ACCE 212: STUDY UNIT 4

ANALYSIS OF FINANCIAL STATEMENTS OF PARTNERSHIPS

Nr. CALCULATION FORMULA EXPLANATION COMPARE / COMMENT RECOMMEND /

ADVICE
1. PROFITABILITY RATIO’S
AIM: To see how profitable the business is and how well the business controls expenses
1.1 Percentage Gross profit: •This is also known as the Compare with previous year • Check pricing
gross profit on Sales – Cost of Sales gross profit margin. •Avoid too much
sales (turnover) Turnover/Sales: •It shows what percentage of Reasons for DECREASE in %: Discount.
Sales – Debtors the selling price will be gross  Sales prices incorrectly marked /  Increase sales
allowance profit. Inaccurate bookkeeping by offering
Example: A gross profit on  Too much trade discount was allowed. specials/sales
sales % of 30% means that  Calculation errors.
Gross profit x 100 for every R1 of Sales a Gross  Goods are sold for less than
Sales/Turnover 1 profit of 30c will be made. mark-up policy (stock
= x% clearance sales)
Reasons for INCREASE in %:
 Calculation mistakes and bookkeeping
errors.
Percentage Gross profit: This answer should be the AIM:
gross profit on Sales – Cost of Sales mark-up% used by the To see if the intended profit mark-up% was
cost of sales business. reached by the partnership.
(also the mark- Gross profit x 100 Example: The business Compare to the mark-up% policy
1.2
up percentage) Cost of sales 1 wanted to reach a profit Reasons for DECREASE in Mark-up%
= x% mark-up% on the cost price (For example wanted 40% but only reached
of 40%, but only reached 35%):
35%. This means that the  prices incorrectly marked
business did NOT reach their  too much trade discount
intended profit mark-up.  goods are sold for less than
mark-up policy
Reasons for INCREASE in %:
 Calculation mistakes and bookkeeping
errors.
 Look at SALES, higher profit mark-up
means higher prices charged on goods.
Customers will buy somewhere else,
sales will decrease.
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1.3 Percentage Operating profit 100 •This takes the income and •Compare to last year to see whether •Better Internal
operating profit x
Sales(Turnover ) 1 expenses into account in business is improving control over
on sales =% order to manage the Reasons for DECREASE in the %: Operating
NOTE:
Difference
business before interest.  Insufficient internal control over operating expenses.
between the % of sales that will be •Are expenses being well expenses.
%operating Operating profit managed?  If % is low, a large amount of income is
profit on sales used to cover operating expenses.
and the % Reasons for INCREASE in %:
operating
expenses on
•The higher the percentage, the better the
sales = % Internal control over operating expenses
financing cost •If sales have increased, operating profit
should have increased.
1.4 Percentage net Net profit x 100 •This shows how efficiently •Compare with previous year If % decreased:
profit on sales Turnover 1 the business is being •Compare with ⅓ of the percentage •expenses must
managed. gross profit on sales. If the percentage be better
= x% •This percentage should not managed
differs greatly from this, the expenses are
be lower than ⅓ of the too high •reduce the loan to
percentage gross profit on •If compared to operating profit on sales, it decrease interest
sales. gives an indication of the effect of finance
•This is similar to operating charges on the business. If answer is much less
profit on sales, but after than this, interest expense is too high
interest (income & expense)
is taken into account.

1.5 Percentage Operating exp x 100 •This shows the part of the •Compare with last year – it should be the •If the %
operating Turnover 1 Gross Profit on sales same or decrease. increased, there
expenses on that is used for operating What does a DECREASE in the % show?: should be better
sales = x% expenses. •The lower the %, the better the expenses control over costs.
NOTE: •It relates to cost control are managed. •advertising
Difference •It indicates whether the •If it decreased, there was better internal control expenses should
between the expenses have maintained over operating expenses. be in relation to
%operating constant in relation to sales. sales
What does an INCREASE in % show?:
profit on sales
Example: An answer of 60% •There was poor control over operating
and the %
operating means that 60% of the expenses.
expenses on amount earned for Sales will
sales = % be used to pay operating
financing cost expenses.

