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Accounting 3/4 > Chapter 19 Exercise Review > Flashcards

Chapter 19 Exercise Review Flashcards

1
Q

Define Liquidity

A

Liquidity is the ability of a business to meet it short term debts as they fall due

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2
Q

Indicators that can be used to the level of liquidity

A

· Working Capital Ratio (WCR)
· Quick Asset Ratio (QAR)
· Cash Flow Cover (CFC)

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3
Q

Three indicators that are used to assess the speed of liquidity

A

· Stock Turnover (STO)
· Debtors Turnover (DTO)
· Creditors Turnover (CTO)

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4
Q

Define: Working Capital Ratio

A

Working Capital Ratio is a liquidity indicator that measures the ratio of current assets to current liabilities, to assess the firm’s ability to meet its short term debts

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5
Q

WCR Formula

A

WCR = Current Assets / Current Liabilities

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6
Q

Actions the owner may be able to take if the working capital ratio is too low or too high

A

· Too Low
○ Make a capital contribution
○ Seek additional finance by entering into, or extending and overdraft facility
○ Take out a loan to purchase non-current assets

· Too High
○ Use excess cash by repaying debts, purchasing non-current assets, or taking extra drawings
○ Allow stock levels to run down before recording
○Contract debtors to collect amounts outstanding

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7
Q

Define: Quick Asset Ratio

A

Quick Asset Ratio is a liquidity indicator that measures the ratio of quick assets to quick liabilities to assess the firm’s ability to meet its immediate debts

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8
Q

QAR Formula

A

QAR = Current Assets (excluding stock & prepaid expenses) / Current liabilities (excluding bank overdraft)

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9
Q

Why the following items are excluded from the calculation of the QAR:

A

· Stock: No guarantee that all stock will be sold

· Prepaid Expenses: Cannot be converted back into cash

· Bank Overdraft: It is unlikely that it will be called in for repayment as long as it remains under the limit

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10
Q

What does it mean if the working capital ratio is satisfactory but the quick asset ratio is unsatisfactory?

A

If the working capital ratio is satisfactory but the quick asset ratio is unsatisfactory it means that the business has a large investment in its stock and prepaid expenses

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11
Q

Define: Cash Flow Cover

A

Cash Flow Cover is a liquidity indicator that measures the number of times Net Cash Flows from Operations is able to cover average Current Liabilities

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12
Q

CFC Formula

A

CFC = Net Cash Flows from Operations / Average Current Liabilities

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13
Q

Benchmarks that could be used to assess the adequacy of the cash flow cover

A

· CFC from previous periods

· Budgeted CFC

· CFC of similar businesses

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14
Q

Define: Stock Turnover

A

Stock turnover is the average number of days it takes for a business to convert its stock into sales

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15
Q

STO Formula

A

STO = (Average Stock x 365) / Cost of Goods Sold

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16
Q

Actions the owner could take to improve stock turnover

A

Employ strategies to increase sales:
○ Advertising
○ Changing selling prices
○ Changing stock mix

Decrease the level of stock on hand
○ Ordering smaller amounts more frequently
○ Replace slow moving stock lines

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17
Q

Define: Debtors Turnover

A

Debtors Turnover measures the average number of days it takes for a business to collect cash from its debtors

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18
Q

DTO Formula

A

DTO = Average Debtors x 365 / Credit Sales

19
Q

Define: Creditors Turnover

A

Creditors Turnover measures the average number of days it takes for a business to pay its creditors

20
Q

CTO Formula

A

CTO = Average Creditors x 365 / Credit Purchases

21
Q

Negative Consequences of exceeding the credit terms offered by suppliers:

A

Interest Charges on late accounts

Removal of credit facilities

Reduction in credit rating

22
Q

Justification for WCR being unsatisfactory

A

The Working Capital Ratio is less than 1:1. Thus, the firm has insufficient current assets to meet its current liabilities, and may be unable to meet its short-term debts as they fall due without the aid of additional finance (such as loans or capital).

23
Q

Actions the owner could take to improve WCR

A

Make a capital contribution/Reduce drawings

Organise a bank overdraft

Defer the purchase of assets

Use credit facilities/Defer the repayment of loans

24
Q

Explanation of WCR decreasing and what it means

A

It has reduced, indicating less current assets for every dollar of current liabilities. This means the firm is less able to meet its short-term debts as they fall due, and may require the owner to organise or extend a bank overdraft or make a capital contribution.

25
Q

Limitations of relying on WCR to assess liquidity

A

It is a static measure, and does not indicate the timing of cash flows, such as when current assets will be turned into cash or current liabilities are due to be paid.

It relies on historical data, which may not result in cash flows, e.g. bad debts or stock loss.

It includes some assets that might be difficult to liquidate, e.g. stock or prepaid expenses.

