Queensway Secondary School

Name: ____________________________ Index: ________

Class: ____________________________ Date: ________
Topic: Chapter 16
Financial Statements Analysis (Part 1)

16.1 Financial Statements Analysis (TB pg 291)

To make informed decisions, stakeholders of a business analyse absolute figures from its
financial statements and financial ratios to evaluate its:
• Profitability;
• Liquidity;
• Efficiency of inventory; and
• Efficiency of trade receivables management.

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2024 QSS POA | Secondary 4 / 5
 16.2 Profitability (TB pg 292 to 296)
Profitability is the ability of a business to generate excess income to cover its expenses.

I. Importance of profitability
A profitable business can
• continue its business operations
• distribute the profits earned to reward its owners for their contributions to the
business and to attract other investors to invest in the business
• expand to a bigger store or add more stores since it means that its products or services
are in demand
• rewards its employees well and retain their services

II. Consequences of not being profitable

If a business continues to suffer losses, it is likely to close down eventually.

III. Measures of profitability

Absolute figures Profitability ratios
Net sales revenue/ Service fee revenue Gross profit margin
Cost of sales Mark-up on cost
Gross profit Profit margin
Expenses Return on equity
Profit / (Loss) for the period

Absolute figures
It is important to make a gross profit from the buying and selling of goods as it means that
the business is selling its goods at a price that is above its cost price.

Gross profit = Net sales revenue – Cost of sales

A gross loss means that the business is selling its goods at a price that is below its cost
price. A business that generates a gross loss may be unable to compete with its
competitors.

Gross loss = Cost of sales – Net sales revenue

It is also important for the business to make a profit so that this can be reinvested in the
business.

Profit for the period = Gross profit + Other income – Other expenses
OR
Profit for the period = – Gross loss + Other income – Other expenses

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Profitability ratios
In addition to analysing absolute profit figures, a business should also analyse profitability
ratios.
Profitability
Formula Definition Interpretation
ratio
Gross profit Gross profit Measures how much Higher gross profit
margin × 100 gross profit (cents) a margin
Net sales revenue
(%) business earns for ➢ more
every dollar ($) of profitable
net sales revenue.
Mark-up Gross profit Measures how much Higher mark-up on
on cost × 100 gross profit (cents) a cost
Cost of sales
business earns for ➢ more
(%)
every dollar ($) of profitable
cost of sales.
Profit Profit for the period Measures how much Higher profit
margin × 100 profit (cents) a margin
Net sales revenue
business earns for ➢ more
(%)
every dollar ($) of profitable
net sales revenue.
Return Profit for the period Measures how much Higher return on
on equity × 100 profit (cents) a equity
Average equity
(%) business earns for ➢ more efficient
Average equity every dollar ($) of in generating
Beg. equity + Ending equity equity invested by profits for its
=
2 the owner (SP) or owners or
shareholders (PLC) shareholders
in the business.

Practice: WB Ex 1

Q1 to Q3

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IV. Ways to improve profitability
Strategy Examples Explanation
1. Sell goods at higher Increase sales revenue
selling price. ➢ Increase gross profit.
2. Buy goods at lower • Buy in bulk to obtain trade Decrease cost of sales
cost price. discount. ➢ Increase gross profit.
• Switch to another supplier than
offers lower prices, without
compromising on quality.
3. Increase other • Sublet excess space to another Increase other income
sources of income. business to earn rental income. ➢ Increase profit for the
• Pay early to take advantage of period.
cash discounts.

4. Reduce operating • Reduce the use of electrical Decrease operating

expenses. appliances to lower utilities expenses
expenses. ➢ Increase profit for the
• Hire freelancers or part-timers on period.
a needs basis.
• Negotiate for lower rental.
• Relocate to another premise that
chargers lower rental.
• Capitalise on technology to
reduce cost of manpower.

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 Adapted from WB pg 210, Exercise 1, Question 7
Timeless Trading, a company retailing in clocks and watches, provided the following
statement of financial performance for the year ended 31 August 2018.
Timeless Trading
Statement of financial performance for the year ended 31 August 2018
$ $
Sales revenue 769 000
Less: Sales returns 3 046
Net sales revenue 765 954
Less: Cost of sales 637 926
Gross profit 128 028

Less: Other expenses

Interest on loan 1 350
Discount allowed 7 494
Insurance expense 5 040
Internet expense 5 214
Rental expense 64 035
Salaries expense 32 475
Utilities expense 8 376
Transport expense 3 044 127 028
Profit for the year 1 000

REQUIRED
(a) Calculate the following profitability ratios for the year ended 31 August 2018. Show
your answers to two decimal places.

