Analysis and Interpretation

Question 1

Working Capital

Answer 1

The capital amount available for day-to-day business operations.
Current Assets - Current Liabilities

Question 2

Capital

Answer 2

The amount invested by the owners/ shareholders.

Question 3

Capital for a sole trader

Answer 3

Capital is invested by the owners

Question 4

Capital for partnership

Answer 4

Capital is invested by the partners

Question 5

Capital for limited companies

Answer 5

Capital (equity) will be invested by shareholders and reserves.

Question 6

Equity of limited companies

Answer 6

Equity of limited companies = Ordinary share capital + Retained earnings + General reserves.

Question 7

Capital employed

Answer 7

Total funds invested by the owners and lenders.
Capital employed = Owners fund Capital + Borrowed Fund loans
or
Capital employed = Issued Shares + Reserves + Non-Current Liabilities

Question 8

Accounting Ratios

Answer 8

1) Profitability Ratios
2) Liquidity Ratios
3) Activity Ratios

Question 9

Profitability Ratios

Answer 9

It measures the performance of the business by comparing the profit to other figures in the same set of financial statements.
1) Gross Margin
2) Profit Margin
3) Return on Capital Employed (ROCE)

Question 10

Liquidity Ratios

Answer 10

It measures the ability of the business to turn assets into cash to pay short-term debts.
1) Current ratio
2) Liquid Ratio ( Acid Test Ratio)

Question 11

Activity Ratio

Answer 11

1) Rate of inventory turnover
2)Trade receivables turnover
3)Trade payables turnover

Question 12

Gross Margin

Answer 12

This expresses gross profit as a percentage of revenue / net sales (sales - sales return)
Gross Margin = Gross profit/Revenue x 100
Gross Markup = Gross profit/Cost of Sales x 100

Question 13

Analysis of Gross Margin

Answer 13

1) This ratio shows the gross profit earned for every $100 of sales.
2) Higher gross profit margin indicates higher gross profits available to pay for the other expenses.

Question 14

How to improve Gross Margin

Answer 14

1) Increase the selling price
2) Reduce the purchasing cost/Manufacturing cost
3) Changing the sales mix

Question 15

Profit Margin

Answer 15

This expresses profit as a percentage of revenue.
Profit Margin= Profit for the year/Revenue × 100

Question 16

Analysis of Profit Margin

Answer 16

1) It shows the profit earned for every $100 of revenue.
2) This ratio shows as an indicator of how well a business is able to control its expenses.
3) If the profit margin of a business has a high percentage, it indicates that the operating expenses are being controlled.

Question 17

How to improve Profit Margin

Answer 17

1) Steps to increase the gross profit
✓ increasing the selling price
✓ Reduce the cost
2) Maintain better control over business expenses.

Question 18

Return on Capital employed (ROCE)

Answer 18

Expresses operating profit as a percentage of capital employed.
ROCE= Net profit before interest/Capital employed × 100

Question 19

Analysis of Return on Capital employed

Answer 19

1) It shows the operating profit earned for every $100 capital employed.
2) A higher rate of ROCE indicates better use of funds invested in the business and hence higher efficiency in business operations.

Question 20

How to improve the Return on Capital employed

Answer 20

1) Increase the gross profit
2) Efficiently manage expenditures

Question 21

Current Ratio/ Working Capital Ratio

Answer 21

It compares the current assets of the business to its current liabilities.
Current ratio = Current Assets/Current Liabilities

Question 22

Analysis of Current Ratio

Answer 22

It shows the current assets held for every $1 current liabilities. It measures the ability of the business to meet its current liabilities.
1) The ideal current ratio is suggested to be 2:1
2) 1.5:1 to 2:1 Satisfactory
3) If the current ratio is greater than 2:1 shows poor management of the current assets. A high ratio indicates inefficiency in the management of working capital.
4) If the rate is below 1.5:1, it shows short of working capital.
5) A lower ratio indicates a risk of default by the business in meeting its short-term liabilities.

