Current Ratios in Business Finance

Questions and Answers

What does a current ratio of less than 1 indicate about a business?

The business is efficiently converting its assets to cash.

The business is at risk of not meeting its short-term obligations. (correct)

The business has a surplus of cash to cover its liabilities.

The business has equal current assets and current liabilities.

Which of the following is excluded from the calculation of the acid test ratio?

Inventory (correct)

Accounts receivables

Bank deposits

Cash

If a business has a quick ratio of 1.5, what does this imply?

For every RM1 of current liabilities, the business has RM1.50 of liquid assets. (correct)

The business may struggle to meet current liabilities.

The current ratio is lower than the ideal ratio.

The business is at risk of bankruptcy.

What is a desired ideal current ratio for a business?

2:1 Signup and view all the answers

How is inventory turnover calculated?

Cost of sales divided by average inventory Signup and view all the answers

What does a high inventory turnover typically indicate about a business?

The business is selling its products in a timely manner. Signup and view all the answers

How is the average inventory calculated?

(Opening Inventory + Closing Inventory) / 2 Signup and view all the answers

What does a net profit margin measure?

The amount left from sales revenue after all expenses are paid. Signup and view all the answers

What effect does not collecting debts on time have on a business?

It can lead to insufficient cash resources for operations. Signup and view all the answers

Which statement about gross profit margin is true?

It shows profit before deducting administrative costs. Signup and view all the answers

Study Notes

Liquidity Ratios

Ratios assess a business's ability to meet short-term obligations as they arise.
The current ratio compares total current assets to current liabilities; ideal is 2:1.
A current ratio below 1 signifies liabilities exceed expected cash-convertible assets, indicating financial risk.
Liquidity assets, such as cash and receivables, are considered for calculations; inventory and prepayments are excluded.
A higher liquidity ratio indicates stronger financial health, while a lower ratio suggests potential payment struggles.
A quick ratio of 1.5 means RM1.50 in liquid assets available for each RM1 current liability, while a ratio below 1 indicates difficulty in meeting short-term debts.

Efficiency Ratios

These ratios evaluate a business's asset management efficiency in generating revenue.
Inventory turnover reflects how often inventory is sold and replaced; calculated by dividing cost of sales by average inventory.
Average inventory is computed as (Opening Inventory + Closing Inventory) / 2.
A high inventory turnover suggests healthy sales; a rate of 1 or less indicates excess inventory and cash flow risks.
The collection period measures time taken to collect money from debtors; shorter periods improve liquidity.

Performance Ratios

Performance ratios illustrate business performance over an accounting period, often shown as gross profit percentage of net sales.
Gross profit is net sales minus the cost of goods sold; gross profit margin reflects profit after cost of goods sold and before other expenses.
A gross profit margin of 40% indicates RM60 of costs for every RM100 in sales, leaving RM40 for operating expenses.
Net profit margin indicates net profit per sales revenue, showing efficiency in managing operating and overhead costs.
Net profit is derived by subtracting total expenses from net sales; calculated as a percentage of net sales.
A positive net profit margin reflects strong financial health; high margins suggest efficient management and pricing strategies.

Description

This quiz covers the concept of current ratios and their significance in assessing a business's ability to meet short-term obligations. Understand the relationship between current assets and current liabilities and learn why an ideal ratio of 2:1 is considered healthy for businesses. Test your knowledge on how these ratios influence financial stability.