Finance: Measuring Liquidity and Profitability

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Questions and Answers

What is the primary purpose of the current ratio?

To evaluate long-term financial stability

To determine inventory efficiency

To measure profitability over a period

To assess the ability to pay short-term debts (correct)

How can a business improve its liquidity?

Reduce selling price to attract customers

Increase inventory levels substantially

Obtain a long-term loan (correct)

Focus solely on reducing production costs

Which formula represents the quick ratio?

Total current assets / Total current liabilities

Cost of Sales / Average Inventory

(Total current assets - Inventory - Prepayments) / Total current liabilities (correct)

Current assets - Current liabilities

What does working capital represent?

Current assets minus current liabilities Signup and view all the answers

What indicates a more efficient inventory management for a business?

A higher rate of inventory turnover Signup and view all the answers

Which of the following factors is important for managing cash outflow effectively?

Reducing operating expenses Signup and view all the answers

What does 'Days Sales in Inventory' measure?

The duration to sell inventory on hand Signup and view all the answers

Which liquidity ratio is commonly associated with the acceptable norm of 2?

Current ratio Signup and view all the answers

Which financial ratio expresses the relationship between gross profit and sales revenue?

Gross profit margin percentage Signup and view all the answers

What is a potential consequence of selling goods at a price below its cost price?

Gross loss leading to reduced competitiveness Signup and view all the answers

Which of the following can improve a business's profitability?

Reducing operating expenses Signup and view all the answers

What does liquidity measure in a business context?

Ability to convert current assets into cash Signup and view all the answers

Which formula calculates profit or loss for the period?

Gross profit + Other income - Other expenses Signup and view all the answers

What is the effect of high liquidity on a business?

Enhances ability to meet short-term obligations Signup and view all the answers

Which of the following results from using absolute figures in financial analysis?

Enables performance comparison across time Signup and view all the answers

What might be a strategy to enhance trade receivables management?

Conduct regular follow-ups on outstanding invoices Signup and view all the answers

What does a higher rate of trade receivables turnover indicate about a business?

It is collecting payments more frequently. Signup and view all the answers

Which of the following methods can be employed to improve the collection of trade receivables?

Offering cash discounts for early payments. Signup and view all the answers

How is the trade receivables collection period calculated?

(Average net trade receivables x 365 days) / Net credit sales revenue Signup and view all the answers

What is a key element of a trading business's financial statement?

Current and non-current assets Signup and view all the answers

Which financial ratio is essential for assessing a company's liquidity?

Working capital ratio Signup and view all the answers

In a private limited company financial statement, which category is not typically included?

Accounts payable Signup and view all the answers

What is the effect of a longer trade receivables collection period on a business's efficiency?

It signals potential inefficiencies in collecting receivables. Signup and view all the answers

Which formula is used to calculate average net trade receivables?

(Beginning receivables + Ending receivables) / 2 Signup and view all the answers

Study Notes

Measuring Liquidity

Working Capital: Difference between current assets and current liabilities.
- Formula: Working capital = Current assets - Current liabilities
Liquidity Ratios: Measure a business's ability to pay short-term debts.
- Current Ratio: Indicates ability to pay short-term debts using all current assets.
  - Formula: Current ratio = Total current assets / Total current liabilities
  - General benchmark: 2
- Quick Ratio: Indicates ability to pay short-term debts using quick assets (assets easily converted to cash).
  - Formula: Quick Ratio = (Total current assets - Inventory - Prepayments) / Total current liabilities
  - General benchmark: 1

Profitability

Definition: Ability of a business to generate excess income to cover its expenses.
Absolute Figures: Gross profit, profit for the period, sales revenue, service fee revenue, cost of sales.
Financial Ratios:
- Gross profit margin percentage: Percentage of gross profit to sales revenue.
- Mark-up on cost percentage: Percentage of gross profit to cost of sales.
- Profit margin percentage: Percentage of profit for the period to sales revenue.
- Return on equity percentage: Percentage of profit for the period to owner's equity.

Efficiency in Inventory Management

Definition: Maintaining optimal inventory levels to meet customer demand.
Measuring Efficiency:
- Rate of Inventory Turnover: Indicates how many times inventory is sold and replaced during a period.
  - Formula: Rate of inventory turnover = Cost of Sales / Average Inventory
- Days Sales in Inventory: Indicates how many days it takes to sell inventory.
  - Formula: Days sales in inventory = (Average inventory x 365 days) / Cost of sales
Ways to Improve Efficiency:
- Sell inventory faster: Offer discounts, attract more customers.
- Keep sufficient inventory on hand: Use technology to track inventory levels.

Efficiency in Trade Receivables Management

Definition: Granting appropriate credit terms to promote sales and collecting cash from credit customers on a timely basis.
Measuring Efficiency:
- Rate of Trade Receivables Turnover: Indicates how many times a business collects payment from credit customers.
  - Formula: Rate of trade receivables = Net credit sales revenue / Average net trade receivables OR Net credit service fee revenue / Average net trade receivables
- Trade Receivables Collection Period: Indicates how many days it takes to collect payments from credit customers.
  - Formula: Trade receivables collection period = (Average net trade receivables x 365 days) / Net credit sales revenue OR (Average net trade receivables x 365 days) / Net credit service fee revenue
Ways to Improve Efficiency:
- Improve credit granting processes: Monitor collection patterns, only grant credit to financially stable customers.
- Provide monetary incentives: Offer cash discounts for early payments.
- Increase debt collection efforts: Send reminders, utilize debt recovery agencies.

Financial Statement Analysis

Purpose: To make informed decisions, evaluate profitability, liquidity, efficiency in inventory management, and trade receivables management.
Tools: Absolute figures and financial ratios.
Stakeholders: Owners, shareholders, managers, employees, competitors, lenders, government, suppliers, and customers.

Financial Statement Formats

Types Covered: Trading business, service business, sole proprietorship, and private limited company.
Structure: Includes assets (non-current and current), equity and liabilities (owner's equity, non-current liabilities, current liabilities).

Formulas and Calculations

Chapter provides formulas for calculating:
- Financial ratios discussed in the chapter.
- Working capital.
- Average inventory.
- Average net trade receivables.

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Description

This quiz covers crucial financial concepts related to measuring liquidity and profitability within a business context. You'll explore key formulas such as working capital, current ratio, and quick ratio, along with their implications on a company's financial health. Test your knowledge on how these measures help assess a company's capability to cover short-term debts and generate profits.