Chapter 16 Financial Statement Analysis

Question 1

Define the term profitability

Answer 1

Profitability is the ability of a business to generate excess income to cover its expenses

Question 2

Explain why is it important for a business to be profitable

Answer 2

-continue operating and sustain in the long term
-distribute profits to the owners for their contributions to the business
-rewards employees and retain them to continue to work for the business
-attract other investors

Question 3

State ways to improve profitability

Answer 3

-Sell goods at high selling price
-buy goods at lower cost price by buying in bulk to obtain trade discount or switching to another supplier that offer lower prices, without compromising on quality
-increase sources of other income by subletting excess space to another business to earn rental income or pay early to take advantage of cash discount

Question 4

gross profit margin formula

Answer 4

gross profit/net sales revenue x100%

Question 5

mark up on cost formula

Answer 5

gross profit/ cost of sales x 100%

Question 6

profit margin formula

Answer 6

profit margin/ net sales revenue x 100%

Question 7

Return on equity formula

Answer 7

profit/ average equity x 100%

Question 8

Define the term liquidity

Answer 8

liquidity is the ability of a business to repay its current liabilities when they fall due. It measures the ability of a business to convert current assets into cash to pay for current liabilities

Question 9

Explain why is it important for a business to be liquid

Answer 9

-to settle its immediate debts
-to take advantage of cash discounts as the business is able to pay promptly
-take advantage of good investment opportunities using existing funds

Question 10

Problem a business might face as a result of poor liquidity

Answer 10

-unable to take advantage of cash discount given by credit suppliers as the business is unable to pay promptly
-unable to settle its immediate debts. if this persists, the business may eventually close down
-unable to take advantage of good investment opportunities

Question 11

State ways to improve liquidity of a business

Answer 11

-obtain long-term loan
-sell excess non-current assets for cash
-reduce operating expenses
-negotiate for better credit terms form supplier

Question 12

state ways to improve efficiency in inventory management

Answer 12

-reduce selling price for slow moving goods
-provide trade discounts to encourage customers to buy in bulk and regularly
-attract more customers through marketing campaigns

Question 13

state ways to improve efficiency in trade receivables management

Answer 13

-improve its credit granting process by monitoring collection patterns closely and ensure that credit is grant to customers who are financially able
-provide monetary incentives by offering cash discounts to encourage credit customers to pay early