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Questions and Answers
What is the primary purpose of the current ratio?
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?
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?
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?
What does working capital represent?
What indicates a more efficient inventory management for a business?
What indicates a more efficient inventory management for a business?
Which of the following factors is important for managing cash outflow effectively?
Which of the following factors is important for managing cash outflow effectively?
What does 'Days Sales in Inventory' measure?
What does 'Days Sales in Inventory' measure?
Which liquidity ratio is commonly associated with the acceptable norm of 2?
Which liquidity ratio is commonly associated with the acceptable norm of 2?
Which financial ratio expresses the relationship between gross profit and sales revenue?
Which financial ratio expresses the relationship between gross profit and sales revenue?
What is a potential consequence of selling goods at a price below its cost price?
What is a potential consequence of selling goods at a price below its cost price?
Which of the following can improve a business's profitability?
Which of the following can improve a business's profitability?
What does liquidity measure in a business context?
What does liquidity measure in a business context?
Which formula calculates profit or loss for the period?
Which formula calculates profit or loss for the period?
What is the effect of high liquidity on a business?
What is the effect of high liquidity on a business?
Which of the following results from using absolute figures in financial analysis?
Which of the following results from using absolute figures in financial analysis?
What might be a strategy to enhance trade receivables management?
What might be a strategy to enhance trade receivables management?
What does a higher rate of trade receivables turnover indicate about a business?
What does a higher rate of trade receivables turnover indicate about a business?
Which of the following methods can be employed to improve the collection of trade receivables?
Which of the following methods can be employed to improve the collection of trade receivables?
How is the trade receivables collection period calculated?
How is the trade receivables collection period calculated?
What is a key element of a trading business's financial statement?
What is a key element of a trading business's financial statement?
Which financial ratio is essential for assessing a company's liquidity?
Which financial ratio is essential for assessing a company's liquidity?
In a private limited company financial statement, which category is not typically included?
In a private limited company financial statement, which category is not typically included?
What is the effect of a longer trade receivables collection period on a business's efficiency?
What is the effect of a longer trade receivables collection period on a business's efficiency?
Which formula is used to calculate average net trade receivables?
Which formula is used to calculate average net trade receivables?
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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
- Current Ratio: Indicates ability to pay short-term debts using all current assets.
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
- Rate of Inventory Turnover: Indicates how many times inventory is sold and replaced during a period.
- 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
- Rate of Trade Receivables Turnover: Indicates how many times a business collects payment from credit customers.
- 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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