6.2 Interpretation of accounting ratios (3)
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1.
The following information is available for Green Grocers for the years ended 31 December 2021 and 31 December 2022.
- 2021
- Sales: £60,000
- Cost of Goods Sold: £30,000
- Other Income: £2,000
- Other Expenses: £8,000
- 2022
- Sales: £75,000
- Cost of Goods Sold: £37,500
- Other Income: £2,500
- Other Expenses: £9,500
Prepare a statement comparing the results of Green Grocers for the years ended 31 December 2021 and 31 December 2022. Comment on the key differences.
Comparison of Results for Green Grocers (2021 vs. 2022)
Statement of Comparison
| Item | 2021 (£) | 2022 (£) | Change (£) |
| Sales | 60,000 | 75,000 | 15,000 |
| Cost of Goods Sold | 30,000 | 37,500 | 7,500 |
| Other Income | 2,000 | 2,500 | 500 |
| Other Expenses | 8,000 | 9,500 | 1,500 |
| Profit Before Tax | 22,000 | 25,000 | 3,000 |
Analysis:
- Sales: Sales increased by £15,000 (25%) from 2021 to 2022. This is a significant positive change.
- Cost of Goods Sold: Cost of Goods Sold increased by £7,500. This is likely due to the increase in sales, but it's important to consider the cost of purchasing goods.
- Other Income: Other income increased by £500. The source of this income should be identified.
- Other Expenses: Other expenses increased by £1,500. The reasons for this increase should be investigated.
- Profit Before Tax: Profit before tax increased by £3,000, from £22,000 to £25,000. This is a positive result, indicating improved profitability.
Conclusion: Green Grocers has experienced positive growth between 2021 and 2022, particularly in sales and profit. However, the increase in both the cost of goods sold and other expenses needs to be monitored to ensure profitability remains sustainable. Further investigation into the drivers of these changes is recommended.
2.
XYZ Manufacturing has a high level of working capital requirements. They often struggle to pay suppliers on time and occasionally experience cash flow problems. Their current ratio is 1.5. (a) Explain what the current ratio indicates about a company's working capital. (b) Suggest two specific recommendations XYZ Manufacturing could make to improve its working capital position. (c) For each recommendation in part (b), explain how it would improve the current ratio.
(a) The current ratio indicates a company's ability to pay off its short-term liabilities (working capital) with its short-term assets. A current ratio of 1.5 suggests that for every £1 of current liabilities, the company has £1.50 of current assets. This indicates a reasonable, but not necessarily excellent, level of liquidity.
(b) Two recommendations for improving working capital are:
- Improve Inventory Management: Reduce the amount of inventory held.
- Negotiate Extended Payment Terms with Suppliers: Ask suppliers for longer periods to pay invoices.
(c) How each recommendation improves the current ratio:
- Improve Inventory Management: By reducing inventory levels, the current assets (specifically inventory) will decrease. If current liabilities remain the same, the current ratio will increase.
| Current Ratio = Current Assets / Current Liabilities. Reducing Current Assets (Inventory) while keeping Current Liabilities constant increases the ratio. |
- Negotiate Extended Payment Terms with Suppliers: By delaying payments to suppliers, the current liabilities (accounts payable) will decrease. If current assets remain the same, the current ratio will increase.
| Current Ratio = Current Assets / Current Liabilities. Reducing Current Liabilities (Accounts Payable) while keeping Current Assets constant increases the ratio. |
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.