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Nr. CALCULATION FORMULA EXPLANATION COMPARE / COMMENT RECOMMEND /
ADVICE
2. SOLVENCY:
When the Total ASSETS exceeds the Total LIABILITIES of the business. A business will be INSOLVENT when the opposite happens.
Solvency Total assets : Total liabilities •This ratio refers to the •The business is regarded as solvent if the If the total Assets
ratio business’s degree of solvency – ratio is more than 1 : 1 (total assets more of a business
=x:1 in other words whether the than total liabilities) exceeds its total
business will be able to pay its •If the ratio is less than 1:1, the business is Liabilities, the
Answer is a ratio business will be
long-term debts. insolvent (if total assets are less than total
able to meet its
liabilities) obligations.
Total assets = Fixed assets + Fixed •A business is:
deposit + Current assets
The total value of
Solvent – assets is not
Total liabilities = Non-current when total assets > total always a true
liabilities (Loan) + Current liabilities+ liabilities reflection of the
Bank overdraft Insolvent – current rand
when total assets < total value of those
liabilities assets, because
of the roll
Historical cost
•This means that the assets plays in the
should be more than the financial
liabilities. statements.

•The ratio should be as high as

possible.

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 Nr. CALCULATION FORMULA EXPLANATION COMPARE / COMMENT
3. LIQUIDITY RATIO’S:
The ability of a business to meet its short-term obligations.
3.1 Current ratio Current assets : Current •This shows the ability of
liabilities the business to pay its
short-term debts.
= x:1 •The ratio is always
presented as x:1.
Answer is a ratio •It is best if the answer is
2:1
•The greater the ratio, the
Current assets = inventories, greater the business’s
debtors (Accrued Incomes + ability to pay its short-term
Pre-paid expenses) and cash debts.
•Can the business pay
Current liabilities = its short-term debts?
creditors(Accrued expenses + Is the business liquid?
3.2 Income received in advance) +
bank overdraft + short-term loan
Acid-test ratio Current assets - inventories: •Can the business pay its
Current liabilities short-term debts without
having to sell stock?
= x:1 •It is not easy to convert
trading stock into cash. It
Answer is a ratio
can be dated (old), stolen
or could break.
To calculate the acid test
ratio, the inventories must
therefore be subtracted
from the current assets.
•The business is liquid if
the Acid test ratio is 1:1.
More reliable ratio
RECOMMEND /
ADVICE
Compare with last year. If ratio is too
•If the ratio is 2:1, there is R2 current high
assets for each R1 current liabilities - that •check stock
means R2 assets is available to pay for levels - should
each R1 debt. not be too high
If ratio DECREASED (less than 2:1): •check obsolete
- Debtors must be encouraged to pay stock
there accounts on time. •check whether
Business will not be able to pay their prices are not
Short-term debts and will not be liquid too high
If ratio is IMPROVED (More than 2:1):
- Business will not have liquidity
problems and will be able to pay their
short-term debts
•Compare to previous year If ratio is low
If ratio DECREASED (less than 1:1): •Debtors could
The business cannot pay its short-term take too long to
liabilities without having to sell stock. pay – offer
If ratio is IMPROVED (More than 1:1): discounts for
•The business can pay its short-term debts early payments
without having to sell stock. •Creditors are
paid too soon

ACCE 212: Study Unit 4/Analysis & Interpretation of Financial Statements of a Partnership / Summary of important Ratios 4/10
3.3 Average debtors’ Average Debtors x 365 The debtors’ collection COMPARE Methods to
collection period Credit Sales 1 period is calculated to improve the
determine whether the *Compare the result with the credit terms collection
= x days debtors are complying with (e.g. 60 days) period:
the credit terms policy. - charge
Average debtors = It therefore shows how *Compare result with the previous year. interest
½(debtors opening balance + long debtors take to pay on overdue
debtors closing balance) their accounts. COMMENT accounts
- offer
If the figure for credit sales is not The result must be as If the result is longer than the credit discount
provided, use total sales. short as possible. terms policy, it means for
A good figure is 30 days –  *It could have a early payments
the quicker the debtors negative effect on the liquidity of the - no more
pay, the better for the business if they take long to pay – it affects sales to
business. the available working capital (payment to debtors with
creditors, salaries, rent, etc.) overdue
How does this result  The credit term policy is amounts
compare with the credit not efficient - sent out
terms policy? monthly
If the result complies with the credit statements
The ratio is used to terms policy, it means - regular
determine if there is an  The credit term policy is follow-up
increase or weakening in efficient telephonically,
credit control – how well  It has a positive effect SMS
are debtors being on the liquidity of the business – cash is - strict credit
controlled? available to pay operating expenses control

