UNIT STANDARD 117156 - INTERPRET BASIC FINANCIAL STATEMENTS

DETAILS OF UNIT STANDARD

 Unit Standard Number: 117156

 Type: Fundamental

 Name of Unit Standard: Interpret Basic Financial Statements

 Number of Credits: 4

 NQF Level: 4

1.1 Introduction
The unit standard is divided into the following outcomes:

 Outcome 1: Analyse the basic elements of an income and expenditure statement.

 Outcome 2: Analyse the basic elements of a balance sheet.

 Outcome 3: Compile a personal assets and liabilities statement.

 Outcome 4: Use the evidence in financial statements to make a financial decision.

1.2 Outcome 1
Analyse the basic elements of an income and expenditure statement.

This outcome is divided into the following sub-outcomes:

 Sub-outcome 1: The purposes of an income and expenditure statement and an indication of how often these
statements are required for two case studies.

 Sub-outcome 2: Sources of income and expenditure for three different kinds of financial statements.

 Sub-outcome 3: Sources of income and expenditure with reference to an income and expenditure statement.

 Sub-outcome 4: Three income and expenditure statements examined and evaluated in terms of financial viability
of the enterprise.
1.2.1 Accounting concepts
The fundamental concepts in accounting are considered in the subsections following.

1.2.1.1 Different forms of business enterprises

Different forms of business enterprises are distinguished by virtue of how the capital was gathered and who is entitled at
the end of the financial year to the profit which was made. On ground of these two aspects there can be distinguished
between a sole trader, partnerships, and public companies.

1.2.1.2 Business entity principle

The entity principle determines that the owner and the business are two separate “persons” or “entities” each with a
separate set of financial records, assets, and liabilities. The business owns therefore separate assets, and the owner owns
only that share contributed as capital as his interest in the assets. If there are other liabilities, they will also have interest in
the assets of the business.

The owner of a sole trader can be kept legally liable for all incurred expenses in the name of the business. If a sole trader
becomes insolvent the owner is liable for the outstanding debt that cannot be repaid. If all the debts cannot be repaid out
of the asset sales of the business, personal assets of the owner must be sold to discharge the debt.

1.2.1.3 Owner’s equity

As mentioned above, the owner has interest in the assets of the business. This interest is determined by the amount of
capital contributed by the owner. If the business has no debt, the owner will possess 100% of the interest in the assets of
the business.

If there are liabilities, the owner will own the interest in the assets which remain after all liabilities are repaid. This amount
should be equal to the initial capital invested by the owner in the business plus all profits made, less the part of the profits
already withdrawn by the owner.

A simple way to explain the owner’s equity is to assume that the business closes its doors, and all the assets are sold. All
the money from the asset sales is thrown on a heap. From this money all the liabilities must be repaid (it is their interest in
the assets). The money that remains after all liabilities are repaid, is the money that the owner gets, in other words, it is his
interest in the assets.

From the above the following two logical deductions should be made:

𝑂𝑤𝑛𝑒𝑟 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑂𝑤𝑛𝑒𝑟 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝐷𝑟𝑎𝑤𝑖𝑛𝑔𝑠

1.2.1.4 Assets
The assets of a business are the possessions in which the owner and other institutions, outside the business like banks
allowing loans to the business and creditors from whom goods were bought on credit, have an interest in.

Banks will only allow loans to a business if the bank is sure that they will get their money back or if they cannot repay,
enough assets are available to be sold so that the bank can be sure they will get their money back.

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Same, creditors will only sell on credit to a business if the business is liquid, i.e., the business can repay its debt with
proceeds that the business generates monthly, but, if the business does not earn enough, the business owns enough assets
that can be sold to repay the debt.

For credit lenders it is always important to be aware of the amount of debt a business already has, in other words, who has
already interest in the assets of the business before allowing further debt.

From the above, the following logical deduction can be made:

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑂𝑤𝑛𝑒𝑟 𝑠𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

The subsections following consider the three types of assets.

i) Non-current (fixed) assets

Fixed assets are bought to be used over a long period in a business and in the everyday operations of the business. We only
distinguish between three non-current assets, viz. Land and buildings, Vehicles, and Equipment. These assets are used so
that the business can make a profit. Naturally the value of these assets will not remain the same over the years.

ii) Financial assets

A financial asset arises when a business transfers money not needed for a period, from the current bank account where
absolute minimum interest is earned, to a fixed deposit account where it is invested at a higher interest rate for a fixed
period at the bank.

iii) Current asset

Assets whose value varies monthly and can relatively easily be transformed into cash to meet monthly obligations, and
therefore fairly liquid in nature, are called current assets. The six current assets, which usually are placed in liquidity order
are as follows:

 Trading stock: Goods purchased for reselling later at a profit.

 Debtor’s control: A summary of all transactions with debtors.

 Savings: Money in separate bank account with a view to higher interest rates, but no fixed investment period, is
anytime available.

 Bank: Money in a current account or checking account for day-to-day payment transactions.

 Petty cash: Cash amount for small cash payments made every day.

 Cash float: Small change (money) needed to start and end every day in the cash registers.

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1.2.1.5 Liabilities
Liabilities are concerns outside the business to whom money is owed and thus having a share in the assets of the business.

If a business closes its doors, and sell all the assets, all the liabilities have to be repaid firstly whereupon the owner will be
entitled to the remaining money.

𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑂𝑤𝑛𝑒𝑟 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

The two main types of liability are considered in the subsections following.

i) Non-current (long-term) liabilities

Long term liabilities are debt repaid over a period longer than a year. We distinguish only one non-current liability, viz.
Loan: ABSA. This money is used within the business to make a profit. The bank will of course not lend the money free of
charge. The cost linked to the lending of money is interest that must be paid.

ii) Current (short-term) liabilities

Liabilities repaid over a period shorter than a year, and of which the amount changes continuously are called current
liabilities. The two current liabilities are as follows:

 Creditor’s control: Summary of all transactions with creditors.

 Bank overdraft: An arrangement is made with the bank to withdraw money for more than the amount of money
in the current bank account. The bank determines a limit for the bank overdraft based on the business’ credit
ability. This is the same as a loan and the bank will also charge interest on the overdraft amount.

1.2.1.6 Transactions, source document and subsidiary journals

The first step in the accounting process is to keep book of all the daily transactions which involves the business. A
transaction can be described as any trade action which involves money. When a transaction incurs a source document is
completed that provides information regarding the transaction. Each transaction is then recorded from the information as
it appears on the source document in the specific subsidiary journal, also called the book of first entry.

1.2.1.7 Debtors, creditors, and general ledger

For each debtor and creditor, a personal account is created in, what we call a subsidiary ledger. Each transaction involving
a debtor or creditor must be posted the same day that it happens to the creditor or the debtor’s personal account and the
balance immediately adapted.

This is done to determine at any given time the amount that a debtor owes us, or the amount that we owe a specific
creditor.

