Gross Profit Margin Net Profit Margin ROCE
Current Ratio Acid Test Ratio
Suggestion
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Basic Ratio Analysis
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Basic Ratio Analysis – Home Assignment
Section A: Multiple Choice Questions (@1, total 10 marks)
1. Why does financial analysis involve the expression of the reported numbers in relative term?
A. It is easy to calculate.
B. It helps users to make comparison on the same basis.
C. Absolute numbers are difficult to identify.
D. All of the above.
Level of difficulty: **
2. Which of the following cannot be ascertained from an income statement of a company?
A. Sales generated for the year.
B. Share price of the company.
C. Profit for the year.
D. Operating expenses of the year.
Level of difficulty: *
3. A ratio by itself may have no meaning. Hence, a given ratio is compared to:
A. Ratios from previous years B. Ratios of other companies C. Both A and B.
D. None of the above.
Level of difficulty: *
4. The shareholders of the company will analyse the financial statement of the company and
A. decide whether or not to invest in a company.
B. determine a company’s credit worthiness.
C. evaluate performance of employee and determine relevant compensation.
D. understand the financial performance of the company’s competitors.
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Level of difficulty: *
5. A ___________ ratio is a measure of how profitable a company is in doing its business.
A. profitability.
B. liquidity.
C. solvency.
D. investment.
Level of difficulty: *
6. Which of the following is the best description for return on capital employed (ROCE)?
A. It describes a company’s ability to earn a net income from sales.
B. It is the difference between current assets and current liabilities C. It is defined as the ability to pay your debts when they come due.
D. It is a measure of efficiency of a company in using its capital to generate profit.
Level of difficulty: *
7. Given the following information, calculate the working capital.
Office equipment: $85,000 Furniture & fixture: $24,000 Accounts receivable: $5,200 Inventory: $6,100
Bank overdraft: $1,500 Accounts payable: $4,400 A. $5,400.
B. $8,400.
C. $114,400.
D. $117,400.
Level of difficulty: **
Basic Ratio Analysis
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8. Which of the following description about current ratio is correct?
A. A ratio of 0.8:1 means a company will be liquidated.
B. The higher the ratio the better.
C. Accounts receivables are assumed to be collected on a timely basis.
D. The non-current assets can be sold immediately when there is a liquidity problem.
Level of difficulty: **
9. Other than the use of accounting ratios, which of the following factors will not affect the decision of investing in another company?
A. Legal environment.
B. Reputation of the company.
C. Relationship with customers.
D. Research expenses already paid for this investment project.
Level of difficulty: ***
10. If the current ratio of a company is 7:1, the company may be holding ____________ idle short-term assets.
A. too much B. too little C. sufficient D. right level of Level of difficulty: *
Basic Ratio Analysis
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Section B: Short Questions
Question 1
Briefly describe four internal uses of financial ratios to a company. (4 marks) Level of difficulty: *
Question 2
What is the reason of using ‘profit before interest and tax’ instead of ‘profit after interest and tax’ as the numerator in the ROCE formula? (4 marks)
Level of difficulty: * Question 3
Suggest four methods to a company when there is a liquidity problem to settle the balance with its supplier in next month. (8 marks)
Level of difficulty: ***
Question 4
Given the following information, calculate the current ratio and acid test ratio of the company and provide comment on its liquidity. (10 marks)
Non-current assets: $241,000 Accounts receivable: $6,300 Inventory: $15,500
Cash: $5,500
Accounts payable: $9,800 Tax payable: $3,200 Level of difficulty: **
Basic Ratio Analysis
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Question 5
(a) State the characteristics of a company using aggressive working capital policy byshowing its effects on the level of items listed in the following table. (4 marks) (b) Briefly describe the overall impacts on profitability and risk to a company using aggressive working capital policy by outlining its implication to the items listed in the following table. (10 marks)
Level of cash
Level of accounts receivable
Level of inventory
Short-term debts/
long-term liabilities
Overall Impact
(a) Characteristics
----
(b) Profitability
Risk
Level of difficulty: **
Basic Ratio Analysis
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Solutions:
Section A: MCQs
1. B 2. B 3. C 4. A 5. A
6. D 7. A 8. C 9. D 10. A
Section B: Short Questions.
