Diana and Eduardo each operate a retail business. The following information has been extracted from their financial statements for the year ended 30 June 20...
Question 1 Report
Diana and Eduardo each operate a retail business. The following information has been extracted from their financial statements for the year ended 30 June 2025.
| Item | Diana ($) | Eduardo ($) |
|---|---|---|
| Revenue | 200 000 | 350 000 |
| Cost of sales | 120 000 | 245 000 |
| Profit for the year | 32 000 | 35 000 |
| Non-current assets | 100 000 | 180 000 |
| Current assets | 50 000 | 70 000 |
| Current liabilities | 30 000 | 60 000 |
| Non-current liabilities | 20 000 | 40 000 |
| Average inventory | 15 000 | 35 000 |
| Trade receivables | 20 000 | 30 000 |
| Trade payables | 18 000 | 40 000 |
(a) Calculate the following ratios for both businesses:
(i) Gross profit margin [2]
(ii) Profit margin [2]
(iii) Return on capital employed [2]
(iv) Current ratio [2]
(v) Rate of inventory turnover (times) [2]
(b) Using the ratios calculated, advise a potential investor on which business would be a better investment. Give reasons for your answer. [6]
(c) State two other factors a potential investor should consider before making a decision. [4]
Answer Details
(a) Ratio calculations for Diana and Eduardo
(i) Gross profit margin
Gross profit margin = (Revenue - Cost of sales) / Revenue x 100
Diana: (200 000 - 120 000) / 200 000 x 100 = 80 000 / 200 000 x 100 = 40% [1]
Eduardo: (350 000 - 245 000) / 350 000 x 100 = 105 000 / 350 000 x 100 = 30% [1]
(ii) Profit margin
Profit margin = Profit for the year / Revenue x 100
Diana: 32 000 / 200 000 x 100 = 16% [1]
Eduardo: 35 000 / 350 000 x 100 = 10% [1]
(iii) Return on capital employed (ROCE)
Capital employed = Total assets - Current liabilities
Diana: (100 000 + 50 000) - 30 000 = $120 000
ROCE = 32 000 / 120 000 x 100 = 26.7% [1]
Eduardo: (180 000 + 70 000) - 60 000 = $190 000
ROCE = 35 000 / 190 000 x 100 = 18.4% [1]
(iv) Current ratio
Current ratio = Current assets / Current liabilities
Diana: 50 000 / 30 000 = 1.67 : 1 [1]
Eduardo: 70 000 / 60 000 = 1.17 : 1 [1]
(v) Rate of inventory turnover (times)
Inventory turnover = Cost of sales / Average inventory
Diana: 120 000 / 15 000 = 8 times [1]
Eduardo: 245 000 / 35 000 = 7 times [1]
(b) Investment advice
Diana appears to be the stronger investment based on the ratio analysis. [1]
- Diana has a significantly higher gross profit margin (40% vs 30%), indicating she retains more of each dollar of revenue after covering the cost of goods sold, suggesting better pricing strategy or purchasing power. [1]
- Diana has a higher profit margin (16% vs 10%), demonstrating more efficient management and control of operating expenses relative to revenue. [1]
- Diana achieves a higher ROCE (26.7% vs 18.4%), meaning each dollar of capital employed generates a greater return. For an investor, this signals more productive use of resources. [1]
- Diana has a healthier current ratio (1.67:1 vs 1.17:1), indicating a more comfortable ability to meet short-term debts as they fall due. [1]
- However, Eduardo generates significantly more revenue ($350 000 vs $200 000) and higher absolute profit ($35 000 vs $32 000), which may indicate greater growth potential and market reach. [1]
(c) Two other factors to consider
- The type of goods sold and general market conditions [1] - different industries have different typical margins and turnover rates, so the comparison may not be like-for-like if the businesses sell different products. [1]
- The age and condition of the non-current assets [1] - older, fully depreciated assets inflate ROCE but may need replacing soon, requiring significant capital investment that would reduce future returns. [1]
Download The App On Google Playstore
Everything you need to excel in your exams
