Financial statement and profitability analysis

Profit Margins

• Expenses grew faster due to inflation and increased salaries/wages.

• Key profit margins include:

  • Gross Profit Margin
  • Operating Profit Margin
  • Net Profit Margin

• These ratios should ideally trend upwards, indicating better profitability.

• They reflect the percentage of sales retained as profit (different types of profit).

Types of Profit

• Gross Profit: Sales minus the cost of sales.
• Operating Profit: Profit generated from the core functions of the business before interest and taxes.
• Net Profit: Profit after all expenses, including interest and taxes, are deducted.

Importance of Each Margin

• Operating Profit:

  • Highlights the performance of the business separate from factors outside managerial control (e.g., taxes).
  • Formula: \frac{\text{Operating Profit}}{\text{Revenue or Sales}}
  • Indicates how much operating profit is retained for every R100 of sales

• Gross Profit:

  • Focuses on the business model and the efficiency of sales relative to the cost of goods sold.
  • A declining gross profit can result from:
    • Selling at cheaper prices (due to competition).
    • Increased supplier costs
  • Formula: Sales - Cost of Sales
  • Indicates how much of every R100 in sales remains after paying suppliers.

Business Model and Gross Profit

• Gross profit illustrates the fundamental business model. For example, buying an item for R10 and selling it for R15 yields a gross profit of R5.
• Crucial for manufacturers: If production costs exceed potential sales price, the business is unviable.

Funding

• Businesses can obtain funding from:
  • Investors (who expect returns).
  • Debt (loans).
  • Debt pros: Using debt in the business's favor.
  • Debt cons:
    • Requires consistent payments regardless of customer payments.
    • May result in asset seizure if payments are not met.

Exam Strategies

• Time Management: Allocate time effectively across all sections.
• Prioritize questions: Start with topics you're most comfortable with.

Financial Statement Analysis Ratios

• Debt Ratio:
  • Formula: \frac{\text{Total Debt}}{\text{Total Assets}}
  • Higher percentage indicates a greater reliance on debt, meaning more assets would need to be sold to cover debts.
  • Example: A debt ratio of 50% means all assets must be sold to pay back the bank.
• Debt to Equity Ratio:
  • Compares the proportion of funding from lenders (debt) versus investors (equity).
  • Most businesses rely heavily on debt.

Liquidity Ratios

• Current Ratio:
  • Formula: \frac{\text{Current Assets}}{\text{Current Liabilities}}
  • Indicates whether a company has enough short-term assets to cover its short-term liabilities.
  • A desirable range is typically around 1.5 to 2.
• Asset Test (Quick Ratio):
  • A modification of the current ratio.

Working Capital Cycle

• Inventory Days:
  • Aims for a low number, indicating efficient inventory management.
• Collection Period:
  • Aims for a low number, indicating prompt customer payments.
• Settlement Period:
  • How long it takes to pay suppliers.
  • Longer settlement periods provide more flexibility and breathing room.
  • Longer settlement period could hurt relationships with suppliers, incur penalties, and higher charges however.
• Operating Cycle:
  • Formula: Inventory Days + Collection Period - Settlement Period

Shareholder Returns

• Dividends:
  • A portion of the company's profits distributed to shareholders.
  • Shareholders are owners of the company.
• Total Shareholder Interest:
  • The overall return received for investing in a company.