Question 1
The four internal uses of financial ratios include:
1. Identify deficiencies of the company and take remedial action.
2. Evaluate performance of employees and determine relevant compensation.
3. Compare the financial performance of different divisions within the company.
4. Understand the financial performance and status of the company’s competitors.
(@1, total 4 marks) Question 2
The reason of using net profit before interest and tax in calculating ROCE is that such profit is the income generated from the company’s assets regardless of how the company’s funds come from.
If the company relies heavily on borrowing, the net profit before tax will be adversely affected because of high interest expense and hence affect the comparison with companies with different capital structure.
(@2, total 4 marks) Question 3
A company might consider the following methods to cope with the liquidity problems:
• Offering an early settlement discount to its customers. This is a reduction in the amount of the payment required from the customer provided that the customer pays within a specified time limit.
• Offering trade discount on cash sales to its customers for receiving immediate cash.
• Buy less inventory = applying Just-in-time inventory system to reduce the carrying cost of the inventory and increase the cash balance.
• Borrow a short to medium-term loan (e.g. 1 to 3 years) to enhance the liquidity.
[remarks: it is not suggested to use long-term loan as the interest expense will be too high when it is only a temporary running short of cash.]
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• Disposal of idle non-current assets to improve the liquidity.
• Any other valid suggestions.
(@2, max 8 marks) Question 4
Calculation Comments Current
ratio
($6,300 + $15,500 +
$5,500) / ($9,800 +
$3,200) = 2.1:1 (2 marks)
The current ratio is satisfactory as the current assets are about two times of its current liabilities which indicates the company has sufficient short-term funds to settle its short-term obligations. (2 marks)
Acid test ratio
($6,300 + $5,500) / ($9,800 + $3,200) = 0.91:1
(2 marks)
The acid test ratio is a bit unsatisfactory as there is less than $1 dollar of liquid assets to cover $1 dollar of current liabilities. The significant drop of the ratio indicates there are too many inventories on hand and the company may not have sufficient short-term funds without the sale of inventory to settle its short-term obligations. (4 marks)
Question 5
Level of cash
Level of accounts receivable
Level of inventory
Short-term debts/
long-term liabilities
Overall Impact
(a) Characteristics
Lower Lower Lower Higher/lower -
(b) Profitability
Increase investment opportunity.
Less cost of financing when cash
is received.
Lower carrying costs
and obsolescence.
Lower interest expenses.
Higher return
Risk Higher risk as less immediate
cash.
Higher probably
of bad debts.
Probability of stock out and
miss the chance of
sales.
More short-term obligation to
meet.
Higher risk
(@1, total 14 marks)
Ratio Analysis
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Basic Ratio Analysis – Quiz
Section A: Multiple Choice Questions (@1, total 10 marks)
1. Which of the following issue can be indicated by reviewing the income statement of a company?
A. The operating expense spent for the year in percentage of the income for the year.
B. How much non-current asset is employed to generate profit.
C. Whether the debt level is high or low.
D. Whether the company is able to pay for their short-term obligation.
Level of difficulty: *
2. What can be showed by comparing a computer company’s the financial information over the past 5 years?
A. Trends of financial performance.
B. Company’s competitive position.
C. Development of the industry.
D. Technological change.
Level of difficulty: ***
3. What is the implication of having a higher return on capital employed (ROCE)?
A. The company has a better control on cost of goods sold.
B. The company is able to settle its short-term loan.
C. The company relies too much on capital.
D. The company is more effective in using its capital assets to generate returns.
Level of difficulty: *
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4. Which of the following may be affected by the profitability of a company?