Each transaction is posted separately to the personal account of debtors or creditors. In the General Ledger a debtor’s
control account and creditors control account is composed which is a summary of all the separate transactions that
appeared during the month in the different personal accounts. At the end of the month a list of all the outstanding balances
of debtors and creditors, up as it appears in the subsidiary ledgers, are drawn up. The total of the debtors list has to
correspond with the balance of the debtors control account and the total of the creditors list with the balance of the
creditors control account.

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The General Ledger is divided in two main sections, viz. the Balance sheet accounts section and Nominal accounts section.

i) Balance sheet accounts section

 The Balance sheet accounts-section consists of all accounts employed to prepare the Balance sheet at the end of
the year:

 The two direct owner’s equity accounts, viz. Capital and Drawings.

 All assets, viz. Land and buildings, Vehicles, Equipment, Fixed deposit: ABSA, Trading stock, Debtors control,
Savings account, Bank, Petty cash and Cash float.

 All liabilities, viz. Loan: ABSA and Creditors control.

ii) The nominal accounts section

The Nominal accounts-section consists of all incomes and expenses employed to prepare the Income statement and
calculate the net profit:

 Incomes, e.g., Sales, Rent income, etc.

 Expenses, e.g., Cost of sales, Debtor’s allowance, Telephone, Stationery, etc.

At the end of the month all subsidiary journals are posted to the General Ledger. It is very important that the double entry
principle is always applied when posting to the General Ledger. The double entry principle determines that for every debit
entry a credit entry must be made in another account and that the accounts must refer to each other.

All ledger accounts must be balanced at the end of the month and a Trial balance drawn up to control whether the
double entry principle was applied correctly.

iii) Income and expenses

As already mentioned, all income and expenditures appear in the nominal accounts section of the General Ledger.

Income can be described as money earned by the business from any trading activity or any investment activity, e.g., Sales,
Rent income, Interest on fixed deposit, etc.

Expenses can be described as any incurred expenses with regard to trading activities and finance activities, e.g., Cost of
sales, Wages, Interest on loan, etc.

Net profit consists of the income earned less the incurred expenses.

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

1.2.1.8 Profit and loss

The main reason to start a business, is to make profit. The owner invests capital in a business to make profit. The capital is
used to buy assets to run the business and thus making a profit.

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In the case of a sole trader all the profit belongs to the owner. The owner has the choice to leave the profit, which has been
made, in the business and to buy more assets with it to enlarge the business. It remains the money of the owner, and all
profits not withdrawn will increase his share in the assets of the business. However, if the owner withdraws some of the
profits, it will decrease his share in the business.

Profit is calculated by deducting incurred expenses from the incomes earned. If the expenses are more than the income,
there will be a loss, and the owner’s share and his investment in the business will decrease.

It is the risk taken by the owner when he starts the business. If the business makes a profit the investment of the owner
can grow but in case of a loss the value of the investment will decrease.

From the above, the following two logical deductions can be made:

𝑂𝑤𝑛𝑒𝑟 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐷𝑟𝑎𝑤𝑖𝑛𝑔𝑠

𝑂𝑤𝑛𝑒𝑟 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑁𝑒𝑡 𝐿𝑜𝑠𝑠 − 𝐷𝑟𝑎𝑤𝑖𝑛𝑔𝑠

1.2.1.9 Financial statements

At the end of the financial year, i.e., the twelve months on which an accounting report must be presented, the financial
results of the business are given in an easily readable manner in the form of two financial statements: the Income statement
and the Balance sheet.

Only income and expenditures appear in the Income statement to calculate the net profit for the preceding year. Only
nominal accounts appear thus in the Income statement.

The Balance sheet provides a clear picture of the financial situation of a business on the last day of the financial year in the
form of assets which is equal to owner’s equity plus liabilities.

One can thus see exactly what the interest of the owner and that of outsiders are in the assets of the business.

Companies also draw up a cash flow statement that provides an overview of the company's cash flows from operating
activities, investing activities, and financing activities. Net income is carried over to the cash flow statement where it is
included as the top line item for operating activities. Like its title, investing activities include cash flows involved with
firmwide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom
line shows how much cash a company has available.

According to the Companies Act 61 of 1973 a company’s financial statements have to be drawn up in accordance with
generally accepted accounting practice (GAAP) as well as the specific requirements of schedule 4. In this module you are
not expected to know the specific requirements, but an awareness of the common elements will assist you in understanding
financial statements.

1.2.1.10 Financial performance

Financial statements are maintained by companies daily and used internally for business management. In general, both
internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and
evaluating overall financial performance/

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When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal
analysis. Each financial statement is also analyzed with vertical analysis to understand how different categories of the
statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement
and bring together data points across statements collectively.

1.2.1.11 Accounting cycle

It is always important to distinguish between which accounting procedure happens daily, monthly or only once annually.

 Daily procedure: Transactions take place, source documents are completed, complete subsidiary journals, posting
to Debtors and Creditors Ledgers.

 Monthly procedure: Closing off of subsidiary journals, posting to the General Ledger, prepare a Trial balance,
prepare Debtors and Creditors Lists.

 Annual procedure: Prepare Income statement, cash flow statement and Balance sheet, analysis and
interpretation of financial statements.

Figure 0.1: Cycle of actions in accounting

1.2.1.12 Financial Viability

The concept of the going concern is an important accounting concept. Financial Statements are usually prepared with the
assumption that the enterprise is a going concern, without evidence to the contrary. This assumption implies that the
business will continue its operations for the foreseeable future.

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Financial viability implies the following:

 The concern will continue its operations in the foreseeable future.

 The enterprise is sufficiently profitable (or will be in the future) to continue its operations.

 There is inherent worth in continuing operations. This is related to the concept of ongoing profits. It is important
to note that sometimes companies do not make a profit every year – especially in the first few years of operations.
A businessperson would examine financial statements for their financial viability and also take a view on the
inherent worth. A full assessment or analysis of a company does not just look at one year in isolation: many years
of operational results need to be examined for a fundamental analysis.

1.2.2 Sub-outcome 1
The purposes of an income and expenditure statements and an indication of how often these statements are required

1.2.2.1 What is an income statement?

An income statement is a financial statement that shows you the business’s income and expenditures. It also shows whether
a business is making profit or loss for a given period. The income statement, along with the balance sheet and cash flow
statement, helps you understand the financial health of your business.

The income statement is also known as a profit and loss statement, statement of operation, statement of financial result
or income, or earnings statement.

Individual can also set up an income and expense statement to analyse personal income and expenses.

1.2.2.2 Importance of an income statement

An income statement helps business owners decide whether they can generate profit by increasing revenues, by
decreasing costs, or both. It also shows the effectiveness of the strategies that the business set at the beginning of a
financial period. The business owners can refer to this document to see if the strategies have paid off. Based on their
analysis, they can come up with the best solutions to yield more profit.
Following are the few other things that an income statement informs:

 Frequent reports: While other financial statements are published annually, the income statement is generated
either quarterly or monthly. Due to this, business owners and investors can track the performance of the business
closely and make informed decisions. This also enables them to find and fix small business problems before they
become large and expensive.

