Accounting - Term 4 - Week 9

Imagine Thandi runs a tuckshop in Khayelitsha. She wants to know if her business is doing well compared to last year. Like many South African entrepreneurs, she doesn’t have time to read every line in her financial statements. Instead, she uses ratios—a quick way to measure performance, just like a Springbok coach uses stats to pick players. For example, if her gross profit ratio increases, she’s keeping more money from each sale. Ratios turn confusing numbers into clear signals. The rule: ratios compare two related figures, giving a percentage or number that’s easy to understand. A misconception is that a high sales number always means success. In reality, if costs rise faster than sales, profit falls. Ratios help spot this before it’s too late. Ratios are used by businesses of all sizes, from the spaza shop on the corner to major supermarkets in Durban. They allow owners to make quick, informed decisions without getting lost in pages of numbers. If you learn to use ratios well, you’ll be able to advise any business owner in your community.

Sipho owns a minibus taxi in Polokwane. He checks his profit after paying for petrol, maintenance, and loan repayments. The net profit ratio tells him what percentage of his sales is left as profit. For example, if Sipho’s net profit is R15 000 and his sales are R100 000, his net profit ratio is 15%. The formula is: Net Profit ÷ Sales × 100. This ratio shows how efficiently the business turns sales into profit. A common mistake is to confuse gross profit ratio (which only looks at cost of goods sold) with net profit ratio (which includes all expenses). Always check which expenses are included before calculating. Gross profit ratio is calculated as Gross Profit ÷ Sales × 100. For example, if Sipho’s gross profit is R40 000, his gross profit ratio is 40%. Profitability ratios help owners see if their business is truly making money after all costs. They are also used by banks when deciding to give loans.

Lerato’s hair salon in Durban faces load-shedding, so she needs cash to buy a generator. She checks her current ratio—Current Assets ÷ Current Liabilities. If her current assets are R30 000 and her current liabilities are R15 000, her current ratio is 2:1. This means she has R2 for every R1 she owes soon. A ratio below 1:1 is risky—she may struggle to pay bills. Another key ratio is the acid-test (quick) ratio, which excludes inventory: (Current Assets – Inventory) ÷ Current Liabilities. This shows if she can pay debts immediately. Many learners forget to subtract inventory for the acid-test ratio—always double-check! Liquidity ratios are important for small businesses that often face cash flow problems, especially during tough times like the COVID-19 lockdowns or when unexpected expenses arise. If Lerato’s ratios drop, she might not be able to buy supplies or pay staff on time. Understanding these ratios helps her plan ahead and avoid financial stress.

Step 1: Find gross profit and sales from the income statement. Thandi’s gross profit is R25 000. Her sales are R100 000. Step 2: Use the formula: Gross Profit ÷ Sales × 100. This formula gives the percentage of sales that is gross profit. Step 3: Calculate: 25 000 ÷ 100 000 = 0.25. This means gross profit is 25% of sales. Step 4: Multiply by 100 to get a percentage: 0.25 × 100 = 25%. Final answer: Thandi’s gross profit ratio is 25%. Sanity check: 25% means she keeps 25 cents from every rand sold after paying for goods. If her ratio was much lower, she’d need to check if her supplier prices increased or if she’s selling at too low a price.

Step 1: Identify current assets and current liabilities. Lerato’s current assets: R30 000. Current liabilities: R15 000. Step 2: Use the formula: Current Assets ÷ Current Liabilities. This formula shows how many rands of current assets Lerato has for every rand of short-term debt. Step 3: Calculate: 30 000 ÷ 15 000 = 2. Final answer: The current ratio is 2:1. Sanity check: For every R1 Lerato owes, she has R2 available—safe for now. If her ratio was below 1:1, she would not have enough assets to pay her debts as they become due.

Step 1: Get net profit and sales for both years. Year 1: Net profit R10 000, Sales R80 000. Year 2: Net profit R12 000, Sales R100 000. Step 2: Calculate Year 1: 10 000 ÷ 80 000 × 100 = 12.5%. This shows how much profit was made from each rand of sales in Year 1. Step 3: Calculate Year 2: 12 000 ÷ 100 000 × 100 = 12%. This shows the same for Year 2. Step 4: Compare: The ratio dropped from 12.5% to 12%. Final answer: The net profit ratio decreased by 0.5 percentage points. Sanity check: Even though profit increased, sales grew faster, so the ratio fell. This could mean costs are rising or prices are not increasing enough.