A. Its ability to obtain debt and equity financing B. Its liquidity position.
C. Its ability to grow.
D. All of the above.
Level of difficulty: *
5. What is the implication when a company has high gross profit but low net profit?
A. Poor control on working capital.
B. Better control on cost of goods sold and operating expense.
C. Better control on cost of goods sold but poor control on operating expense.
D. Decline in sales demand.
Level of difficulty: **
6. Which of the following would lead to an immediate outflow of cash in a period?
A. Purchase of goods on credit.
B. Payment to suppliers.
C. Unpaid dividend declared.
D. Receipt from customers.
Level of difficulty: **
7. By using aggressive working capital policies, current assets are often financed by ___________.
A. Selling non-current assets.
B. Borrowing short-term debts.
C. Issuing bonds.
D. Issuing shares.
Level of difficulty: *
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8. Which of the following is not a component of working capital?
A. Plant and machinery.
B. Cash.
C. Trade payables.
D. Inventory.
Level of difficulty: *
9. Which of the following is not a component of quick assets?
A. Trade receivable.
B. Cash.
C. Inventory.
D. None of the above.
Level of difficulty: *
10. Which of the following is not the limitation of financial ratio analysis?
A. Seasonal factor cannot be reflected.
B. Information used are historical.
C. Different accounting practices adopted by companies.
D. Too much accounting information included.
Level of difficulty: *
Ratio Analysis
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Section B: Short Questions
Question 1
Briefly describe the signs of liquidity problems of a company. (10 marks) Level of difficulty: *
Question 2
Calculate the following financial ratios for XYZ Ltd for both 20X4 and 20X5, and comment briefly the result of each ratio.
Gross profit margin.
Net profit margin.
Return on capital employed.
Current ratio.
Acid test ratio.
20X5 20X4
$'000 $'000
23,220 20,123 (16,420) (14,836) 6,800 5,287 Distribution (898) (704) Selling and marketing (1,322) (1,201) General and (1,054) (988) 3,526 2,394 (435) (332) 3,091 2,062 (456) (354) 2,635 1,708 Profit after tax
Sales
Cost of sales Gross profit Expenses
Operating profit Interest expenses
XYZ Ltd Income Statement
For the year ended 31 December
Profit before tax Income tax expenses
Ratio Analysis
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20X5 20X4
$'000 $'000
Non-current assets
Equipments 45,205 42,084
Current assets
Inventories 1,564 1,186
Trade receivables 2,349 2,561 Cash and bank 851 358
4,764
4,105 Current liabilities
Trade payables 1,894 2,334 Tax payable 456 354
2,350
2,688 Total assets less current liabilities 47,619 43,501
Financed by:
Share capital 30,000 30,000
Retained earnings 8,515 5,880 38,515
35,880
Non-current liabilities
Long-term loan 9,104 7,621 47,619
43,501
XYZ Ltd
Statement of Financial Position As at 31 December
(20 marks)
Level of difficulty: ***
Ratio Analysis
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Solutions:
Section A: MCQs
1. A 2. A 3. D 4. D 5. C
6. B 7. B 8. A 9. C 10. D
Section B: Short Questions.
Question 1
The signs of liquidity problems of a company include:
1. Persistent decline in daily or weekly cash inflows.
2. Significant decline in operating profit which indicates the company is unable to pass the cost on to customers.
3. Unexpected build-up of accounts receivable and inventory which indicates the company may not be able to collect money from customers or is unable to sell goods.
4. Unexpected build-up of accounts payable indicates the company is unable to pay to its suppliers.
5. Shape decline in company’s working capital.
(@2, total 10 marks) Question 2
Formula 20X5 20X4
Gross profit margin
Gross profit / Sales
$6,800/$23,220 = 29.29% $5,287/$20,123 = 26.27%
Comment: The gross profit margin for 20X5 is better than 20X4 which indicates a better control on purchase costs (e.g. good bargain with suppliers) and/or better sales performance of the company.
Net profit margin
Net profit before tax / sales
$3,091/$23,220 = 13.31% $2,062/$20,123 = 10.25%
Comment: The net profit margin for 20X5 is better than 20X4 which indicates a better control on purchase costs and/or operating expenses and/or better sales performance of the company..
ROCE PBIT / Average $3,526/$47,619 = 7.4% $2,394/$43,501= 5.5%