Accounting - Term 4 - Week 5

Imagine Thandi runs a spaza shop in Khayelitsha. She wants to know if her business is doing well, but just looking at her bank balance isn’t enough. Financial ratios help her see if she can pay her suppliers, if she’s making enough profit, and how her shop compares to the supermarket down the road. For example, the current ratio shows if Thandi can pay her debts in the next year. If her current assets are R12 000 and her current liabilities are R8 000, her current ratio is 1.5:1. This means for every rand she owes, she has R1.50 to pay it. The rule: a ratio above 1 is usually safe. Many learners think a higher ratio is always better, but too high can mean money is just sitting idle. The key is balance, not just big numbers. In South Africa, where cash flow can be tight due to things like load-shedding or supplier delays, using ratios helps business owners make smart decisions and avoid nasty surprises.

Sipho owns a tuckshop in Polokwane, selling cold drinks and vetkoek. He buys stock for R10 000 and sells it for R15 000. His gross profit is R5 000. To find his gross profit percentage, he divides gross profit by sales: 5 000 ÷ 15 000 = 0.33, or 33%. This tells Sipho how much profit he makes before paying rent or wages. A common mistake is to divide by cost of sales instead of sales. Always use sales as the denominator for gross profit percentage. This ratio helps Sipho compare his business to others and decide if he needs to raise prices or cut costs. For example, if another tuckshop in the area has a gross profit percentage of 40%, Sipho might need to review his pricing or find cheaper suppliers. Gross profit percentage is a key indicator of how efficiently a business is turning its sales into profit, and it’s vital for making strategic decisions.

During load-shedding, Ahmed’s Durban bakery loses sales but still has bills to pay. Solvency ratios show if his business can survive tough times. The solvency ratio is total assets divided by total liabilities. If Ahmed’s assets are R60 000 and his liabilities are R30 000, his solvency ratio is 2:1. This means his assets are double his debts—a good sign. Many learners confuse solvency (long-term survival) with liquidity (short-term cash flow). Remember: liquidity is about paying bills now; solvency is about surviving for years. For example, a business might have enough cash to pay this month’s bills (good liquidity) but still owe more than it owns (poor solvency). In South Africa, where unexpected events like strikes or power cuts can affect sales, understanding both ratios helps businesses plan for both today and the future. Don’t mix them up: liquidity is the business’s ability to pay now, solvency is its ability to last.

Step 1: Identify current assets and current liabilities from the statement. Example: Current assets = R18 000 (cash, stock), current liabilities = R12 000 (fuel, repairs owed). Step 2: Divide current assets by current liabilities: 18 000 ÷ 12 000 = 1.5. Step 3: State the ratio as 1.5:1. This means for every rand owed, there is R1.50 available. Step 4: Sanity check—assets should be more than liabilities for safety. If the ratio was below 1, the taxi business might struggle to pay its bills. Final answer: The current ratio is 1.5:1, showing the business is in a safe position.

Step 1: Find gross profit and sales. Example: Gross profit = R8 000, Sales = R20 000. Step 2: Divide gross profit by sales: 8 000 ÷ 20 000 = 0.4. Step 3: Convert to percentage: 0.4 × 100 = 40%. Step 4: State the answer and check—percentage should be less than 100%. If the percentage is over 100%, you’ve made a calculation error. Step 5: Think about what this means: 40% of every rand of sales is gross profit, before expenses. Final answer: Gross profit percentage is 40%, which is healthy for a bakery.

Question: Ahmed’s bakery has total assets of R50 000 and total liabilities of R25 000. What is the solvency ratio, and what does it mean? Let’s think: Solvency ratio = assets ÷ liabilities. 50 000 ÷ 25 000 = 2. The answer: 2:1. This means Ahmed’s assets are twice his debts, so the business is financially healthy and can survive tough times. Now you try: If Thandi’s assets are R30 000 and liabilities are R15 000, what is her solvency ratio? Answer: 2:1. This shows Thandi’s business is also in a strong position.

Question: Sipho’s tuckshop has sales of R12 000 and gross profit of R3 000. What is his gross profit percentage? Think: 3 000 ÷ 12 000 = 0.25, or 25%. Worked response: Sipho’s gross profit percentage is 25%. This means for every rand of sales, 25 cents is gross profit. Your turn: Lerato’s salon has sales of R10 000 and gross profit of R4 000. What is her gross profit percentage? Answer: 40%. Lerato is making more gross profit per rand of sales than Sipho.

1. List two reasons why businesses use financial ratios in South Africa, such as comparing performance or checking financial health. 2. State the formula for the current ratio, and write it out in words and numbers. 3. Identify if a current ratio of 0.8:1 is safe or risky, and explain your answer briefly using a real-life example of a business that might struggle with a low ratio.

1. Calculate the current ratio for a business with assets of R24 000 and liabilities of R12 000, showing all your steps. 2. Calculate the gross profit percentage for a business with sales of R16 000 and gross profit of R4 000. 3. Explain what a gross profit percentage of 50% means for a business in terms of profit and costs, using a local business example. 4. Give one reason why a business might want to improve its current ratio, and suggest a way to do so.

1. Compare two businesses: Business A has a current ratio of 1.1:1, Business B has 2.5:1. Which is safer and why? Give a detailed explanation. 2. Interpret what a gross profit percentage of 20% tells you about a business’s pricing or costs, and suggest a possible improvement. 3. In an NSC-style question, justify why a business with a solvency ratio below 1:1 is at risk of closing down, using evidence from the ratios. 4. Suggest one way a South African business could improve its gross profit percentage, and explain how this would affect its overall financial health.

• Profitability
• Short-term liquidity
• Long-term solvency
• Owner’s equity

Answer: Short-term liquidity

The current ratio measures if a business can pay its short-term debts. Many confuse it with profitability, but that’s incorrect.

• 0.5:1
• 1:1
• 2:1
• 5:1

Answer: 2:1

Divide assets by liabilities: 10 000 ÷ 5 000 = 2. A common error is to subtract instead of divide.

• Gross profit ÷ Sales × 100
• Sales ÷ Gross profit × 100
• Gross profit ÷ Cost of sales × 100
• Net profit ÷ Sales × 100

Answer: Gross profit ÷ Sales × 100

Always divide gross profit by sales, not cost of sales. Many learners mix up the denominator.

• 60% of sales is profit before expenses
• 60% of costs are covered by profit
• The business is not profitable
• 60% of profit is net profit

Answer: 60% of sales is profit before expenses

Gross profit percentage shows how much of each rand of sales is left after paying for goods sold, but before other expenses. Many confuse this with net profit, but gross profit does not include costs like rent or wages.

• Assets are greater than liabilities
• Liabilities are greater than assets
• Business is highly profitable
• Business has no debts

Answer: Liabilities are greater than assets

A solvency ratio below 1:1 means the business owes more than it owns. This is a warning sign that the business may not be able to pay all its debts in the long run, which is risky for survival.