6.2 Interpretation of accounting ratios (3)
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1.
ABC Ltd prepared the following income statements for the years ended 31 December 2022 and 31 December 2023.
Income Statement for the Year Ended 31 December 2022
- Revenue: £80,000
- Cost of Sales: £48,000
- Gross Profit: £32,000
- Operating Expenses: £15,000
- Profit Before Tax: £17,000
- Tax: £4,250
- Net Profit: £12,750
Income Statement for the Year Ended 31 December 2023
- Revenue: £95,000
- Cost of Sales: £55,000
- Gross Profit: £40,000
- Operating Expenses: £18,000
- Profit Before Tax: £22,000
- Tax: £5,500
- Net Profit: £16,500
Compare the results of ABC Ltd for the years ended 31 December 2022 and 31 December 2023. Comment on any significant differences.
Comparison of Results for ABC Ltd (2022 vs. 2023)
The following table summarises the key financial figures for ABC Ltd for the years ended 31 December 2022 and 31 December 2023:
| Financial Item | 2022 (£) | 2023 (£) |
| Revenue | 80,000 | 95,000 |
| Gross Profit | 32,000 | 40,000 |
| Net Profit | 12,750 | 16,500 |
Analysis:
- Revenue: Revenue increased from £80,000 to £95,000, representing a growth of £15,000 or 18.75%. This indicates a positive trend in sales.
- Gross Profit: Gross profit increased from £32,000 to £40,000, an increase of £8,000. This is likely due to the increase in revenue and potentially improved efficiency in production or purchasing.
- Net Profit: Net profit increased from £12,750 to £16,500, an increase of £3,750. This is a positive outcome, reflecting improved profitability.
- Operating Expenses: Operating expenses increased from £15,000 to £18,000. This increase needs further investigation to determine the reasons. It could be due to increased marketing costs, higher salaries, or other factors.
Conclusion: Overall, ABC Ltd has shown positive financial performance between 2022 and 2023. Revenue and profit have increased. However, the rise in operating expenses should be monitored to ensure profitability remains strong. Further investigation into the reasons for the increase in operating expenses is recommended.
2.
The owner of a small consultancy business, "Consult Solutions," is concerned about the company's profitability and cash flow. They have noticed that many clients are slow to pay invoices, and they are struggling to cover their day-to-day expenses. (a) Describe two specific methods Consult Solutions could use to improve its cash flow. (b) Explain how each of the methods you suggested in part (a) would impact the company's profitability.
(a) Two specific methods Consult Solutions could use to improve cash flow are:
- Implement a Clearer Invoicing and Payment Policy: Ensure invoices are issued promptly and include clear payment terms (e.g., net 30 days).
- Offer Early Payment Discounts: Provide a discount to clients who pay their invoices before the due date.
(b) How each method impacts profitability:
- Clearer Invoicing and Payment Policy: This will directly improve cash flow by reducing the time it takes to receive payments. Faster cash flow allows Consult Solutions to meet its day-to-day expenses and potentially invest in growth opportunities. This can indirectly improve profitability by reducing the need for expensive short-term borrowing.
| Improved cash flow reduces the need for borrowing, which lowers interest expenses and improves net profit. |
- Offer Early Payment Discounts: While offering a discount reduces the amount received upfront, it can accelerate cash flow. The increased cash flow can be used to cover expenses and potentially invest in projects that generate higher profits. The discount should be calculated carefully to ensure the profit margin remains positive.
| The increased cash flow allows for investment in profitable projects, potentially increasing overall profit. |
3.
ABC Ltd is a small retail business experiencing declining profitability. Their current profit margin is 12%. The business has a significant amount of inventory, and cash flow is often tight. (a) Identify three specific areas where ABC Ltd could make recommendations to improve its profitability. (b) For each recommendation identified in part (a), suggest a practical action ABC Ltd could take.
(a) Three specific areas for profitability improvement are:
- Cost of Goods Sold (COGS): Reducing the cost of the products sold.
- Pricing Strategy: Reviewing and potentially adjusting the selling prices of goods.
- Operating Expenses: Identifying and reducing unnecessary overhead costs.
(b) Practical actions for each recommendation:
- COGS: Negotiate better prices with suppliers, explore alternative suppliers, or consider bulk purchasing discounts.
- Pricing Strategy: Conduct market research to determine optimal pricing, implement promotional offers, or consider tiered pricing.
- Operating Expenses: Review utility bills for potential savings, reduce discretionary spending (e.g., travel, entertainment), or explore energy-efficient equipment.