Question: Sipho’s minibus taxi business has current assets of R20 000, inventory of R5 000, and current liabilities of R10 000. What is the acid-test ratio? Let’s think: Acid-test ratio = (Current Assets – Inventory) ÷ Current Liabilities. This ratio checks if Sipho can pay debts without selling stock. Worked response: (20 000 – 5 000) ÷ 10 000 = 15 000 ÷ 10 000 = 1.5. Sipho’s acid-test ratio is 1.5:1. He can pay his debts even without selling inventory, which is a strong position. Now you try: If Ahmed’s shop has current assets of R18 000, inventory of R8 000, and current liabilities of R8 000, what is the acid-test ratio? Answer: (18 000 – 8 000) ÷ 8 000 = 10 000 ÷ 8 000 = 1.25.

Question: Thandi’s gross profit ratio fell from 30% last year to 25% this year. What could cause this? Let’s model: A lower ratio means she keeps less profit from each sale. Possible reasons: higher cost of goods, lower selling prices, or more discounts. Maybe her supplier raised prices, or she had to drop prices to compete with a new shop. Worked response: Thandi’s suppliers may have raised prices, or she offered more discounts to attract customers. She could also be facing theft or wastage. Now you try: Sipho’s gross profit ratio dropped from 40% to 35%. Suggest one possible reason. Answer: Petrol prices increased, raising his cost of goods sold.

Question: Lerato’s current ratio last year was 2.5:1. This year it’s 1.2:1. What does this mean? Let’s model: Her ability to pay short-term debts has weakened. She has less cushion if something goes wrong. This could be because she bought new equipment, used cash for renovations, or her debts increased. Worked response: Lerato may have used cash to buy equipment or her debts have increased. She is now closer to not being able to pay her bills on time. Now you try: Ahmed’s current ratio fell from 3:1 to 1.5:1. What does this suggest? Answer: Ahmed’s business is less liquid and may struggle to pay short-term debts.

1. Define the term 'current ratio' in your own words. 2. List two types of profitability ratios used by businesses. 3. State the formula for gross profit ratio. 4. Give one reason why a business owner would check their current ratio. 5. Name one risk of having a current ratio below 1:1.

1. Calculate the net profit ratio if net profit is R8 000 and sales are R40 000. 2. Calculate the current ratio if current assets are R24 000 and current liabilities are R12 000. 3. Explain why a business would want a current ratio above 1:1. 4. List two possible causes for a drop in gross profit ratio. 5. Describe what the acid-test ratio shows about a business.

1. Compare the gross profit ratios for two years: Year 1 (R30 000 gross profit, R120 000 sales), Year 2 (R28 000 gross profit, R100 000 sales). 2. Analyse what a drop in the acid-test ratio from 2:1 to 0.8:1 could mean for a business. 3. Justify whether a net profit ratio of 5% is good for a small spaza shop. 4. Predict what might happen if a business ignores falling liquidity ratios. 5. Solve: If a business has current assets of R15 000, inventory of R5 000, and current liabilities of R10 000, what is the acid-test ratio?

• Profitability of a business
• Ability to pay short-term debts
• Value of inventory
• Total sales compared to expenses

Answer: Ability to pay short-term debts

The current ratio measures liquidity, not profitability. Many confuse it with profit ratios, but it focuses on short-term debt.

• Current Assets ÷ Current Liabilities
• (Current Assets – Inventory) ÷ Current Liabilities
• Net Profit ÷ Sales × 100
• Gross Profit ÷ Sales × 100

Answer: (Current Assets – Inventory) ÷ Current Liabilities

The acid-test ratio excludes inventory. Learners often forget to subtract inventory, leading to wrong answers.

• Sales increased and cost of goods stayed the same
• Cost of goods increased or selling price decreased
• Expenses decreased
• Net profit increased

Answer: Cost of goods increased or selling price decreased

A falling gross profit ratio means less profit per sale, usually due to higher costs or lower prices.

• The business can easily pay its short-term debts
• The business has more assets than liabilities
• The business may struggle to pay short-term debts
• The business is highly profitable

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

A ratio below 1:1 means liabilities are higher than assets, which is risky for paying debts.

• Current ratio
• Acid-test ratio
• Net profit ratio
• Inventory turnover

Answer: Net profit ratio

Net profit ratio measures how much profit a business makes from its sales, which is the definition of profitability. Current and acid-test ratios measure liquidity, not profit. Inventory turnover measures how quickly stock is sold, not profit.