Syllabus Edition
First teaching 2025
First exams 2027
Evaluating Profitability, Liquidity & Efficiency (Cambridge (CIE) IGCSE Accounting): Revision Note
Exam code: 0452 & 0985
Cash versus profit
Is cash the same as profit?
Cash and profit are two different measures
Cash is the money that the business actually has
Profit is a measure of the financial performance of the business
A business can make a profit but have no cash
The business may have made lots of sales on credit but not yet received payment
The business may have purchased an expensive non-current asset
A business can have cash but make a loss
The business may have taken out a loan to cover its expenses
The business may have purchased goods on credit that have not yet been sold
Evaluating profitability
How do I evaluate the profitability of a business?
It is best to look at multiple profitability ratios together to get a better understanding
The gross profit margin might be high but the profit margin might be low
This suggests that gross profit is not an issue
The business needs to look at other income and expenses
The difference between the gross profit margin and profit margin is the proportion of revenue that is spent on expenses after deducting other income
A smaller difference indicates that a business has better control of expenses
Consider actions which have a positive and negative effect
For example, if a business finds a cheaper supplier:
The gross profit margin might increase as a result of lower cost of sales
However, the quality of the goods might not be as good, which could cause customers to shop elsewhere, reducing sales revenue
How do I compare the profitability of a business between years?
Compare the ratios to the same ratios from previous years
For each ratio
Make a general comment
State whether it has improved or gotten worse
State the percentages
Give possible reasons for the change
Calculate the difference between the gross profit margin and the profit margin to see if the business has gotten better at controlling expenses
Worked Example
Sana and Taz are business partners. They provide information for the financial years ending 31 December 2022 and 31 December 2023.
Year ended | ||
31 December 2022 | 31 December 2023 | |
Gross profit margin | 32.25% | 43.75% |
Profit margin | 9.43% | 10.31% |
Return on capital employed | 21.08% | 10.45% |
Comment on the performance of the business over the two years.
Answer:
Comment on the gross profit margin
The gross profit margin has improved from 32.25% to 43.75%. This could be because Sana and Taz increased the selling prices of their goods. They could have decreased the cost of sales by changing to a cheaper supplier.
Comment on the profit margin
The profit margin has improved from 9.43% to 10.31%. This could be due to a higher gross profit, but it could also be due to an increase in other income.
Comment on the differences between the gross and profit margins
In 2022, the difference between the gross and profit margins was 22.82%. In 2023, this difference was 33.44%. The difference worsened, which could be because Sara and Taz had worse control over their expenses.
Comment on the return on capital employed
The return on capital employed worsened from 21.08% to 10.45%. This could be due to an increase in the capital employed. This may have involved more capital being introduced by the partners or a long-term loan.
Evaluating liquidity
How do I evaluate the liquidity of a business?
The acid test (liquid) ratio is the best indicator of the liquidity of a business
However, it is helpful to look at both the current ratio and the acid test ratio together
The difference between the two ratios tells you about the proportion of the current assets that are made up of inventory
The current ratio might be good but the acid test ratio might be too low
This suggests the business has a lot of money tied up in inventory
The ratios might be very similar
This suggests the business does not have a lot of inventory
This means they might not have sufficient supplies to meet demand
If both ratios are too low then:
The business might not be able to repay short-term debts on time
The business might not have the resources to pay credit suppliers quickly and therefore miss out on cash discounts
The owner(s) might not be able to take drawings
Pay attention to whether the goods are purchased and sold on credit or cash
If goods are purchased using cash then there will be no trade payables
If goods are sold for cash then there will be no trade receivables
This might not affect the current assets as the bank increases instead of the trade receivables
How do I compare the liquidity of a business between years?