N.B.
The Debtors’ Collection
Period must be shorter
than the Creditors’
Payment Period.

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3.4 Average creditors Average Creditors X 365 The creditors’ payment COMPARE Pay on time -
payment period Credit Purchases 1 period is calculated to If accounts are
determine: 1. Compare with the credit settled on time,
= x days  whether there is terms policy discounts can
compliance with the credit be obtained
terms facilities arranged 1. Compare with the
with creditors. previous year Do not pay
 Whether it is in before the date
keeping with the internal 2. Compare with the –
payment policy of the debtors’ collection period. rather invest the
business so that: money to earn
1 Settlement Comment interest
discounts are If the debtors take longer to
received. pay than the business is Do not pay too
2 Interest is not paying its creditors, it may late –
charged on lead to cash flow problems. to avoid paying
overdue accounts. interest.
3 Suppliers do not
stop supplying due
to late payment. Methods to
improve the
A longer payment period is payment
better (60 – 90 days) to period:
ensure cash flow to meet Purchase
expenses. from suppliers
that allow a
payment period
that suits the
business needs
Be strict on
stock levels
3.5 Rate of stock Cost of sales . This is calculated to COMPARE If the stock
turnover Average inventories determine the number of *Compare with previous year turnover rate
times stock is replaced *Compare with other businesses that sell is low
= x times per year per year – how fast stock the same kind of product. Look at
is sold. purchase
COMMENT policy
Average inventories = (opening The answer should be as Look at sales

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 inventories + closing high as possible, but will
inventories) / 2 depend on the type of
business. Food will have a
higher turnover than cars.
This checks liquidity and
operating efficiency.
3.6 Stock holding Average Inventories . x 365 This is calculated to help
period Cost of sales 1 the business in planning to
replace stock
= x days (to place orders in time).
Average inventories = (opening This must be as low as
inventories + closing possible, but it depends on
inventories) / 2 the type of business, time
of the year, etc.
Clothing needs to change
quarterly but perishable
food has to be replaced
daily or weekly.
ACCE 212: Study Unit 4/Analysis & Interpretation of Financial Statements of a Partnership / Summary of important Ratios
A high stock turnover rate policy
 Advantage to business Check stock
Sales increase – money levels - current
is quicker available assets should
Increase in sales leads not consist of
to profits realized quicker only stock.
Low stock turnover rate
 Stock piling
(due to poor quality, aging, changes in
fashion)
 Wrong purchase policy
 Poor sales policy
Consequences of stock piling
 Decrease in profits due
to storage costs
 Liquidity is affected due
to cash tied up in stock that cannot be sold
easily.
COMPARE If stock levels
Compare to previous year. are high
Better
COMMENT buying policy
Strategy to
Low stock levels mean increase sales
 High turnover rate
 Loss of stock due to
obsolescence can be eliminated
 Loss due to price
reductions can be eliminated
 Profits can be generated
quickly
 No working capital is tied
up in stock
High stock levels mean
 Low turnover rate
 Working capital is tied up
in stock
7/10
  Loss of stock due to
obsolescence and price reductions

