Section A: Key terms and recall
Define the term 'gross profit margin'. [2 marks]
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Gross profit margin is a percentage that shows how much profit a company makes from its sales before deducting operating, interest, and tax expenses. It is calculated as (Gross Profit / Sales) x 100. [2 marks]
What is the formula for calculating the profit margin? [1 mark]
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Profit Margin = (Profit for the Year / Sales) x 100 [1 mark]
Explain what is meant by 'return on capital employed (ROCE)'. [2 marks]
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ROCE measures how effectively a company uses its capital to generate profits. It is calculated as (Profit before Interest and Tax / Capital Employed) x 100. [2 marks]
What does the current (working capital) ratio indicate about a business? [2 marks]
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The current ratio indicates a business's ability to pay its short-term liabilities with its short-term assets. It is calculated as Current Assets / Current Liabilities. [2 marks]
What is the purpose of the acid test (liquid) ratio? [1 mark]
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The acid test ratio measures a company's ability to meet its short-term obligations with its most liquid assets (excluding inventory). [1 mark]
Name two ratios that measure how efficiently a business manages its inventory. [2 marks]
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Rate of Inventory Turnover (times) and Inventory Turnover (days). [2 marks]
Section B: Applying your knowledge
A business has sales of £200,000 and a gross profit of £80,000. Calculate the gross profit margin. [2 marks]
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Gross Profit Margin = (£80,000 / £200,000) x 100 = 40% [2 marks]
If a company has a profit for the year of £50,000 and sales of £300,000, what is the profit margin? [2 marks]
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Profit Margin = (£50,000 / £300,000) x 100 = 16.67% [2 marks]
Calculate the ROCE for a business with a profit before interest and tax of £40,000, issued shares of £100,000, reserves of £50,000, and non-current liabilities of £30,000. [3 marks]
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Capital Employed = Issued Shares + Reserves + Non-Current Liabilities = £100,000 + £50,000 + £30,000 = £180,000 ROCE = (£40,000 / £180,000) x 100 = 22.22% [3 marks]
A business has current assets of £150,000 and current liabilities of £75,000. Calculate the current ratio. [2 marks]
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Current Ratio = £150,000 / £75,000 = 2:1 [2 marks]
If a company has current assets of £200,000, inventory of £50,000, and current liabilities of £100,000, what is the acid test ratio? [3 marks]
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Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities = (£200,000 - £50,000) / £100,000 = 1.5:1 [3 marks]
Section C: Explain and analyse
Explain the significance of the rate of inventory turnover (times) and inventory turnover (days) for a business. [4 marks]
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Rate of Inventory Turnover (times) measures how quickly a business sells its inventory. A high turnover indicates efficient inventory management. Inventory Turnover (days) shows the average number of days it takes to sell the inventory. Fewer days indicate better efficiency. These ratios help businesses manage their inventory levels and avoid excess stock or stockouts. [4 marks]
Analyse the importance of trade receivables turnover (days) and trade payables turnover (days) in assessing a business's liquidity. [5 marks]
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Trade Receivables Turnover (days) measures how quickly a business collects payments from its customers. Faster collection improves cash flow and liquidity. Trade Payables Turnover (days) indicates how long it takes a business to pay its suppliers. Longer payment terms can improve liquidity but may strain supplier relationships. Together, these ratios help assess a business's ability to manage its short-term obligations and maintain liquidity. [5 marks]
Section D: Challenge
A business has the following information:
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1. Gross Profit Margin = (£500,000 - £300,000) / £500,000 x 100 = 40% 2. Profit Margin = (£500,000 - £300,000 - £50,000 - £10,000) / £500,000 x 100 = 10% 3. ROCE = (£140,000 - £10,000) / (£200,000 + £100,000 + £50,000) x 100 = 23.33% 4. Current Ratio = £150,000 / £75,000 = 2:1 5. Acid Test Ratio = (£150,000 - £30,000) / £75,000 = 1.67:1 The business has a healthy gross profit margin and current ratio, indicating efficient sales and liquidity. However, the profit margin is relatively low, suggesting higher operating expenses. The ROCE is good, showing effective use of capital. The acid test ratio is also strong, indicating good short-term liquidity. [10 marks]