business has 25% more sales than expenses.
• The business’s profit is 25% of its expenses.

Answer: The business keeps 25c profit from every R1 of sales after cost of sales.

Gross profit percentage tells us how much of each rand of sales is left as gross profit after paying for stock (cost of sales). It does not refer to expenses or how much is spent on stock. Many learners confuse gross profit with net profit or expenses, but this ratio is only about sales and cost of sales.

• It may struggle to pay debts quickly.
• It is highly profitable.
• It has too much inventory.
• It has no current liabilities.

Answer: It may struggle to pay debts quickly.

A ratio below 1:1 means current assets (excluding inventory) are less than liabilities. This is a warning sign.