 Pinpointing expenses: This statement highlights the future expenses or any unexpected expenditures which are
incurred by the company, and any areas which are over or under budget. Expenses include building rent, salaries
and other overhead costs. As a small business begins to grow, it may find its expenses soaring. These expenditures
may involve hiring workers, buying supplies, and promoting the business.

 Overall analysis of the company: This statement gives investors an overview of the business in which they are
planning to invest. Banks and other financial institutions can also analyse this document to decide whether the
business is loan-worthy.

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1.2.2.3 Who uses an income statement?
There are two main groups of people who use this financial statement: internal and external users.

Internal users include company management and the board of directors, who use this information to analyse the business’s
standing and make decisions to turn a profit. They can also act on any concerns regarding cash flow.

External users comprise investors, creditors, and competitors. Investors check whether the company is positioned to grow
and be profitable in the future, so they can decide whether to invest in the business. Creditors use the income statement
to check whether the company has enough cash flow to pay off its loans or take out a new loan. Competitors use them to
get details about the success parameters of a business and get to know about areas where the business is spending an extra
bit.

1.2.2.4 The items in an income statement

The income statement includes several pieces of key financial information that's used to calculate profit and losses. They
include the following items:

 Operating revenue: Operating revenue includes all of the money the business earns from providing a service or
selling goods.

 Nonoperating revenue: This is revenue earned through noncore business activities, such as rent from a property
the business owns or royalties from a partnership.

 Gains: Often called other income, this is money the business made outside of its core operations. For instance, it
could be money made from selling off land or an old vehicle.

 Expenditures: Expenditures are money spent on goods or services to run the business. They are recorded at the
time of purchase. Expenditures differ from expenses, which are typically offset over a period. For example, if you
spend R10,000 on a copy machine and pay for it on the spot, that would be listed as an expenditure. But if you
pay off the printer over several years, it's an expense.

 Cost of goods sold: Known as COGS, these are the costs associated with selling your products. They include the
materials to develop your goods and the labor to get them in the market.

 Operating expenses: These are the costs not linked to the goods or services you're providing. They can include
rent, office supplies and utilities, among other things.

 Depreciation: These are expenses that are spread out over a long period of time. The value declines as the
equipment or vehicle ages. Depreciation varies depending on the type of business you are operating.

 Owner's draw: This is the money you take out of the business to pay yourself a salary.

 Earnings before taxes: This refers to your income before you pay any taxes on it.

 Gross profit: Calculated by subtracting the cost of goods sold from revenue, gross profit is the profit the company
makes.

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  Net income: Net income is the income left over after you subtract all of your expenses from your gross profits.
It's the most important line of the income statement. If your net income is positive, your business is doing OK. If
your net income is negative, you may need to take a deeper look at operations. It's common for businesses just
starting out to have a loss.

1.2.2.5 Example of an income statement

While there are different types of income statements, they all include the key information listed above.

Figure 0.2: Example of an income statement

Item 2020 2019

Sales R820 000 R760 000
Cost of Goods Sold (COGS) R180 400 R182 400
Gross Profit R639 600 R577 600

OPERATING EXPENSES
Gross Wages/Salaries R92 000 R84 000
Advertising R40 000 R38 000
Car, Delivery and Travel R35 800 R32 400
Accounting and Legal R12 000 R10 200
Rent R80 000 R72 000
Telephone/Utilities R32 000 R 28 500
Insurance R6 000 R5 200
Postage & Delivery R8 200 R9 000
Interest Expenses R0 0
Other Expenses R7 500 R6 250
Owner’s Withdrawal R46 000 R52 000
Total Operating Expense R359 500 R337 500

Profit before tax R280 100 R240 050

Income Taxes R42 000 R31 200

Net Profit after Tax R238 100 R208 850

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1.2.3 Sub-outcome 2, 3 & 5
Sources of income and expenditure for three different kinds of financial statements.

Sources of income and expenditure with reference to an income and expenditure statement.

Three income and expenditure statements examined and evaluated in terms of financial viability of the enterprise.

1.2.3.1 Introduction
The format of the financial statements and entry items is slightly different based on the legal form of the business and the
type of concern.

A business concern can operate as a sole proprietor (trader) or can be incorporated as a company or a partnership. The
table following details the differences between these three business forms from an accounting perspective.

Sole Trader Partnerships Public Company

Shareholders  limited by number of

One owner 2 – 20 owners  partners
authorised shares

Each owner contributes capital in one Shareholders contributes capital by

Provides all capital
form or another buying shares

Owners’ equity
Owners’ equity Owners’ equity
Capital: Mar A
Capital Ordinary share capital
Current account: Mr A
Drawings Retained income
Drawings: Mr A

Jointly and separately responsible for Shareholders’ liability is limited to the

Solely responsible for debt
debt value of shares owned

Share the profits as determined in the Profit sharing in form of dividends 

Takes all profit
partnership agreement only if company’s profit permits it

Final accounts Final accounts

Final accounts
Trading account Trading account
Trading account
Profit & loss account Profit & loss account
Profit & loss account
Appropriation account Appropriation account

Most business can be classified into one or me of the three following categories:

 Manufacturing concern: A manufacturing concern typically produce product to be sold to a retailer. This type of
business buys the raw material and process it into a product.

 Trading concern: A trading concern typically buy manufactured products and sell it to the retail market for a profit.

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  Service concern: A service concern provides a service such an accounting or legal services.

The income and cost items for the different legal forms and types of concerns differs slightly in the financial statements.

1.2.3.2 Income statement for a service concern

With a service concern, the operating revenue is represented by the item operating income.

The operating expenses are deducted from the gross operating income to arrive at the net income for the year.

Figure 0.3: Example income statement - service concern

While there are different types of income statements, they all include the key information listed above.

Item 2020 2019

Sales R820 000 R760 000
Cost of Goods Sold (COGS) R180 400 R182 400
Gross Profit R639 600 R577 600

OPERATING EXPENSES
Gross Wages/Salaries R92 000 R84 000
Advertising R40 000 R38 000
Car, Delivery and Travel R35 800 R32 400
Accounting and Legal R12 000 R10 200
Rent R80 000 R72 000
Telephone/Utilities R32 000 R 28 500
Insurance R6 000 R5 200
Postage & Delivery R8 200 R9 000
Interest Expenses R0 0
Other Expenses R7 500 R6 250
Owner’s Withdrawal R46 000 R52 000
Total Operating Expense R359 500 R337 500

Profit before tax R280 100 R240 050

Income Taxes R42 000 R31 200

Net Profit after Tax R238 100 R208 850

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1.2.3.3 Income statement for a trading concern
With a trading concern, the operating revenue is represented by the turnover. The cost of sales is deducted from the
turnover to arrive at the gross profit. Other operating income is added to the gross profit to derive at the gross operating
income.

The operating expenses is deducted from the gross operating income to derive the net profit for the year.

