O Level Principles of Accounts Ratios Analysis Quiz

O-Level Principles of Accounts Quiz - Ratios Analysis - ANSWERS

Total Marks: 40

Section A: Short Answer (10 marks)

1. State the formula for calculating the gross profit margin. (1 mark) Answer: (Gross Profit / Revenue) × 100%

2. State the formula for calculating the current ratio. (1 mark) Answer: Current Assets / Current Liabilities

3. State the formula for calculating the quick ratio (acid test ratio). (1 mark) Answer: (Current Assets - Inventory) / Current Liabilities

4. State the formula for calculating the inventory turnover ratio (times). (1 mark) Answer: Cost of Sales / Average Inventory

5. State the formula for calculating the trade receivables turnover ratio (times). (1 mark) Answer: Credit Sales / Average Trade Receivables

6. Explain what the net profit margin measures. (2 marks) Answer: The net profit margin measures the percentage of revenue that remains as net profit after all expenses (including operating expenses, interest, and taxes) have been deducted. It indicates how effectively a business controls its overall expenses to generate profit from its sales.

7. Explain what the current ratio indicates about a business. (2 marks) Answer: The current ratio indicates a business's ability to meet its short-term obligations (current liabilities) with its short-term assets (current assets). A higher ratio suggests better short-term liquidity and a greater margin of safety to cover debts due within a year.

8. Explain what the inventory turnover ratio indicates about a business. (1 mark) Answer: The inventory turnover ratio indicates how many times a business sells and replaces its inventory over a period. It measures the efficiency of inventory management; a higher ratio generally suggests strong sales or effective inventory control.

Section B: Calculation (16 marks)

9. Calculate the gross profit margin and net profit margin. (4 marks) Answer: Gross Profit Margin = (Gross Profit / Revenue) × 100% = ($48,000 /$120,000) × 100% = 40.00%

Net Profit Margin = (Net Profit / Revenue) × 100% = ($18,000 /$120,000) × 100% = 15.00%

10. Calculate the current ratio and quick ratio. (4 marks) Answer: Current Assets = Inventory + Trade Receivables + Cash at Bank = $15,000 +$12,000 + $8,000 =$35,000

Current Liabilities = Trade Payables + Bank Overdraft = $10,000 +$5,000 = $15,000

Current Ratio = Current Assets / Current Liabilities = $35,000 /$15,000 = 2.33 : 1

Quick Ratio = (Current Assets - Inventory) / Current Liabilities = ($35,000 -$15,000) / $15,000 =$20,000 / $15,000 = 1.33 : 1

11. Calculate the inventory turnover ratio (times) and the days sales in inventory. (4 marks) Answer: Average Inventory = (Opening Inventory + Closing Inventory) / 2 = ($18,000 +$22,000) / 2 = $20,000

Inventory Turnover Ratio = Cost of Sales / Average Inventory = $100,000 /$20,000 = 5.00 times

Days Sales in Inventory = (Average Inventory / Cost of Sales) × 365 days = ($20,000 /$100,000) × 365 = 0.2 × 365 = 73.00 days

12. Calculate the trade receivables turnover ratio (times) and the trade receivables collection period (days). (4 marks) Answer: Average Trade Receivables = (Opening Trade Receivables + Closing Trade Receivables) / 2 = ($8,000 +$12,000) / 2 = $10,000

Trade Receivables Turnover Ratio = Credit Sales / Average Trade Receivables = $90,000 /$10,000 = 9.00 times

Trade Receivables Collection Period = (Average Trade Receivables / Credit Sales) × 365 days = ($10,000 /$90,000) × 365 = 0.1111 × 365 = 40.56 days (or 40.55 days depending on rounding)

Section C: Analysis and Evaluation (14 marks)

13. Compare and comment on the profitability and liquidity of the two businesses. (4 marks) Answer: Profitability: Alpha Trading has a significantly higher gross profit margin (45% vs 30%), suggesting it either generates higher selling prices or has a lower cost of sales relative to revenue compared to Beta Trading. Alpha also has a higher net profit margin (15% vs 12%), indicating better overall control of operating expenses relative to revenue. Alpha is more profitable.

