Section A: Key terms and recall
Define the term 'profitability' and explain why it is important for a business. [2 marks]
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Profitability is a measure of the financial performance of a business, showing how much profit is generated in relation to the resources used. It is important because it indicates the long-term sustainability and success of a business. [1 mark for definition, 1 mark for explanation]
What is meant by the term 'liquidity'? [1 mark]
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Liquidity refers to the ability of a business to meet its short-term financial obligations as they fall due. [1 mark]
List the four profitability ratios you have studied. [2 marks]
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Gross profit margin, profit margin, return on capital employed, and asset turnover ratio. [0.5 marks each]
List the two liquidity ratios you have studied. [1 mark]
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Current ratio and acid test ratio. [0.5 marks each]
Explain the difference between a current asset and a current liability. [2 marks]
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A current asset is an asset that can be converted into cash within one year, such as inventory or accounts receivable. A current liability is a debt that is due to be paid within one year, such as accounts payable or short-term loans. [1 mark for each definition]
Section B: Applying your knowledge
A business has revenue of £200,000 and cost of sales of £120,000. Calculate the gross profit margin. [2 marks]
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Gross profit margin = (Revenue - Cost of Sales) / Revenue x 100 = (£200,000 - £120,000) / £200,000 x 100 = 40% [1 mark for correct formula, 1 mark for correct calculation]
A business has a profit of £50,000 and capital employed of £200,000. Calculate the return on capital employed. [2 marks]
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Return on capital employed = (Profit / Capital Employed) x 100 = (£50,000 / £200,000) x 100 = 25% [1 mark for correct formula, 1 mark for correct calculation]
A business has current assets of £80,000 and current liabilities of £40,000. Calculate the current ratio. [2 marks]
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Current ratio = Current Assets / Current Liabilities = £80,000 / £40,000 = 2:1 [1 mark for correct formula, 1 mark for correct calculation]
A business has inventory of £20,000, accounts receivable of £30,000, and accounts payable of £25,000. Calculate the acid test ratio. [3 marks]
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Acid test ratio = (Current Assets - Inventory) / Current Liabilities = (£80,000 - £20,000) / £25,000 = £60,000 / £25,000 = 2.4:1 [1 mark for correct formula, 1 mark for correct calculation, 1 mark for correct answer]
Explain why a business might want to improve its liquidity. [2 marks]
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A business might want to improve its liquidity to ensure it can meet its short-term financial obligations, such as paying suppliers or covering unexpected expenses. Good liquidity can also help a business negotiate better terms with suppliers and obtain favourable loans from banks. [1 mark for each point]
Section C: Explain and analyse
A business has the following financial data:
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Gross profit margin = (Revenue - Cost of Sales) / Revenue x 100 = (£500,000 - £300,000) / £500,000 x 100 = 40% Profit margin = (Profit / Revenue) x 100 = (£50,000 / £500,000) x 100 = 10% Return on capital employed = (Profit / Capital Employed) x 100 = (£50,000 / £200,000) x 100 = 25% Current ratio = Current Assets / Current Liabilities = £100,000 / £50,000 = 2:1 Acid test ratio = (Current Assets - Inventory) / Current Liabilities = (£100,000 - £30,000) / £50,000 = £70,000 / £50,000 = 1.4:1 The business has a good gross profit margin and return on capital employed, indicating it is generating a good level of profit. However, the profit margin is relatively low, suggesting that the business may need to focus on reducing costs or increasing revenue. The current ratio and acid test ratio are both above 1, indicating that the business is liquid and can meet its short-term financial obligations. [1 mark for each calculation, 1 mark for analysis]
Section D: Challenge
A business is considering expanding its operations by investing in new equipment. The equipment will cost £100,000 and is expected to generate additional revenue of £50,000 per year. The business has a current profit margin of 10% and a return on capital employed of 20%. Calculate the new profit margin and return on capital employed if the business makes the investment. Analyse whether the investment is likely to be successful. [6 marks]
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New profit = Current profit + Additional revenue x Profit margin = £50,000 + £50,000 x 10% = £55,000 New profit margin = (New profit / New revenue) x 100 = (£55,000 / £550,000) x 100 = 10% New capital employed = Current capital employed + Investment = £200,000 + £100,000 = £300,000 New return on capital employed = (New profit / New capital employed) x 100 = (£55,000 / £300,000) x 100 = 18.33% The investment is likely to be successful as it will increase the return on capital employed, although the profit margin will remain the same. The business will need to consider other factors, such as the payback period and the impact on liquidity, before making a final decision. [1 mark for each calculation, 1 mark for analysis, 1 mark for conclusion]