Compare the ratios to the same ratios from previous years
For each ratio
Make a general comment
State whether it has improved or gotten worse
State the ratios
Give possible reasons for the change
Possible reasons for a decrease in the ratios
Less cash or a higher bank overdraft due to
Purchase of a non-current asset
Increase in drawings
Repayment of long-term loans
Decrease in other current assets
Trade receivables
Increase in current liabilities
Trade payables
Short-term loans
Possible reasons for an increase in the ratios
More cash or a lower bank overdraft due to
Sale of a non-current asset
Decrease in drawings
New long-term loans
Increase in other current assets
Trade receivables
Decrease in current liabilities
Trade payables
Short-term loans
Worked Example
Tala is a sole trader and her financial year ends 31 March. She provides the following information.
At 31 March 2023 | At 31 March 2024 | |
Current (working capital) ratio | 1.56 : 1 | 0.94 : 1 |
Acid test (liquid) ratio | 1.03 : 1 | 0.79 : 1 |
(a) Suggest two reasons for the change in the ratios.
(b) Suggest two reasons why Tala should aim to increase the ratios.
Answer:
(a)
State two reasons why both ratios could have decreased
As both have decreased then this suggests there has not been a decrease in the inventory
The current ratio has worsened by decreasing from 1.56 : 1 to 0.94 : 1 and the acid test ratio has also worsened by decreasing from 1.03 : 1 to 0.79 : 1.
One possible reason is that Tala might have purchased a non-current asset for cash which would decrease the current assets. Alternatively, she might have used a short-term loan to purchase the non-current asset, which would have increased the current liabilities
Another possible reason is that Tala might have increased the amount of drawings in the form of cash. This would decrease the money in the bank.
(b)
State two reasons why it is better to have higher ratios
One reason why Tala should increase her ratios is so that she is able to repay her short-term debts without incurring late charges or interest.
Another reason to increase the ratios is so that Tala has enough funds to pay for the business expenses without requiring further short-term loans.
Evaluating efficiency
How do I evaluate the efficiency of a business?
Look at all the efficiency ratios together
The rate of inventory turnover tells you how quickly the business can sell its inventory
The higher the rate, the better the liquidity of the business
Look at the difference between the trade receivables turnover and trade payables turnover figures
It is better if the trade receivables turnover is lower
This means the business receives money from its credit customers before paying its credit suppliers
This helps with the liquidity of the business
The difference between them is then the number of days that the business has the money from the customers before paying the suppliers
If the trade receivables turnover is higher:
The business pays its suppliers before receiving money from its customers
This could result in the business taking out short-term loans to pay its suppliers
How do I compare the efficiency of a business over the years?
Compare the ratios to the same ratios from previous years
For each ratio
Make a general comment
State whether it has improved or gotten worse
State the ratios
Give possible reasons for the change
Look at the difference between the trade receivables turnover and the trade payables turnover
Comment on the difference
Worked Example
Odin is a sole trader and his financial year ends 31 October. He provides the following information.
Year ended | ||
31 October 2022 | 31 October 2023 | |
Rate of inventory turnover | 8.25 times | 10.40 times |
Trade receivables turnover | 35 days | 27 days |
Trade payables turnover | 20 days | 28 days |
(a) Explain why Odin is satisfied with the change in the rate of inventory turnover.
(b) Suggest two reasons for the decrease in Odin's trade receivables turnover.
(c) Suggest two reasons for the increase in Odin's trade payables turnover.
Answer:
(a)
State the benefits of having a higher rate of inventory turnover
The rate of inventory turnover has improved by increasing from 8.25 times to 10.40 times. This means Odin sold his inventory at a faster rate than the previous year. This has improved the liquidity of the business as Odin is able to convert assets into cash more quickly.
(b)
Give two reasons why the trade receivables turnover might decrease
On average, Odin is receiving payment from his credit customers 8 days faster.
One possible reason is that Odin has started to offer cash discounts for early repayment.
Another possible reason is that Odin has increased the amount of interest that is charged on overdue balances.
(c)
Give two reasons why the trade payables turnover might increase
On average, Odin is paying his credit suppliers 8 days slower.
One possible reason is that Odin has less available cash to pay his suppliers as promptly.
Another possible reason is that the suppliers are no longer offering cash discounts for early repayments. In this case, Odin is taking longer to pay but still aiming to avoid overdue fees.
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