Figure 0.4: Example income statement - trading concern

Item 2020 2019

Sales R820 000 R760 000
Cost of Goods Sold (COGS) R180 400 R182 400
Gross Profit R639 600 R577 600

OPERATING EXPENSES
Gross Wages/Salaries R92 000 R84 000
Advertising R40 000 R38 000
Car, Delivery and Travel R35 800 R32 400
Accounting and Legal R12 000 R10 200
Rent R80 000 R72 000
Telephone/Utilities R32 000 R 28 500
Insurance R6 000 R5 200
Postage & Delivery R8 200 R9 000
Interest Expenses R0 0
Other Expenses R7 500 R6 250
Owner’s Withdrawal R46 000 R52 000
Total Operating Expense R359 500 R337 500

Profit before tax R280 100 R240 050

Income Taxes R42 000 R31 200

Net Profit after Tax R238 100 R208 850

1.2.3.4 Income statement for a manufacturing concern

The income statement for a manufacturing concern is more complicated. A manufacturing concern has its inventory in
various stages of production. The income statement of manufacturing companies is a multi-step statement having three
inventory accounts that must be dealt with to calculate the cost of goods sold. These are raw materials inventory, work-in-
progress inventory, and finished goods inventory.

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Figure 0.5: Example income statement - manufacturing concern

Item 2020 2019

Sales R 880 000,00 R 844 800,00
Cost of Goods Sold R 224 000,00 R 218 000,00
Opening inventory R 180 000,00 R 172 000,00
+ Purchases R 220 000,00 R 218 000,00
(-) Closing inventory -R 176 000,00 -R 172 000,00
Gross Profit R 656 000,00 R 626 800,00

Operating Expenses -R 206 000,00 -R 182 000,00

Operating income R 89 000,00 R 72 000,00

Other income R 30 000,00 R 27 000,00

Rent received R 24 000,00 R 21 600,00
Interest received R 6 000,00 R 5 400,00

Other expense -R 268 400,00 -R 253 600,00

Gross Wages/Salaries -R 122 000,00 -R 116 000,00
Advertising -R 12 000,00 -R 11 200,00
Car, Delivery and Travel -R 8 200,00 -R 7 600,00
Accounting and Legal -R 12 000,00 -R 11 200,00
Rent -R 65 000,00 -R 61 000,00
Telephone/Utilities -R 40 000,00 -R 38 000,00
Insurance -R 6 000,00 -R 5 600,00
Postage & Delivery -R 3 200,00 -R 3 000,00

Income before taxes R 300 600,00 R 290 200,00

Income tax expense R 84 200,00 R 81 600,00
Net Income R 216 400,00 R 208 600,00

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1.2.3.5 Difference between income statement of a manufacturing and trading concern
The manufacturing business is where raw materials and goods are used to produce finished goods while a trade business is
that where finished products are bought and are sold to the end-users. The difference between the income statement of a
manufacturing concern and a trading concern is explained below:

 Earnings: Manufacturing businesses buy raw materials and convert the same into finished products. These are
then sold in the market to earn profit, whereas trading businesses are the ones buying goods and reselling the
same in order to earn profits.

 Cost of goods sold: In the manufacturing business, cost of goods sold refers to the costs that are incurred in
acquiring or manufacturing of products. The cost of goods sold can be calculated by deducting the value of ending
inventory from purchases. The income statement in a trading concern shows the variance between gross revenue
and cost-of-goods sold. In the trading business, the cost of goods sold is the value that a seller pays for the
inventory sold.

 Method: In the manufacturing business, the manufacturer also considers work-in-progress goods. These are
partially manufactured goods that aren’t finished before the end of the ongoing accounting period. Also,
manufacturers count finished products that are ready to be sold. Manufacturers should also consider labor and
factory overhead costs in determining expenses that are related to the cost of goods. This method is different
from that adopted by trading concerns because they do not include labor costs in cost-of-goods.

15
1.3 Outcome 2
Analyse the basic elements of a balance sheet.

This outcome is divided into the following sub-outcomes:

 Sub-outcome 1: The purpose of a balance sheet and an indication of how often a balance sheet is necessary for
two case studies.

 Sub-outcome 2: A balance sheet analysed and evaluated in terms of equity or financial net worth.

 Sub-outcome 3: The concept of an asset and the assets in a balance sheet are classified in terms of fixed and
current assets.

 Sub-outcome 4: The concept of a liability and the liabilities in a balance sheet classified in terms of long term and
current liabilities.

 Sub-outcome 5: Balance sheets for an entity are compared and evaluated in terms of performance over two years
and a decision are made based on evidence in the balance sheet.

1.3.1 Sub-outcome 1
The purpose of a balance sheet and an indication of how often a balance sheet is necessary

1.3.1.1 Introduction
A balance sheet is a financial statement that reports a business assets, liabilities, and shareholder equity.

The balance sheet is one of the three core financial statements that are used to evaluate a business.

It provides a snapshot of a company's finances (what it owns and owes) on a specific day. The balance sheet is drawn up on
the last day of the financial year of the business.

The balance sheet adheres to an equation that assets = owner’s equity + liabilities

Stakeholders use balance sheets to calculate financial ratios from which we can determine certain aspects of the financial
health of the business.

The balance sheet provides an overview of the state of a company's finances at a moment in time. It cannot give a sense of
the trends playing out over a longer period on its own. For this reason, the balance sheet should be compared with those
of previous periods.

The balance sheet of a business should also be compared with those of other businesses in the same industry since different
industries have unique approaches to financing.

1.3.2 Sub-outcome 3 & 4

The concept of an asset and the assets in a balance sheet are classified in terms of fixed and current assets.

The concept of a liability and the liabilities in a balance sheet classified in terms of long term and current liabilities.

16
1.3.2.1 Components of the balance sheet
The balance sheet adheres to the following accounting equation, with assets on one side, and liabilities plus shareholder
equity on the other, balance out:

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟’𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

This formula is intuitive. That's because a company must pay for all the things it owns (assets) by either borrowing money
(taking on liabilities) or taking it from investors (issuing shareholder equity).

A balance sheet consists of two main headings: assets and liabilities. Let us take a detailed look at these components.

i) Assets
An asset is something that the company owns and that is beneficial for the growth of the business. Assets can be classified
as follows:

 Current assets: Assets which can be easily converted into cash or cash equivalents within a duration of one year.
Examples include short-term deposits, marketable securities, and stock.

 Non-current assets: Assets which cannot be easily or readily converted to cash. For example, buildings, machinery,
equipment, or trademarks.

 Intangible assets: Assets which do not have physical existence, like patents, brands, and copyrights.

 Financial assets: Short-term investments or marketable securities that are not necessary for daily operations.

ii) Liabilities
Liabilities are what the company owes to other parties. This includes debts and other financial obligations that arise as an
outcome of business transactions. Companies settle their liabilities by paying them back in cash or providing an equivalent
service to the other party. Liabilities are listed on the right side of the balance sheet.

Depending on context, liabilities can be classified as current and non-current.

 Current liabilities: These include debts or obligations that have to be fulfilled within a year. Current liabilities are
also called short-term assets, and they include accounts payable, interest payable, and short-term loans.

