Sonia runs a retail business. The following information is available for her business for two consecutive years. 2024 $ 2023 $ Revenue 240 000 200 000 Cost ...

(a) Calculation of ratios for 2024 and 2023

(i) Gross profit margin

The gross profit margin measures the percentage of revenue retained after deducting the cost of sales. The formula is:

\( \text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100 \)

(ii) Net profit margin

The net profit margin measures the percentage of revenue remaining as profit after all expenses have been deducted. The formula is:

\( \text{Net profit margin} = \frac{\text{Net profit}}{\text{Revenue}} \times 100 \)

(iii) Current ratio

The current ratio measures a business's ability to pay its short-term debts using all current assets. The formula is:

\( \text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} \)

Current assets include inventory, trade receivables, and cash/bank.

(iv) Acid test ratio

The acid test ratio (also called the quick ratio) excludes inventory from current assets because inventory may not be quickly convertible to cash. The formula is:

\( \text{Acid test ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}} \)

(b) Commentary on profitability changes

The gross profit margin declined from 40% in 2023 to 35% in 2024. This indicates that the cost of sales has increased at a faster rate than revenue, meaning Sonia is retaining a smaller proportion of each dollar of sales as gross profit. [1]

The net profit margin also fell from 20% to 15%. Although revenue increased by $40,000 (a 20% rise), net profit actually fell from $40,000 to $36,000. [1]

Expenses rose from $40,000 to $48,000, a 20% increase that matched the revenue growth rate. Combined with the declining gross profit margin, this has squeezed overall profitability. [1]

In absolute terms, the business grew its revenue but became less profitable. The cost of sales increased from 60% to 65% of revenue, suggesting Sonia may be paying more for goods or selling at lower prices. [1]

(c) Commentary on liquidity changes

The current ratio declined from 3.33 : 1 in 2023 to 2.4 : 1 in 2024, indicating a reduction in the business's short-term financial cushion. [1]

The acid test ratio also fell from 2.08 : 1 to 1.5 : 1, confirming the downward trend even when inventory is excluded. [1]

Trade payables increased significantly from $12,000 to $20,000 (a 67% rise), suggesting the business may be delaying payments to suppliers, which is a sign of cash flow pressure. [1]

However, both ratios remain above 1 : 1, which means the business can still meet its short-term obligations. The liquidity position has weakened but is not yet critical. [1]

(d) Two actions to improve net profit margin

Action 1: Negotiate better prices with suppliers to reduce the cost of sales. [1] If the cost of sales as a proportion of revenue can be brought back down, the gross profit margin will improve, and since net profit is derived from gross profit, the net profit margin will also increase. [1]

Action 2: Review and reduce expenses such as rent, advertising, or administrative costs. [1] Since expenses are deducted from gross profit to arrive at net profit, any reduction in expenses will directly improve the net profit margin. [1]