Accounting - Term 4 - Week 7

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 doesn’t tell the full story. Financial ratios help her compare her shop’s performance to others, or to previous years, using numbers from her financial statements. For example, the current ratio shows if she can pay her suppliers on time. The rule: ratios are relationships between two numbers from the statements, like current assets divided by current liabilities. Many learners think ratios are only for big companies, but even a minibus taxi owner in Mthatha can use them to check if he can afford new tyres or pay his driver. Ratios turn raw numbers into useful information for real decisions.

Think about Sipho, who owns a small butchery in Polokwane. He needs to know three things: Can he pay his short-term debts (liquidity)? Is he making enough profit (profitability)? Is his business stable in the long run (solvency)? Liquidity ratios, like the current ratio and acid-test ratio, measure if there’s enough cash or assets to pay bills soon. Profitability ratios, such as gross profit percentage and net profit percentage, show how much money is left after costs. Solvency ratios, like the debt/equity ratio, tell if the business relies too much on loans. A common mistake is mixing these up—remember: liquidity is short-term, solvency is long-term, and profitability is about making money. When reading a financial statement, always check which ratio you are being asked to calculate, as using the wrong numbers leads to incorrect answers.

Lerato runs a hair salon in Durban. Her statement shows current assets of R30 000 and current liabilities of R15 000. To find the current ratio, divide current assets by current liabilities: 30 000 ÷ 15 000 = 2:1. This means for every rand she owes, she has two rand in assets. For gross profit percentage, if her sales are R100 000 and cost of sales is R60 000, gross profit is R40 000. The gross profit percentage is (gross profit ÷ sales) × 100 = (40 000 ÷ 100 000) × 100 = 40%. Many learners forget to multiply by 100 for percentages—always check your final answer’s format. It’s important to show all your workings in the exam, as partial marks are awarded for correct steps even if the final answer is wrong.

Ahmed manages a taxi fleet in Soweto. His current ratio is 0.8:1. This means for every rand he owes, he only has 80 cents in assets—he may struggle to pay his bills. If his gross profit percentage is 25%, he keeps 25 cents profit from every rand of sales after paying for fuel and maintenance. Interpreting ratios means comparing them to industry averages or past years. If the industry average current ratio is 1.5:1, Ahmed’s business is less liquid than most. Don’t just calculate—always explain what the ratio means for the business’s health. A common misconception is that a high gross profit percentage always means a business is successful, but high expenses can still lead to a low net profit. Always look at more than one ratio to get the full picture.

Step 1: Identify current assets and current liabilities from the statement. Suppose Thandi’s spaza shop has current assets of R12 000 and current liabilities of R8 000. Step 2: Divide current assets by current liabilities: 12 000 ÷ 8 000 = 1.5. Step 3: Express the answer as a ratio: 1.5:1. Step 4: Interpret the result. Thandi has R1.50 in assets for every R1 she owes. This is generally healthy, as it’s above 1:1. Sanity check: assets are greater than liabilities, so the ratio should be above 1. If the ratio was below 1, it would mean she might not be able to pay her debts on time, which could lead to supplier problems or even stock shortages.

Step 1: Find sales and cost of sales. Lerato’s salon had sales of R80 000 and cost of sales of R50 000. Step 2: Calculate gross profit: 80 000 – 50 000 = R30 000. Step 3: Divide gross profit by sales: 30 000 ÷ 80 000 = 0.375. Step 4: Multiply by 100 to get a percentage: 0.375 × 100 = 37.5%. Step 5: State the final answer: Gross profit percentage is 37.5%. Sanity check: profit is less than half of sales, so percentage should be below 50%. If you forget to multiply by 100, you’ll get 0.375 instead of 37.5%, which is a common exam error—always check your units.

Question: Sipho’s butchery has current assets of R25 000, inventory of R10 000, and current liabilities of R20 000. What is the acid-test ratio? Model: First, subtract inventory from current assets: 25 000 – 10 000 = 15 000. Next, divide by current liabilities: 15 000 ÷ 20 000 = 0.75. So, the acid-test ratio is 0.75:1. This means Sipho has only 75 cents in liquid assets for every rand owed. Now you try: If Ahmed’s taxi business has current assets of R18 000, inventory of R3 000, and current liabilities of R12 000, what is the acid-test ratio? Answer: (18 000 – 3 000) ÷ 12 000 = 15 000 ÷ 12 000 = 1.25:1.

Question: Lerato’s salon has total liabilities of R40 000 and owner’s equity of R80 000. What is the debt/equity ratio, and what does it mean? Model: Divide liabilities by equity: 40 000 ÷ 80 000 = 0.5:1. This means for every rand Lerato invested, she owes 50 cents. Lower ratios are safer. Your turn: Thandi’s spaza shop has liabilities of R30 000 and equity of R30 000. What is her debt/equity ratio? Answer: 30 000 ÷ 30 000 = 1:1.

1. List three types of financial ratios and give one example of each. For example: liquidity (current ratio), profitability (gross profit percentage), solvency (debt/equity ratio). 2. Calculate the gross profit for a business with sales of R60 000 and cost of sales of R40 000. 3. State what a current ratio of 2:1 means for a business and whether it is considered healthy.

1. Calculate the current ratio for a business with current assets of R24 000 and current liabilities of R12 000. Show your workings and express your answer as a ratio. 2. A taxi business has sales of R150 000 and cost of sales of R90 000. Calculate the gross profit percentage and explain what it means. 3. Explain why a debt/equity ratio above 2:1 might worry a bank when considering a loan application.

1. Analyse the liquidity of a business with a current ratio of 0.7:1 and an acid-test ratio of 0.4:1. What problems might this business face? 2. Calculate and interpret the gross profit percentage for a salon with sales of R120 000 and cost of sales of R90 000. Is this a strong result? 3. Compare the solvency of two businesses: A (liabilities R40 000, equity R20 000) and B (liabilities R15 000, equity R30 000). Which is more stable and why?

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

Answer: Current ratio

The current ratio compares current assets to current liabilities, measuring short-term liquidity. Many confuse it with profitability ratios.

• 60 cents of every rand sold is profit before expenses
• The business owes 60% of its sales
• 60% of sales are expenses
• Net profit is 60% of sales

Answer: 60 cents of every rand sold is profit before expenses

Gross profit is before expenses, not net profit. Many learners confuse gross and net profit.

• It may struggle to pay short-term debts
• It is highly profitable
• It has no long-term debt
• Its sales are increasing

Answer: It may struggle to pay short-term debts

A ratio below 1:1 means liabilities exceed assets. Profitability and sales are not measured by this ratio.

• Debt/equity ratio
• Current ratio
• Gross profit percentage
• Acid-test ratio

Answer: Debt/equity ratio

Solvency ratios measure a business’s long-term financial stability by comparing how much is owed (debt) to what the owner has invested (equity). The debt/equity ratio shows if a business is relying heavily on borrowed funds, which can be risky in the long run. The other ratios listed measure short-term liquidity or profitability, not solvency.

• Be highly reliant on borrowed funds
• Have high liquidity
• Have a high gross profit percentage
• Have no owner’s equity

Answer: Be highly reliant on borrowed funds

A high debt/equity ratio means more debt than equity. It does not measure liquidity or profit.