Budgets, ratios, and decisions

Learning goals

• Calculate and interpret budget variances.
• Calculate working capital, current ratio, debt ratio, gross profit percentage, and return on owner's equity.
• Use comparative, trend, and common-size analysis at an introductory level.
• Write a qualified recommendation that includes limitations.

Prerequisite check

Calculate gross profit if net sales are $50,000 and COGS is $31,000. Explain why gross profit is not net income.

Vocabulary

• Budget: quantified plan used for planning and control.
• Variance: actual result minus or compared with budget; favourable/unfavourable depends on context.
• Working capital: current assets − current liabilities.
• Current ratio: current assets ÷ current liabilities.
• Debt ratio: total liabilities ÷ total assets × 100%.
• Gross profit percentage: gross profit ÷ net sales × 100%.
• Return on owner's equity (ROE): net income ÷ average owner's equity × 100% under this lesson's convention.
• Common-size statement: each item shown as a percentage of a meaningful base.

Core idea

Analysis turns statements into questions; it does not produce automatic verdicts. A ratio needs a comparison, business context, calculation convention, and limitation before it supports a decision.

Why this treatment makes sense

Two businesses can have the same current ratio but different receivable quality, seasonality, or payment deadlines. A favourable expense variance may result from efficiency—or from skipped maintenance. The number identifies where to investigate.

A repeatable method

Use CALM:

1. C — Calculate with labelled formula, substitutions, and units.
2. A — Anchor to budget, prior period, competitor, target, or other context.
3. L — Link the direction to a plausible operational meaning.
4. M — Missing evidence: state a limitation and next fact needed.

Worked example

Evergreen Gear reports:

• current assets $42,000; current liabilities $21,000;
• total assets $105,000; total liabilities $63,000;
• net sales $180,000; COGS $117,000; net income $15,000;
• beginning equity $40,000; ending equity $42,000.

Calculations:

• Working capital = $42,000 − $21,000 = $21,000.
• Current ratio = $42,000 ÷ $21,000 = 2.00:1.
• Debt ratio = $63,000 ÷ $105,000 × 100 = 60.0%.
• Gross profit = $180,000 − $117,000 = $63,000; percentage = $63,000 ÷ $180,000 × 100 = 35.0%.
• Average equity = ($40,000 + $42,000) ÷ 2 = $41,000; ROE = $15,000 ÷ $41,000 × 100 = 36.6%.

Budgeted revenue was $190,000 and actual $180,000: $10,000 below budget, unfavourable for revenue. Budgeted expenses were $158,000 and actual expenses are Net Sales $180,000 − Net Income $15,000 = $165,000: $7,000 above budget, unfavourable. Budget net income $32,000 versus actual $15,000, a $17,000 unfavourable gap.

If base-year sales were $160,000, the current $180,000 sales produce a trend percentage of $180,000 ÷ $160,000 × 100 = 112.5%. This means sales are 12.5% above the selected base, not that profit rose 112.5%. The 35.0% gross profit percentage is also a common-size result because gross profit is expressed relative to net sales.

Qualified interpretation: the company has $2 of current assets per $1 of current liabilities and positive working capital, but receivable and inventory quality, due dates, cash flows, and prior-period ratios are needed before calling liquidity strong.

Journal, ledger, and statement connection

Ratios depend on adjusted statement balances, which depend on correct journals, ledgers, counts, and estimates. A spreadsheet may calculate a perfect formula from incorrect source balances. Variance follow-up may lead to corrected entries, revised forecasts, or operational action, but not to changing actual records to match budget.

Common mistakes

• Calling every lower expense favourable without asking what was delayed or lost.
• Comparing ratios calculated with different formulas.
• Using ending equity instead of average equity when the question specifies average.
• Reversing the debt-ratio numerator and denominator.
• Treating a high current ratio as proof that cash is available.
• Recommending an investment or loan from one ratio alone.

Guided practice

A business has current assets $30,000, current liabilities $20,000, total assets $75,000, total liabilities $45,000, net sales $120,000, COGS $78,000, and net income $9,000. Calculate working capital, current ratio, debt ratio, and gross profit percentage. Give one limitation for each category.

Independent practice

Last year, sales were $200,000 and wages $60,000. This year, sales are $230,000 and wages $73,600.

1. Calculate each comparative dollar and percentage change.
2. Calculate wages as a common-size percentage of sales for each year.
3. Decide whether wages simply “rose too fast,” using CALM.
4. If budgeted wages were $70,000, calculate the variance and identify two possible explanations.

Self-check and solutions

Guided practice: Working capital $10,000; current ratio 1.50:1; debt ratio 60.0%; gross profit $42,000 and GP% 35.0%. Limitations include collection quality and due dates for liquidity, financing terms and asset values for debt, product mix/discounts/shrinkage for margin, and missing comparisons for every ratio.

Independent practice: Sales increased $30,000 or 15.0%. Wages increased $13,600 or 22.7%. Prior wages common-size = $60,000 ÷ $200,000 = 30.0%; current = $73,600 ÷ $230,000 = 32.0%. Wages took 2 percentage points more of sales, but hours, pay rates, staffing, service quality, and product mix are needed. Budget variance = $73,600 − $70,000 = $3,600 unfavourable for cost. Possible causes include higher hours, overtime, raises, new staffing, coding error, or timing.

Retrieval practice

Write the five formulas from memory. For each, give one decision user and one limitation.

Exam-style application

Company A current ratio is 1.8:1 and Company B is 1.3:1. Write a four-sentence lender interpretation without declaring a winner.

Answer outline: Name the results and that A has more current assets per dollar of current liabilities. Say this may suggest a larger short-term cushion under the same conventions. Request composition/quality of receivables and inventory, cash flows, due dates, trends, and industry comparison. Conclude that the ratios are evidence, not sufficient approval criteria.

Lesson summary

Calculate transparently, anchor the result, link it to a plausible meaning, and state missing evidence. Budgets and ratios guide investigation and decisions; they are not verdicts.