Nr. CALCULATION FORMULA EXPLANATION COMPARE / COMMENT RECOMMEND /

4. RISK INDICATOR / GEARING RATIO
Give an indication of how the business is financed. Indicate if the Partnership is credit worthy. Will an additional loan be granted?
4.1 Debt / Equity ratio Non-current liabilities :
(gearing ratio) Owners’ equity
=x:1
Answer is a ratio
Non-current liabilities =
borrowed capital
Owners’ equity =
own capital
ADVICE
This ratio gives an indication of When is it favourable for a business to To improve the
how the business is financed and use borrowed capital (loans)? ratio:
therefore indicates the degree of A decrease of
financial risk. A debt/equity ratio of 1:1 is the loans
regarded as acceptable – for every R1 own (repayment of
This ratio shows the following: capital (shares) there is R1 borrowed funds loans)
(loans)
1 It shows the ratio
COMMENT
between borrowed capital (loans
and own capital (partners’ 1 If the ratio is less than 1:1
capital) Example: 0,7:1
•loans are not high
2 It shows the
creditworthiness and ability to • the business is a low risk/
raise more finance low gearing / favourably geared
(will the bank give more loans to •advantage to the business
the business?) •business has a good credit rating
(creditworthy)
3 It shows the degree of
risk 2 If the ratio is more than 1:1
the business has placed itself in. Example: 1,2:1
(paying back loans with interest •loans are high
puts the business at great •interest must be paid
financial risk). Even if the profit •business is a high risk/
decreases, the loans as well as high gearing /
the interest must still be repaid. unfavourably geared
This can put financial strain on •disadvantage to business
the business. •has a bad credit rating
When will the bank consider a
- (not creditworthy)
loan to the business?
If the ratio is between 0,5:1 to

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 1:1

Nr. CALCULATION FORMULA EXPLANATION COMPARE / COMMENT RECOMME

ND /
ADVICE
5. RETURN INDICATOR
Does the partner receive a good return on the capital invested in the business, compared to other investments?
5.1 %Partners’ Partner’s earnings . x 100 The partners would COMPARE If the
earnings Average partner’s equity 1 like to know if they  Compare to interest partner is
made the right rates offered by banks, like interest rates not
Individual =x% decision to invest their on fixed deposits, returns on shares and satisfied, he
partner capital in the unit trusts. may wish to
Total earnings of individual partner = partnership.  Compare with re-negotiate
salary + bonus + interest on capital + share previous year the
of remaining profit Do the partners partners’
receive the highest agreement
Average equity of individual partner = possible return on their COMMENT or decide to
(equity at beginning of year + equity at end investment? If the return is higher than the interest rates withdraw
of year) ÷ 2 on other investments, the partner can be from the
This indicator satisfied partnership
measures how
Equity of individual partner =
profitable the
capital account + current account If the return
investment for the
is much
partners in the
lower than
business is.
interest
•The higher the rates on
percentage, the higher other
is the return, which is investments
positive. year after
year, it is
The return must be advisable to
higher than the rather
interest rate on fixed invest the
deposits. money
elsewhere.

5.2 % Return on VERY IMPORTANT:  Net profit

VERY + Interest
IMPORTANT: onloan
Always compare this % with the %
Total Always compare this % with interest paid on the LOAN.
1/2(Total Capital at the beginning of the year +¿the
at%
the theonfinthe. year +¿ Total of Current accounts at the beginning¿+the end of
end ofpaid
interest the year + Loan b
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 working x 100 LOAN. % RETURN IS HIGHER THAN INTEREST RATE PAID ON
capital =% LOAN:
employed
 This means that we have made money with the borrowed
capital/ loan/money.
 For example if the % return was 25% and the interest paid on
the loan 12%, the business has earned an additional (25 – 12
= 13%) return with borrowed capital/money/loan.

% RETURN IS LOWER THAN THE % INTEREST PAID ON

LOAN:

 This will not be good for the business and it will be wise to pay
off the loan as soon as possible.

5.3 % Return on Net profit Compare it to the figure in the previous financial year.

x 100 Compare to the Interest rate received on the fixed

partners’ ' '
Partne r saverage owne r s equity deposit.
equity  Include the sentence: It is better / not better than
Net profitinvestments.
alternative
'  Only indicator that cancurrent
be motivated as aclosing
good return or
1/2(Partner s capital beginning of year +Capital end of year +¿ Current accounts openingbalance+ accounts balanceif credit balan
not.
 If the % return is less than the previous year and less
than alternative investments, one can motivate that you
still believe that the business shows promise and will
keep growing in the future.

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