(i) Mark-up on cost

Mark-up on cost = Gross profit / Cost of sales X 100
= 128 028 / 637 926 X 100
= 20.07% (2dp)
(ii) Gross profit margin
Gross profit margin = Gross profit / Net sales revenue X 100
= 128 028 / 765 954 X 100
= 16.71% (2dp)

(iii) Profit margin

Profit margin = Profit / Net sales revenue X 100
= 1000 / 765 954 X 100
= 0.13% (2dp)

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The following profitability ratios are extracted from the books of Lorex Co., a direct
competitor of Timeless Trading.
Mark-up on cost 18.00%
Gross profit margin 15.25%
Profit margin 4.00%
REQUIRED
(b) Comment on the profitability ratios of Timeless Trading against Lorex Co.

Lorex Co Timeless Trading

Mark-up on cost 18.00% 20.07%
Gross profit margin 15.25% 16.71%
Profit margin 4.00% 0.13%

1. The mark-up on cost of Timeless Trading at 20.07% is better than that of Lorex Co at
18.00%.
i. It may be because Timeless Trading is able to set a higher selling price on
its products or purchase its goods at a lower cost price as compared to
Lorex Co.
2. This is further supported by its better gross profit margin of 16.71% as compared to
Lorex Co’s of 15.25%.
3. However, the profit margin of Timeless Trading at 0.13% is worse than that of Lorex
Co at 4.00%.
i. This could be attributed to the poor management of expenses by
Timeless Trading as compared to Lorex Co.
a. For example, Timeless Trading had been spending a lot on its
rental which is evident from its high rental expense of $64 035.
b. Its workers might also have been less productive and more
wasteful in using its resources which is shown by its high salaries
expense of $32 475
4. In conclusion, Timeless Trading’s overall profitability is worse than Lorex Co.

(c) Suggest two ways to improve the profitability of Timeless Trading.

(Hint: Timeless Trading had less effective measures in reducing its operating expenses
than Lorex Co.)

1. Timeless Trading could reduce its operating expenses to increase its profit for the
period and hence improve its profitability.
i. It could negotiate for lower rental or relocate to another premise that charges
lower rental to cut down its rental expense and hence operating expenses.
ii. It could also capitalise on technology to reduce cost of manpower to reduce
its salaries expenses and also operating expenses.
2. Timeless Trading could also find ways to increase its other income to increase its
profit for the period and hence improve its profitability.
i. It could pay early to take advantage of cash discounts.

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(d) Santhosh is considering investing in one of the two businesses retailing in clocks and
watches. Which business should Santhosh invest in? Explain your answer.

Santhosh should consider investing in Lorex Co as based on accounting information, it is

more profitable than Timeless Trading. Lorex has a higher and better profit margin of 4%
than Timeless Trading’s 0.13%.
However, Santhosh should also analyse the profitability trend of Lorex Co. and other
factors before investing in Lorex Co.

Practice: WB Ex 1

Q4 to Q6, Q8 to Q11

Objectives accomplished
Indicate…
‘√’ if you have really understood this objective
‘?’ if you still have question about this objective
‘x’ if you do not understand this objective

 Explain the importance of being profitable.

Analysis of absolute values

 Analyse the gross profit/loss and profit/loss for the year.
 Interpret sales revenue, cost of sales, gross profit/loss and profit/loss for the year across a
maximum of three financial years.
 Evaluate the profitability of businesses from the trend of sales revenue, service fee revenue, cost
of sales, gross profit/loss and profit/loss for the year across a maximum of three financial years.
 Recommend means to improve gross profit/loss and profit/loss for the year.

Analysis of ratios
 State and calculate the profitability ratios.
 Interpret profitability ratios across a maximum of three financial years or against one other
business.
 Evaluate the profitability of businesses from the trend of profitability ratios across a maximum
of three financial years or against one other business.
 Recommend means to improve profitability ratios.

=== That’s all for now folks ===