 Non-current liabilities: These are debts or obligations for which the due date is more than a year. Non-current
liabilities, also called long-term liabilities, include bonds payable, long-term notes payable, and deferred tax
liabilities.

iii) Owner’s Equity/ Earnings

Owner’s equity is equal to total assets minus total liabilities. In other words, it is the amount that can be handed over to
shareholders after the debts have been paid and the assets have been liquidated. Equity is one of the most common ways
to represent the net value of the company. Part of shareholder’s equity is retained earnings, which is a fixed percentage of
the shareholder’s equity that has to be paid as dividends.

17
The equity value can be positive or negative. If the shareholder’s equity is positive, then the company has enough assets to
pay off its liabilities. If it is negative, then liabilities exceed assets.

iv) General sequence of accounts in a balance sheet

According to Generally Accepted Accounting Principles (GAAP), current assets must be listed separately from liabilities.
Likewise, current liabilities must be represented separately from long-term liabilities. Current asset accounts include cash,
accounts receivable, inventory, and prepaid expenses, while long-term asset accounts include long-term investments, fixed
assets, and intangible assets.

Under your current liability accounts, you can have long-term debt, interest payable, salaries, and customer payments,
while long-term liabilities include long-term debts, pension fund liability, and bonds payable.

Asset accounts will be noted in descending order of maturity, while liabilities will be arranged in ascending order. Under
shareholder’s equity, accounts are arranged in decreasing order of priority.

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Table 0.1: Example balance sheet

Assets

Non-current assets 3 R800 000

Property, plant and equipment R660 000

Financial assets

Fixed deposit: ABSA R140 000

Current assets R100 000

Stock 4 R60 000

Trading and other debtors 5 R30 000

Cash and cash equivalents 6 R10 000

Total assets R900 000

Equity and liabilities

Owner’s equity 7 R300 000

Non-current liabilities R200 000

Mortgage loan: ABSA R200 000

Current liabilities R400 000

Trade and other liabilities 8 R320 000

Loan payable within 12 months R50 000

Bank overdraft R30 000

Total equity and liabilities R900 000

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1.3.3 Sub-outcome 2
A balance sheet analysed and evaluated in terms of equity or financial net worth

In this section we will look at how changes are reflected in the balance sheet under different transaction scenarios.

Let us assume that your business is expanding, and you need more space to accommodate your employees. For this, you
purchase a building for R350,000. After paying R350,000 as a down payment, you apply for a loan from the bank for
R300,000. What would the balance sheet look like in this scenario?

The asset column in the balance sheet will show R350,000 irrespective of who owns the asset. By now, you know
that liability is an amount you owe to someone. Since you took a loan from the bank for R300,000, then that amount
becomes a liability. It is recorded as long-term debt on the liabilities side of the balance sheet.

Following is a balance sheet for the day after you purchased the building.

Table 0.2: Snippet of balance sheet after a transaction

Assets Liabilities
Cash R4 000 Accounts payable R10 000
Equipment R5 0000 Credit card balance R9 000
Building R350 000 Long-term debts R300 000
Inventory R5 000 Total liabilities R319 000
Accounts receivable R5 000
Total assets R369 000
Owner’s Equity R50 000

We know that the balance sheet is based on the accounting equation. You can apply the values of assets, liabilities, and
owner’s equity to check whether assets and liabilities are equal.

𝐴𝑠𝑠𝑒𝑡𝑠 ($350,000) = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 ($300,000) + 𝐸𝑞𝑢𝑖𝑡𝑦 ($50,000)

In this case, the assets and liabilities are equal.

Let us assume another scenario where the property’s value depreciated by R30,000. How will it affect the balance sheet
accounts?

The asset account is now reduced by R30,000. The actual value of assets is now R320,000. For the sake of this example,
let’s ignore any cash you’ve paid toward your loan and keep the liability value at R300,000. Now we have to adjust the
equity value to R20,000.

On applying the values of assets, liabilities, and equity to the accounting equation, you can see that assets are equal to
liabilities.

20
1.3.4 Sub-outcome 5
Balance sheets for an entity are compared and evaluated in terms of performance over two years and a decision are made
based on evidence in the balance sheet.

A balance sheet can be compared in terms of performance over two or more periods. This type of analysis is known as
horizontal analysis.

To make useful deduction, the difference between the two period should not only be noted in Rand value but also in
percentage value.

Table 0.3: Balance Sheet compared over 2 reporting periods

Assets Year 1 % Year 2 %

Non-current assets R800 000 88,89% R720 000 88,24%

Property, plant and equipment R660 000 73,33% R600 000 73,53%

Fixed deposit: ABSA R140 000 15,56% R120 000 14,71%

Current assets R100 000 11,11% R96 000 11,76%

Stock R60 000 6.67% R54 000 6,62%

Trading and other debtors R30 000 3,33% R32 000 3,92%

Cash and cash equivalents R10 000 1,11% R10 000 1,23%

Total assets R900 000 100.00% R816 000 100.00%

Equity and liabilities

Owner’s equity R300 000 33,33% R211 000 25,86%

Non-current liabilities R200 000 22,22% R240 000 29,41%

Current liabilities R400 000 44,44% R365 000 44,73%

Trade and other liabilities R320 000 35,56% R200 000 36,76%

Loan payable within 12 months R50 000 5,56% R20 000 3,45%

Bank overdraft R30 000 3,33% R45 000 5,51%

Total equity and liabilities R900 000 100.00% R816 000 100.00%

21
From the balance sheet, we can deduce that the company remained relatively stable as the asset percentage per item
remained relatively the same.

The non-current assets increased by R80 000 compared to the previous year. This was due to property, plant and equipment
being increased with R60 000 and R20 000 added to the ABSA fixed deposit account. There was a positive change of R4 000
in current asset. Therefore, the total assets increased from R816 000 in the first year to R900 000.

From the equity and liability section, it can be deduced that the equity changed positively by 7,47%. Non-current liabilities
reduced with R20 000 to R200 000 in the second year. Current liabilities showed a slight upward trend by moving to
R400 000 from R365 000. Total equity and liabilities for year 1 equal R816 000 and for year 2 it is R900 000.

22
1.4 Outcome 3
Compile a personal assets and liabilities statement.

This outcome is divided into the following sub-outcomes:

 Sub-outcome 1: A personal assets and liabilities statement compiled based on own financial situation over the
past year.

 Sub-outcome 2: The situations when an assets and liabilities statement are required and an indication of the
advantages of keeping such records.

1.4.1 Sub-outcome 1:
Personal Assets and Liabilities Statement

1.4.1.1 Introduction
In the same way that a business prepares a balance sheet to reflect their financial position at certain point in time, an
individual or family can draw up a personal asset and liability statement.

The statement will consist of two sections: Assets and liabilities and the difference between the two components will be
balanced by the Net worth.

The Personal Assets and Liabilities Statement represents the following equity.

𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠

An individual’s net worth (or owner’s equity) is determined by deducting all liabilities from the total assets. Net worth is
obtained by redeeming all liabilities from the available assets, even if it means that some assets have to be sold (or
converted into cash).

Personal assets represent everything a person owns. Assets typically found in a household can be divided into two groups,
namely fundamental and investment assets.

Fundamental assets are those assets a family owns due to the function they perform in the household. Examples of
fundamental assets are cash on hand, cash in bank accounts, deposits at banks, a house, or houses, motor vehicles, and
equipment. However, personal property is usually excluded. Personal property refers to furniture, clothing, and jewellery
(unless they value can be verified with an appraisal,

Investment assets, on the other hand, are assets acquired to earn a return on these assets. They do not perform a specific
function in the household. Examples of investment assets are securities (shares, debentures, and fixed interest-bearing
securities), the cash value of life and endowment insurance, and other investments such as coins.

In a personal asset and liability statement all debt is classified as personal liabilities. As with assets, some liabilities are short
term and other are long term.

Long-term liabilities may be long-term debt and mortgage bonds on fixed property, such as a home, holiday home, sectional
title, and time-share unit or business property.

23
Short-term liabilities may be an overdrawn bank account, a loan from a private person, arrears expenditure (for example
credit card purchases, medical and dental services, repairs, water and electricity, property tax), creditors, and any other
accounts payable.

The following items are not included in a personal financial statement:

 Business-related assets and liabilities: These are excluded unless the individual is directly and personally
responsible. So if someone personally guarantees a loan for their business—similar to co-signing—the loan is
included in their personal financial statement.

 Rented items: Anything rented is not included in personal financial statements because the assets aren't owned.
This changes if you own the property and rent it out to someone else. In this case, the value of the property is
included in your asset list.

 Personal property: Items such as furniture and household goods are typically not included as assets on a personal
balance sheet because these items can’t easily be sold to pay off a loan. Personal property with significant value,
such as jewelry and antiques, may be included if their value can be verified with an appraisal.

1.4.1.2 Example of a personal assets and liabilities statement

The following is a personal assets and liabilities statement for Mrs Poggenpoel.

Table 0.4: Example personal assets and liabilities statement

Name: Mrs Poggenpoel

As of: dd/mm/yy

Assets Amount in Rands

Cash – checking accounts R 20 000

Cash – savings account R5 000

Securities – stocks/ bonds/ mutual funds R300 000

Notes & contracts receivable R0

Life insurance (cash surrender value) R2 000 000

Personal property (autos, jewellery, etc. R400 000

Retirement funds (e.g., IRAs, 401k) R220 000

Real estate (market value) R1 600 000

Other assets R2 000

Total Assets R4 547 000

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 Liabilities Amount in Rands

Current Debt (Credit cards, Accounts) R2 000

Taxes payable R1 600

Real estate mortgages R1 200 000

Other liabilities (specify) R76 000

Total liabilities R1 279 600

The net worth of Mrs. Poggenpoel is calculated by subtracting the total liabilities by the total assets.

1.4.2 Sub-outcome 2
The situations when an assets and liabilities statement are required and an indication of the advantages of keeping such
records

An individual should thus also compile his or her personal statement of assets and liabilities to determine the net worth of
his/her estate.

Situations where an assets and liabilities statement are required:

 When applying for a bank loan.

 When required by the Receiver of Revenue.

 For personal records.

It is always advantageous to keep track of your personal net worth. This allows you to assess your financial situation when
making decisions, for example, to obtain a loan. It allows you to see at a glance, whether or not, for the loan example, you
could afford to repay the loan. It also allows you to present the records easily as you might be required to do. It is a relatively
simple exercise to keep the records up to date with each new purchase of goods. It means that you can see at a glance how
much your things are worth and how much you owe others.

Keeping records of personal assets and liabilities has certain advantages, for example:

 The net worth indicated in the balance sheet, indicates the person’s wealth.

 By comparing two or more years’ balance sheets, one can see whether this wealth has accumulated or declined.

 A person’s net worth can be used for retirement planning.

25
1.5 Outcome 4
Use the evidence in financial statements to make a financial decision.

This outcome is divided into the following sub-outcomes:

 Sub-outcome 1: The financial strengths and weaknesses of an entity analysed and suggestions of ways to improve
income and reduce costs.

 Sub-outcome 2: The concept of a cost to income ratio and suggestions on how to improve the ratio.

 Sub-outcome 3: The relationship between turnover, income, revenue, sales/earnings and profit with examples.

 Sub-outcome 4: The concept of cash flow in terms of liquidity.

1.5.1 Sub-outcome 1
The financial strengths and weaknesses of an entity analysed and suggestions of ways to improve income and reduce costs

1.5.1.1 Concept of turnover, income, revenue, sales/earning and profit

Turnover, income, revenue, sales/earnings and profit are all commonly used terms in accounting and finance. We will
discuss and define each of these terms and give examples to demonstrate how each of these is derived.

Turnover is the term used to describe the sales or income that the company earned from pursuing its operations. In a retail
or selling organisation, this would be the sales that the company made from retailing to third parties. In an insurance-type
organisation, turnover might be derived from commissions, or the sales of policies. Turnover is usually the first item that
appears on a company income statement.

Income can be viewed as the net receipts received from the operations of the business. It excludes the money received
from extraordinary items. Extraordinary items are significant, material transactions that would not be defined as normal
transactions for the company. An example would be the sale of a company which the holding company holds title to.

Revenue is all the money that the company received in the course of its business. It includes earnings from extraordinary
items, as defined above. Also included would be interest earned on cash balances in bank accounts, as well as income from
subsidiaries. The sales/Earnings ratio considers the relationship between sales, which are derived from the ordinary
operations of the business, and the net earnings of the company, which include extraordinary items and interest. The
Sales/Earnings ratio indicates what proportion of income comes from normal day-to-day business and which comes from
other business. Consider, as a demonstration, a company that has very small trading sales, but declares large earnings due
to the profit on sale of land that it owned. If you looked at the income statement, it may appear that the company was
doing very well and earning a lot of money. But in fact, the directors may be disposing of company assets that might affect
the future earnings of the company.

26
Profit is the difference between Income and Expenses. In a public company, the profits of the company are regarded as
available for distribution. This is what the shareholders of the company will receive as dividends, assuming that the directors
don’t retain earnings for the purposes of furthering the business’s aims. Last of all, the Profit available for distribution is the
monies that will be paid out to shareholders as dividends. It is important to notice where this is placed: dividends are paid
out of the profits after tax. This is because it would prejudice the Receiver of Revenue’s claim on company profits if the
taxation charges were calculated after distribution. It would be possible to take all of the money out of the company and
not leave the taxman his share, which he would not approve of.

Financial statement analysis is used to indicate the relationship between these elements in a business.

1.5.1.2 Financial statement analysis

When it comes to investing, analysing financial statement information (also known as quantitative analysis), is one of, if not
the most important element in the fundamental analysis process. At the same time, the massive number of numbers in a
company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio
analysis, you will be able to work with these numbers in an organized fashion.

