Accounting Ratios (Cambridge (CIE) IGCSE Accounting): Flashcards

Liquidity ratios measure how quickly a business can turn its assets into cash.

They compare the current assets with the current liabilities.

The completed formula is:

It leaves the inventory out of the current assets.

Inventory is the current asset that is hardest to turn into cash quickly, so removing it gives a stricter test.

The business has $1.84 of current assets for every $1 of current liabilities.

Both liquidity ratios are written in the form X : 1, to two decimal places.

False.

A ratio around 2 : 1 is generally healthy. Too high a figure suggests too much money is tied up in inventory or owed by credit customers.

That the business does not have enough current assets to cover its current liabilities.

It may be unable to pay its short-term debts as they fall due.

1.22 : 1.

Taking out the inventory leaves $39 000, and $39 000 ÷ $32 000 = 1.21875, which rounds to 1.22.

By increasing its current assets, through introducing capital or selling non-current assets.

Or by reducing its current liabilities, such as an overdraft or the amount owed to trade payables.

Efficiency ratios measure how well a business manages the buying and selling of its goods.

They cover collecting money from customers, paying suppliers, and selling inventory.

The number of times in a year the business fully sells and replaces its inventory.

It is written as a number of times, to two decimal places.

The rate is a number of times per year, while the inventory turnover is a number of days.

They are the same measurement in different units, so dividing 365 by either one gives the other.

The completed formula is:

The average number of days the business takes to pay its credit suppliers in full.

Like the other turnovers measured in days, it is rounded up to the next whole day.

101 days.

That is $11 000 ÷ $40 000 × 365 = 100.375, which rounds up to 101 days.

127 days.

That is $8000 ÷ $23 000 × 365 = 126.95…, which rounds up to 127 days.

True.

A lower figure means customers are settling their accounts sooner, which helps the business's cash position. There is no such ideal for the trade payables turnover, which can be too high or too low.

By encouraging customers to pay sooner, with cash discounts or interest charged on late payments.

Or by limiting what they can owe in the first place, through a credit limit or a cash deposit.

Yes.

It may have made many of its sales on credit and not yet been paid, or it may have spent its cash on an expensive non-current asset.

Yes.

It may have taken out a loan to cover its expenses, or bought goods on credit that it has not yet managed to sell.

The completed sentence is:

The difference between the gross profit margin and the profit margin is the proportion of revenue spent on expenses, so a smaller difference means better control of them.

The goods may be sold more cheaply than before, or more trade discount may be allowed.

Alternatively the cost of the goods has risen while the selling price has stayed the same.

The gross profit margin may rise, because the cost of sales has fallen.

But if the goods are of poorer quality, customers may shop elsewhere and the revenue may fall as a result.

The acid test ratio, because it excludes the inventory.

It is still worth reading both, since the gap between them shows how much of the current assets is tied up in inventory.

That it holds very little inventory.

That is good for liquidity, but it may mean the business has too little stock to meet demand.

It may fail to repay short-term debts on time, or be unable to pay suppliers quickly enough to earn cash discounts.

The owner may also be unable to take drawings.

True.

It means the business is paid by its customers before it has to pay its suppliers, and the difference is the number of days it holds that money. That helps its liquidity.

Because it is converting its inventory into cash more quickly.

It is also less likely to have to write inventory off as out of date or out of season.

That it is better at passing its costs on to its customers.

It may be applying a higher mark-up, or charging higher selling prices for the same goods.

That it is deploying its capital more effectively.

More of its long-term finance is being turned into profit.

False.

Businesses should only be compared within the same trade. Inventory, expenses and margins differ so much between trades that a food shop will always turn its inventory over faster, whatever either business does well.

A newer business tends to carry higher expenses and liabilities.

An established one is more likely to have built up a loyal customer base and a reputation.

The completed sentence is:

A difference in the end date of the financial year can distort a comparison, because inventory levels swing with the seasons and with holidays.

One may buy for cash while the other buys on credit.

That alone changes their current assets and current liabilities, and so changes their liquidity ratios.

It pays its suppliers about 5 days before its own customers pay it.

It may therefore need short-term finance to bridge the gap, which can be why such a business's liquidity looks weak.

The interested parties are the people and organisations that use a business's accounting information to make decisions.

Some are internal to the business and others are external to it.

The three internal parties are:

• owners, to compare with previous years and plan ahead

• managers, to check the efficiency and progress of the business

• employees, to judge whether their jobs are secure

To check that the business can pay for its goods as agreed.

The trade payables turnover shows how long it takes to pay, on average.

To judge whether the business is a safe candidate for a loan or an overdraft.

It also looks at the value of the assets, since those can be used as security against a loan.

To compare that business's profitability against their own.

They may also use it to identify gaps in the market.

False.

Public limited companies publish theirs, and private limited companies publish some information. Sole traders and partnerships can keep their financial statements private.

The completed sentence is:

The government and tax authorities use a business's accounting information to work out how much tax is owed and to gather data for government statistics.

Every transaction is recorded at its actual cost at the time it happened.

Transactions from different times are therefore hard to compare fairly, because prices will have moved in between.

There is a gap between the end of the financial year and the statements being prepared.

The business's actual position by the time anyone reads them may differ from what they show.

Businesses lay their statements out differently, so items that look alike may not represent the same thing.

One may subtract sales returns from revenue before stating it while another does not, and one may show a profit from operations while another does not.

False.

Financial statements record only what can be measured in money. Reputation, the quality of the goods and how satisfied the employees are all fall outside them.

The money measurement principle means that only information which can be expressed in money is recorded in the accounts.

It is the reason so much of what matters about a business never reaches its financial statements.