Liquidity: Alpha Trading has a strong current ratio of 2.5 : 1, well above the typical benchmark of 2 : 1, and a quick ratio of 1.8 : 1, well above the 1 : 1 benchmark. This indicates excellent short-term liquidity and ability to pay debts. Beta Trading has a current ratio of 1.2 : 1, which is below the 2 : 1 benchmark, and a quick ratio of 0.6 : 1, below the 1 : 1 benchmark. This suggests Beta may face difficulties meeting its short-term obligations and has a weaker liquidity position, potentially relying heavily on inventory to cover debts.

14. Comment on the efficiency of Siti Trading. Suggest one possible reason for the change in each ratio. (4 marks) Answer: Comment on Efficiency: The efficiency of Siti Trading has declined from Year 1 to Year 2. Inventory is being sold more slowly (turnover decreased from 8 to 5 times), and trade receivables are taking longer to collect (collection period increased from 30 to 45 days). This indicates poorer management of inventory and credit control.

Possible Reasons:

• Inventory Turnover: The decrease could be due to a build-up of obsolete or slow-moving inventory, overstocking, or a decline in sales demand.
• Trade Receivables Collection Period: The increase could be due to offering longer credit terms to customers to boost sales, poor follow-up on overdue accounts, or customers experiencing financial difficulties.

15. Recommend two actions the business could take to improve its liquidity. Give reasons to support your answers. (6 marks) Answer: Action 1: Introduce a discount for early payment to trade receivables. Reason: This would encourage customers to pay their debts faster, converting trade receivables into cash more quickly. This increases the cash balance (a current asset) without increasing current liabilities, directly improving both the current ratio and the quick ratio.

Action 2: Sell off slow-moving or obsolete inventory at a discount. Reason: This converts less liquid inventory into cash. While the quick ratio excludes inventory, the cash generated increases the numerator in both ratios. Reducing inventory levels also frees up storage space and reduces holding costs, improving overall cash flow and the quick ratio specifically.

Section D: Extended Application (10 marks)

16. Explain why a business with a high gross profit margin might still have a low net profit margin. (2 marks) Answer: A business may have a high gross profit margin but a low net profit margin if its operating expenses (such as salaries, rent, utilities, and marketing) are very high relative to its revenue. The high gross profit is eroded by these excessive expenses, leaving a small percentage of revenue as net profit.

17. State one limitation of using ratio analysis to evaluate a business's performance. (1 mark) Answer: Ratio analysis is based on historical financial data, which may not be indicative of future performance. (Accept any other valid limitation, e.g., different accounting policies can affect comparability, ratios do not consider non-financial factors, etc.)

18. A business has a trade receivables collection period of 60 days. The industry average is 30 days. Explain one potential problem this might indicate and suggest one way to address it. (3 marks) Answer: Problem: The longer collection period (double the industry average) indicates that the business is inefficient in collecting debts from its customers. This could lead to cash flow problems, as cash is tied up in receivables for too long, and increases the risk of bad debts. Suggestion: The business could implement stricter credit control procedures, such as sending timely reminders, imposing interest on overdue accounts, or offering cash discounts for early settlement to encourage faster payment.

19. Calculate the new current ratio and quick ratio after the transaction. (2 marks) Answer: Before transaction: Current Assets = $50,000 (including Inventory$30,000) Current Liabilities = $25,000

Transaction: Pay off $5,000 trade payables using cash at bank. New Current Assets =$50,000 - $5,000 =$45,000 New Inventory = $30,000 (unchanged) New Current Liabilities =$25,000 - $5,000 =$20,000

New Current Ratio = $45,000 /$20,000 = 2.25 : 1

New Quick Ratio = ($45,000 -$30,000) / $20,000 =$15,000 / $20,000 = 0.75 : 1

20. Explain how this decision might affect its current ratio and debt-to-equity ratio. (2 marks) Answer: Taking a long-term bank loan to purchase new equipment would not immediately affect the current ratio, as the loan is a non-current liability and the equipment is a non-current asset. However, the debt-to-equity ratio would increase because total liabilities (debt) increase while equity remains unchanged, indicating higher financial risk.

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