The raw information available in these financial statements is of limited value. For example, if we had to say that Company
X made a profit after tax of R1 000 000, while Company Y made an after-tax profit of R6 000 000. Which one would you say
has performed better? Your response initially may be Company Y. But, if I told you that Company X had a turnover of R4
000 000, whilst Company Y had a turnover of R120 000 000, now what would you think?

From this we can see that to make a judgment or decision based purely on raw information could be misleading. Therefore,
there are several ratios that can be used to allow us to interpret financial information more accurately .

The objective of this section is to provide you with a guide to sources of financial statement data, to highlight and define
the most relevant ratios, to show you how to compute them and to explain their meaning as investment evaluators.

1.5.1.3 Comparative analysis

A ratio on its own is useless. It is difficult to gain any meaningful information from a ratio unless it is compared to something.
There are two types of comparison.

Industry comparative analysis involves comparing the financial ratios of different organisations in the same industry at the
same point in time. The purpose is to identify any deviations from the industry norm.

Time series analysis involves comparing the historic ratios of the organisation over time in order to determine whether it is
progressing as planned. Any significant year-to-year changes should be identified and evaluated to assess whether they are
symptomatic of major problems .

Both comparisons are usually done.

The process of financial analysis is a three-step process.

1. Calculation of financial ratios

2. Comparison of results

3. Interpretation of results

27
Financial ratios can be grouped within the broad categories of business performance that they are attempting to examine.
These performance categories are debt management, liquidity, profitability, asset management, and investor ratios.

1.5.2 Sub-outcome 3
The relationship between turnover, income, revenue, sales/earnings and profit with examples.

1.5.2.1 Ratios
As indicated, ratios are used to express the relationship in a business between turnover, income, revenue, sales/earnings
and profit.

The ratios one would use would depend on the particular aspect of the business one wishes to analyse or answers to specific
questions that one is looking for.

The ratios used can be classified under the following categories:

 Profitability: Indicates how profitable the business is and how well expenses are controlled.

 Return: What the owner/s are getting back in return for their investment.

 Liquidity: The ability of the business to pay its short- term debts.

 Solvency: Can the business settle all its liabilities?

 Operating efficiency: Indicates how well operating activities are carried out.

 Risk: Indicates degree of financial risk

The ratios can help us to-

 Check whether there is growth or stagnation in the business

 Check results with competitors’ performance

 Compare current results to previous years

 Compare results to general economic indicators in the country or globally

 Compare results to alternative investments

 Determine the degree of financial risk by investors / creditors

28
Some people interested in measuring the business results:

 Management

 Owners / Investors / Shareholders

 Banks

 SARS

 Trade Unions

 Competitors

The table following lists the ratios to be considered in the subsections following.

Table 0.5: Different ratios to be considered

Ratio Category
Gross profit on turnover Profitability
Gross profit on cost of sales Profitability
Net income before tax on turnover Profitability
Total expenses on turnover Profitability
Solvency ratio Solvency
Current ratio Liquidity
Acid test ratio Liquidity
Rate of stock turnover Liquidity
Number of months of stock on hand Liquidity
Debtors’ collection period Liquidity
Creditors payment period Liquidity
Gearing ratio / Debt equity ratio Risk
Return shareholders’ equity Return
Return on capital employed Return
Earnings per share Return
Dividends per share Return
Net asset value per share Return

29
1.5.2.2 Gross profit on turnover

i) Interpretation
The ratio can be interpreted as follows:

 Illustrated mark-up on selling price.

 Mark-up achieved may be compared to a policy of business.

1.5.2.3 Gross profit on cost of sales

i) Interpretation
The ratio can be interpreted as follows:

 Illustrates mark-up on cost price.

 Mark-up achieve may be compared to policy of business. Possible reasons for difference are as follows: Seasonal
sales, cash discounts, Incorrect pricing and theft.

1.5.2.4 % Net income on turnover

i) Interpretation
The ratio can be interpreted as follows:

 Portion of net income for every Rand of sales.

 Compare to previous results.

1.5.2.5 % Total expenses on turnover

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i) Interpretation
The ratio can be interpreted as follows:

 Indicates absorption rate of expenses on turnover.

 A lower rate is more favourable.

1.5.2.6 Solvency ratio

i) Interpretation
The ratio can be interpreted as follows:

 The ratio is used to answer the question of whether the business is solvent/ an indication of its solvency situation.

 If assets are more than liabilities the business is solvent. The higher the ratio the better the solvency.

 If solvency is close to 1: 1 there is a possible risk of insolvency in the future.

1.5.2.7 Current ratio

i) Interpretation
The ratio can be interpreted as follows:

 Determine liquidity of the business.

 Compared to previous results.

 However, if the ratio is very high it can also indicate excessive investment in current assets. Funds could be used
for a better return on other investments.

31
1.5.2.8 Acid-test ratio

i) Interpretation
The ratio can be interpreted as follows:

 Determine liquidity of business.

 Compare to previous results.

 If current ratio is favourable and acid-test ratio is unfavorable, it shows possibility of too much investment in
stock.

1.5.2.9 Rate of stock turnover

Note the answer must be in times per year.

i) Interpretation
The ratio can be interpreted as follows:

 Compare to previous results.

 Compare to industry.

 Quicker rate is more favourable.

1.5.2.10 Number of months of stock on hand

i) Interpretation
The ratio can be interpreted as follows:

 Gives an indication of how long we can expect the stock on hand to last.

 This can help with determining ordering times.

 We can also comment on the amount of stock carried by the business.

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1.5.2.11 Debtors’ average collection period

i) Interpretation
The ratio can be interpreted as follows:

 Compare to them allowed.

 If longer, then unfavorable.

 How to improve: Send statements more regularly, charge interest on overdue accounts and control credit.

1.5.2.12 Creditors average payment period

i) Interpretation
The ratio can be interpreted as follows:

 Compare to term allowed.

 If longer, then unfavorable.

 Aim for shorter time by one of the following: Good relationship with suppliers, negotiate better terms and
conditions, obtain regular supplies.

1.5.2.13 Debt/ Equity ratio

i) Interpretations
The ratio can be interpreted as follows:

 Measures degree of financial risk of the business.

 A lower ratio is more favorable, the business is less of a financial risk.

 Easier to obtain loans.

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  A high ratio indicates that funds have to be obtained by others means, besides borrowing.

1.5.2.14 Return on total capital employed

i) Interpretation
The ratio can be interpreted as follows:

 Compare to previous results.

 Compared to other outside investments, such as return on a fixed deposit.

1.5.2.15 Return on shareholder’s equity

i) Interpretation
The ratio can be interpreted as follows:

 Compare to previous results.

 Compared to other outside investments, such as return on a fixed deposit.

 Compare to returns by other companies with a similar share price.

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1.5.2.16 Earnings per share

i) Interpretation
The ratio can be interpreted as follows:

 Compare to previous results.

 Compare to earnings by other companies with a similar share price.

 Comment in relation to general economic conditions.