26
Q

Explain how the budgeted cash flow statement could be used to assess liquidity

A

It predicts/forecasts expected cash inflows and outflows, indicating whether the business will generate sufficient cash flows to meet its obligations.

27
Q

Explanation of satisfactory QAR and what it means

A

The Quick Asset Ratio is greater than 1:1. Thus, the firm has sufficient quick assets to meet its quick liabilities, and should be able to meet its short-term debts as they fall due.

28
Q

Explain why stock is excluded from the calculation of quick assets

A

The business will already be selling its stock as fast as it can, so there is no guarantee that stock can be liquidated immediately to meet immediate debts. Therefore, it cannot be counted as a source of immediate liquid funds.

29
Q

Explain how the efficiency of this business in managing its current assets will affect its liquidity

A

The main component if the quick assets is Debtors Control – if the business can collect its cash fast enough from its debtors, it should be able to meet its quick liabilities (the main one of which is Creditors Control)

30
Q

Explain why the WCR of the business increased a lot more than the increase in QAR

A

Large purchases of stock on credit would increase Stock Control and thus current assets and the Working Capital Ratio but not quick assets and thus not the Quick Asset Ratio.

31
Q

A negative consequence if the working capital ratio is too high

A

A high working capital ratio means assets are idle, and not earning as much as they could,

i.e. Bank: the interest rate is relatively low

Debtors Control: debtors are not paying

Stock Control: stock is not selling.

The funds tied up in these assets could be employed more usefully elsewhere.

32
Q

Explain the circumstances in which the business will have no difficulties meeting short term debts
and
have difficulties meeting short term debts

A

Working Capital Ratio above 1:1 means if stock is sold fast enough to meet the creditors’ terms, the business should not have liquidity problems.

Quick Asset Ratio below 1:1 means if stock is not sold fast enough to meet creditors’ terms, liquidity problems could arise.

33
Q

Explain whether liquidity has improved or worsened

Improved

A

Improved:
The business has more Net Cash Flows from Operations available to meet less average current liabilities

meaning

The business is more able to meet its average current liabilities using Net Cash Flows from Operations.

34
Q

Information from the cash flow statement that would assist in the assessment of liquidity

A

Net Cash Flows from Investing Activities

Net Cash Flows from Financing Activities

Bank Balance at start/end

35
Q

Explain why it is important for liquidity that net cash flows from Operations is positive

A

The business must be able to generate enough cash from its day-to-day trading operations otherwise it will be unable to meet its obligations without contributions from the owner, loans, or the sale of non-current assets, none of which can occur indefinitely.

36
Q

Explain why the business should be concerned about a very high WCR

A

The Working Capital Ratio is too high, which means it may have current assets that are idle/unproductive such as stock that is not selling/debtors that are not paying/bank that is earning only a low rate of interest.

37
Q

Explain how the balance sheet could assist in assessing liquidity

A

By detailing the individual current assets and current liabilities, the owner can assess whether current assets are actually too high, which ones may be too high, how much cash will be generated from stock, whether Bank o/draft is actually a source of cash, expected Receipts from Debtors.

38
Q

Information that can assist in the assessment of liquidity

A

Amount of stock on hand

Bank overdraft limit

Stock Turnover

Debtors Turnover

These can be used to assess possible cash from sales

Indicates extra cash available

Indicates speed of sales

Indicates how quickly cash is collected from debtors

39
Q

Explain how a slow Stock Turnover can have a negative consequence for profitability and liquidity

A

Slow Stock Turnover means the business is not generating sales fast enough, so:

  • profit will be reduced as revenue is not earned
  • liquidity will be reduced as cash is not generated from Sales or Receipts from Debtors.
40
Q

An action the owner could take to improve stock turnover without affecting Gross Profit

A

Reduce the level of stock on hand by reducing orders, purchasing less more often, Just in Time ordering.

41
Q

Explain one negative consequence if stock turnover is too fast

A

Stock will have to be ordered very frequently, meaning higher delivery charges and/or the loss of discounts for bulk purchases.

Stock may run out, meaning sales (and profits) are lost as customers go elsewhere.

It may indicate SP is too low, meaning less Gross Profit than is possible.

42
Q

Explain the relationship between Selling Prices and Stock Turnover

A

Higher selling prices are likely to lead to a slower Stock Turnover as customers may be unwilling to pay higher prices, so sales may decrease.

OR

Lower selling prices are likely to lead to a faster Stock Turnover as customers may be more willing to purchase stock, so sales may increase.

43
Q

Strategies the owner could implement to improve Debtors Turnover

A

Conduct extensive credit checks before granting credit

Offer discounts for early payment

Contact slow-paying debtors by phone or letter

Threaten legal action

44
Q

Strategies to improve Stock turnover

A

Increase advertising

Reduce selling prices

Reduce the level of stock on hand/change ordering practices

Accounting 3/4 (18 decks)

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