6.1 Calculation and understanding of accounting ratios (3)
Resources |
Revision Questions |
Accounting
Login to see all questions
Click on a question to view the answer
1.
A company's balance sheet shows the following:
- Current Assets: £30,000
- Current Liabilities: £20,000
Describe the current ratio and explain how a change in the company's current assets and current liabilities would affect the current ratio.
Description of Current Ratio:
The current ratio is a liquidity ratio that measures a company's ability to pay off its short-term liabilities (current debts) with its short-term assets (current assets). It is calculated by dividing current assets by current liabilities.
Impact of Changes:
- Increase in Current Assets: If current assets increase (e.g., due to increased cash or higher debtors), the current ratio will also increase, assuming current liabilities remain the same. This indicates improved liquidity.
- Increase in Current Liabilities: If current liabilities increase (e.g., due to taking out a short-term loan or increasing payables), the current ratio will decrease, assuming current assets remain the same. This indicates a potential weakening of liquidity.
- Both Increase: If both current assets and current liabilities increase by the same proportion, the current ratio will remain unchanged.
- Both Decrease: If both current assets and current liabilities decrease by the same proportion, the current ratio will remain unchanged.
2.
XYZ Company has the following financial information:
- Capital Employed = £1,500,000
- Profit Before Interest and Tax (PBIT) = £250,000
- Interest Expense = £50,000
- Tax = £60,000
Calculate the Return on Capital Employed (ROCE) for XYZ Company. Then, explain what the ROCE tells you about the company's financial performance.
Calculation:
| Item | Amount (£) |
| PBIT | 250,000 |
| Interest Expense | 50,000 |
| Profit After Interest & Tax | 250,000 - 50,000 - 60,000 = 140,000 |
ROCE = (Profit After Interest & Tax / Capital Employed) x 100
ROCE = (£140,000 / £1,500,000) x 100
ROCE = 0.0933 x 100
ROCE = 9.33%
Answer: The Return on Capital Employed (ROCE) for XYZ Company is 9.33%. This indicates that for every £1 of capital employed, the company generates 9.33 pence in profit. A ROCE of 9.33% suggests that the company is using its capital relatively efficiently to generate profit. It's a reasonable return, but whether it's good or bad depends on the industry average and the company's historical performance. A higher ROCE is generally preferred, indicating better capital utilization.
3.
The rate of inventory turnover for XYZ Company was calculated to be 4.5 times. Explain what this means in terms of the company's inventory management and suggest two reasons why the rate might be relatively low.
Explanation: A rate of inventory turnover of 4.5 times means that XYZ Company sold and replenished its entire inventory 4.5 times during the accounting period. This indicates the efficiency of the company in managing its inventory. A higher rate generally suggests efficient inventory management, while a lower rate might indicate problems.
Two reasons for a relatively low rate:
- Slow-moving inventory: The company may be holding a large quantity of inventory that is not selling quickly. This could be due to poor demand, outdated products, or ineffective marketing.
- Overstocking: The company might be ordering too much inventory to meet anticipated demand, leading to excess stock and a lower turnover rate. This could be due to inaccurate forecasting or poor inventory control systems.