 Comment in relation to JSE performance in general.

1.5.2.17 Dividends per share

i) Interpretations
The ratio can be interpreted as follows:

 Compare to previous results.

 Compare dividends to earnings per share. If a huge difference exists, then it means that a large amount has been
kept as retained income. Is there justification for that.

1.5.2.18 Net asset value per share

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑋 100
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑

i) Interpretations
The ratio can be interpreted as follows:

 Used to determine current value of shares.

 Can influence the decision whether to buy a particular share or not.

 If the net asset value is more than the par value, one is inclined to buy the share.

 The difference between dividend per share and earnings per share.

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1.5.2.19 Example 1 of analysis of ratios
Consider the extract of the financial statements and ratios for Branch A and Branch B of a business. For this purpose capital
employed is equal to capital plus profits plus drawings.

Table 0.6: Extract from financial statements and ratios

Branch A Branch B Total

Sales R12 000 R50 000 R62 000
Less cost of sales (R6 000) (R25 000) (R31 000)
Gross profit R6 000 R25 000 R31 000
Expenses (R1 000) (R15 000) (R16 000)
Net profit R5 000 R10 000 R15 000
Capital R50 000 R200 000 R250 000
Gross profit ratio 50% 50% 50%
Net profit ratio 42% 20% 24%
Return on capital employed (ROCE) 10% 5% 6%

The owners must decide on whether to expand Branch 1 or Branch 2. The gross profit for both branches is the same. Both
branches of business are achieving the same gross profit of 50x in every R1 of sales.

However, the net profit ratios are very different.

On the face, it appears that Branch A is controlling expenses to a greater extent. Expenses for the year in Branch B were
R15 000 for achieving R50 000 of sales. In other words, for every R1 of sales made, 30c is spent on expenses. Whereas for
Branch A only R1 000 of expenses were incurred or in other words 8c in very R1 of sales.

If the owners had to decide on where to plan for expansion, Branch A would be the best choice as the branch would return
a much higher net profit on the extra sales made.

The return on capital employed percentage shows that Branch A is returning a much higher return on capital invested in
the business than B and would therefore confirm that further investment should be in Branch A and not B. Branch A is said
to be more profitable than B.

Ratio analysis has therefore allowed a decision on further investment to be made which will maximize profits. A decision
based solely on the comparative net profits of R5 000 for Branch A and R10 000 for Branch B would have been a mistake

1.5.2.20 Example 2 of analysis of ratios

The following ratios of the two companies are considered and compared with each other to make conclusions about the
profitability, liquidity and efficiency of the business.

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Table 0.7: Extract of ratios for two businesses

Company A Company B
Profitability ratios
Gross profit ratio 50 60
Nett profit ratio 20 15
Return on capital employed (ROCE) 10 5
Liquidity ratios
Liquidity ratio 1 to 1 2 to 1
Quick ratio 0.5 to 1 1 to 1
Efficiency ratios
Stock turnover 6 months 6 times
Debtors’ payment 63 days 30 days
Creditors payment 96 days 33 days

In terms of profitability, it can be concluded that although company B is making a higher gross profit on sales than A, it is
not controlling expenses as well as company A (it has a lower net profit ratio). Moreover, company A is providing owners
with a higher return on capital employed (ROCE).

The liquidity and quick ratios of Company A are a cause for concern. Although current assets cover short-term liabilities, if
you remove the figure for stocks which can not always be relied upon to realize cash quickly, then the rest of the current
assets only cover half of the short-term debt. On the face it would seem that this company is in danger of being unable to
pay its debts as they fall due. Urgent credit control action is required.

The stock turnover ratios are 6 months for Company A and 2 months for company B – 6 times turnover a year is the same
as every 2 months. Company B is, therefore, more efficient in the way it turns around its stock. However, even though
company B’s customers pay up more quickly than A’s there is cause for concern because the customer payment period is
so close to the length of time the business takes to pay its suppliers – 30 days and 33 days. There only needs to be a slight
shift in pattern for the business to be in danger of closing down due to a shortage of cash.

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1.5.3 Sub-outcome 2
The Concept of Cost to Income Ratio

The cost to income ratio is an important indicator of the value of the company. It is used a lot in investment analysis to
ascertain how easily the company can increase profits.

If the cost to income ratio is very low, it means that margins are small and that the company must increase turnover by
large volumes to attain relatively small increases in profit.

The cost to income ratio is derived as follows:

𝑪𝒐𝒔𝒕 𝒕𝒐 𝒊𝒏𝒄𝒐𝒎𝒆 𝒓𝒂𝒕𝒊𝒐 = 𝑵𝒆𝒕 𝑪𝒐𝒔𝒕𝒔: 𝑰𝒏𝒄𝒐𝒎𝒆

Example

T-Square Inc has an annual income of R500 000 from selling drawing equipment. The net cost is R300 000.

T-Square Inc Inc.’s cost to income ratio is therefore calculated as follows:

𝑅300 000 ∶ 𝑅500 000 = 3: 5

Interpretation: T-Square Inc. made R200, 000 worth of profits from R500, 000 worth of sales. Or put differently, for
every R3 spent R5 is generated, or yet again differently, for every R5 generated R2 is profit.

1.5.4 Sub-outcome 4
Cash Flow in terms of liquidity

In general, liquidity is the ability of a company to meet its current liabilities using its current assets. Cash flow refers to the
cash that flows into and out of a company. How well a company performs in these two areas can impact its ability to operate
and, ultimately, its profitability as well.

Liquidity refers to the amount of cash an organization has to cover its immediate and short-term obligations. Short-term
refers to obligations that have a time frame of 12 months or less. A long-term obligation is one that has a time frame greater
than 12 months. Liquidity also refers to the assets of an organization that can be easily converted into cash with the loss of
little to no value. A savings account is a type of liquid asset.

Cash flow is the difference between the amount of cash the company has at the beginning of an accounting period versus
the amount of cash it has at the end of an accounting period. Cash flow represents, or is based upon, the operating activities
of the business. The cash at the beginning of the accounting period is called the opening balance. Likewise, the cash at the
end of the accounting period is called the closing balance. Some of the ways a company can increase cash flow include
selling more goods or services, reducing costs and collecting faster on accounts receivables.

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Liquidity can impact cash flow. The cash flow for a company is considered positive if the closing balance is more than the
opening balance. It's considered negative if the closing balance is more than the opening balance. If a company does not
have cash flow sufficient to cover an obligation, it can liquidate an asset to increase the cash on hand. The more liquid an
asset is, the easier it'll be for the company to convert it to cash and improve cash flow. For example, a certificate of deposit
is generally easier to convert to cash than the sale of a piece of land.

A company may have a positive cash flow and sufficient liquidity to meet immediate and short-term obligations, but that
does not automatically mean the company is profitable. Profit is the difference between total costs and total revenue. The
company is only profitable if there's a surplus of funds left over after the payment of all costs. A company could have cash
sufficient for all of its immediate and short-term expenses but still not turn a profit overall because its costs exceed its
revenue.

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