Question 23

Problems that occur when short of working capital

Answer 23

1. Cannot meet immediate liabilities when they are due
2. Experience difficulties in obtaining further suppliers on credit.
3. Cannot take advantage of cash discounts
4. Cannot take advantage of business opportunities when they arise

Question 24

How to improve the Current Ratio

Answer 24

1) Capital investment by owners
2) Obtain long-term loans
3) Dispose of unused non-current assets for cash
4) Reduction of owners’ drawings/ Dividend payment
5) Delaying purchasing non-current assets.

Question 25

Acid Ratio/ Quick Ratio

Answer 25

This ratio compares assets that will convert into money quickly (liquid assets), with liabilities that are due for repayment in the near future.
Acid Ratio = Current Assets – Inventory/ Current Liabilities

Question 26

Analysis of Acid Ratio

Answer 26

1) 1:1 Says all the immediate liabilities can be met out of the liquid assets without having to sell inventories
2) If the ratio falls between 0.7:1 to 1 :1 usually treated as satisfactory.
3) If the ratio is below 0.7:1 it shows not enough liquid assets available in the business to cover immediate liabilities

Question 27

How to improve Acid Ratio

Answer 27

1) Capital investment by owners
2) Obtain long-term loans
3) Dispose of unused non-current assets for cash
4) Reduction of owners’ drawings/ Dividend payment
5) Delaying purchasing non-current assets.

Question 28

Rate of Inventory Turnover

Answer 28

Can be calculated in;
1) Number of times inventory is sold and replaced in the period
Rate of Inventory Turnover = Cost of Sales/Average Inventory —–> () times

2) Number of days on average the inventory is held before being sold.
Inventory Turnover = Average Inventory/ Cost of Sales x 365 —–> () days

Question 29

Analysis of Rate of Inventory turnover/ Inventory Turnover

Answer 29

1) The rate of inventory turnover will vary according to the type of business.
2) Businesses selling luxury goods will have low inventory turnover whereas businesses selling low-value everyday requirements will have a high rate of inventory turnover.
3) It’s better to compare the RIOT from year to year in the same business or compare businesses in the same industry
4) When this year’s inventory turnover is increasing when compared to last year, it says the company improved efficiency. When it decrees it, says, the business has too many inventories or sales are slowing down.

Question 30

Factors caused by a lower rate of inventory turnover

Answer 30

1. Lower Sales
2. Inventory over purchased
3. Too high selling prices
4. Falling demand
5. Business activity slowing down
6. Business inefficiency

Question 31

Trade Receivables turnover

Answer 31

This measures the average time the credit customers take to pay their accounts. This can be
measured in days, weeks, or months.
TRT= Trade receivables/Credit Sales x 365 —> () days

Question 32

Analysis of Trade Receivables turnover

Answer 32

1) If the period increases, it may indicate that the credit control policy is inefficient or
that longer credit terms are being allowed in order to maintain the quantity of credit
sales.
2) If the period decreases that says the credit control policy is being applied more
effectively.

Question 33

How to improve Trade Receivables turnover

Answer 33

1) Improving credit control policy
2) Offering cash discount for early settlement.
3) Charging interest on an overdue account
4) Refusing further supplies until any outstanding debt is paid.
5) Invoice discounting and debt factoring.

Question 34

Trade payables turnover

Answer 34

This measures the average time taken to pay the accounts of credit suppliers.
TPT= Trade Payables/Credit Purchases × 365 —> () days

Question 35

Analysis of Trade payables turnover

Answer 35

1) If the period decreases, it indicates that the company is paying the suppliers more quickly.
2) When the period increases it shows that the business is short of immediate funds and is finding
difficulties to meet debts when they fall due.

Question 36

Relationship of Trade receivables turnover and Trade payables turnover

Answer 36

When the trade receivables ratio carries a high rate, businesses will be facing difficulties to pay their credit suppliers promptly.

Question 37

Advantages of having a high rate of Trade Payables Turnover.

Answer 37

Businesses can use the funds for other purposes

Question 38

Disadvantages of having a high rate of Trade Payables Turnover

Answer 38

1) Suppliers refusing credit in the future
2) The suppliers refusing further supplies
3) The loss of any cash discounts for early settlement
4) Damage to the relationship with the suppliers