Formative Test 2

Question 1

Analyse GPM

Answer 1

Gross Profit Margin measures proportion of profit generated from every dollar of sales before
operating expenses are paid.

That is for every $1 of sales, $… was returned as profit before operating
expenses were paid.”

• The higher the result, the more successful the managers are in making
  gross profit from sales

Question 2

Analyse NPM

Answer 2

“Net Profit Margin measures the percentage of income that remains after all expenses have been paid.

That is, for every $ worth of sales, how much net profit was made.”

• shows the effectiveness of management to minimise expenses per dollar of sale

Question 3

Analyse ROE

Answer 3

ROE measures…

That is, for every $1 of investment, $… of profit has been returned to
the owner.

• The higher the value of this ratio, the greater the return on the
  capital invested in the business.

Question 4

Analyse Return on Total Assets

Answer 4

RTA measures the amount of profit returned for every dollar of assets
invested.

• shows how effectively the business is using its assets to generate
  profit

Question 5

Analyse Expense Ratio

Answer 5

Measures the expense of a business as a proportion of
total sales, giving an indication of how cost-effectively the
business is able to generate its sales revenue.

That is, for $ of sales how much is absorbed by expenses.

Question 6

Suggestions for Improvements GPM

Answer 6

• Increase in selling price
  without a rise in costs
• Bulk buying and gaining
  discounts on purchasing
  inventory
• Higher percentage of
  high-profit product lines
  selling of the product
  mix

Question 7

Suggestions for Improvements NPM

Answer 7

• Rising revenue
• Increase in gross profit
• Falling expenses

Question 8

Suggestions for Improvements ROE

Answer 8

• Rising profit
• Reduced equity
  because of drawings

Question 9

Suggestions for Improvements Return on Total Assets

Answer 9

• Rising profit
• Sale or disposal of
  assets

Question 10

Suggestions for Improvements Expense Ratio

Answer 10

• Rising revenue
• Elimination or reduction
  in a fixed cost such as
  negotiating a lower rent
  and insurance. Larger
  scale of operations
• Fall in costs

Question 11

Analyse the profitability of a business using “Earnings per Ordinary Share”

Answer 11

For every ordinary share, the company generated $… in profit.

Question 12

Analyse the profitability of a business using “Earnings Yield”

Answer 12

for every $1 invested in the share, the company generates $… in earnings
annually

Question 13

Analyse the profitability of a business using “Dividend per Ordinary Share”

Answer 13

For each ordinary share, the company pays a dividend of $…

Question 14

Analyse the profitability of a business using “Dividend Yield”

Answer 14

For each $ invested, investors earn $…

Question 15

State order of Completing “Statement of Changes in Equity”

Answer 15

Capital @ Start $$$
Profits $$$
Less Drawings ($$$)
Capital @ End ===

Question 16

Sources of Finance

Answer 16

LAST DRMBL

Loans
Additional Capital
Sale of Shares
Trade Creditors
Debt Factoring
Retained Profits
Mortgage
Bank overdraft
Leasing

Question 17

Advantages & Disadvantages of Loans

Answer 17

Advantages: Regular set repayments, allowing for cash flow planning, bank cannot demand repayment until

Disadvantages:
May require collateral, Variable interest rates are subject to market fluctuations, increases gearing and therefore business risk, which is less desirable to lenders

Question 18

Advantages & Disadvantages of Additional Capital

Answer 18

Advantages: Inexpensive as does not require repayments, lowers gearing, therefore lower risk and more attractive to lenders

Disadvantages: owners don’t always have funds available to contribute, may take time for owners to recoup their investment

Question 19

Advantages & Disadvantages of Sales of Shares

Answer 19

Advantages Disadvantages: An inexpensive source of finance as interest is not charged and does not require repayment
Lowers the gearing, and therefore the business risk.
The lowered gearing also makes the business more attractive to potential lenders

Dilution of ownership – profits, decision making.

Question 20

Advantages & Disadvantages of Trade Creditors

Answer 20

Advantages: An easily obtained source of finance
Typically, no extra charges are applied, unless charged fees for late payments
Disadvantages: If the business is unreliable and late with payments, this may lead to loss of credit facilities and may impact the credit rating
Only suitable to fund the purchase of supplies/inventory

Question 21

Advantages & Disadvantages of Debt Factoring

Answer 21

Advantages: Generates cash quickly
Frees management from the responsibility of managing debtors

Disadvantages: Full value of the accounts receivable will not be recouped by the business

Question 22

Advantages & Disadvantages of Retained Profits

Answer 22

Advantages: Does not require
repayment, Does not increase
gearing and
therefore risk

Disadvantages: Only available if
profits are made and
cash is available

Question 23

Advantages & Disadvantages of Mortgages

Answer 23

Advantages:

Lower interest rates
due to large loan
amount and security
* The other
advantages
associated with
loans apply

Disadvantages:
* The bank can
possess property
used as security
upon default

• The other
  disadvantages
  associated with
  loans apply

Question 24

Advantages & Disadvantages of Bank Overdraft

Answer 24

Agreed negative limit

Advantages: interest only paid on amount used, flexible as it can be accessed when needed, credit is useful for businesses subject to seasonal demand.

Disadvantages: Only short-term, subject to high interest rates.

Question 25

Advantages & Disadvantages of Leasing

Answer 25

Advantages: doesn't require a cash outlay, thus funds not tied up in assets, lease payments are tax deductible, Not subject to interest rate fluctuation Often, the asset leased is ‘maintained’ by the lessor & may cover some maintenance expenses Does not impact on gearing Disadvantages: - Can be more expensive over the life of the lease * The lessor retains ownership of the asset, therefore cant sell for quick cash.

Question 26

Finance Expenses

Answer 26

the costs associated with loans and costs associated with Debtors. Some examples are interest, bad debts and doubtful debts.

Question 27

Realisation

Answer 27

"Revenue is recorded when it is earned, not necessarily when cash is received." The income statement includes revenue that has been earned during the period so profit is calculated accurately.

Question 28

Accounting Period

Answer 28

The life of the business needs to be split into reporting (accounting) periods... where it can determine its level of profit (or loss) from its operations.... The specific reporting period indicated by the wording, “…month ending XX 20XX” allows for users to realise the profit covers the month of XX... allowing comparison from previous months for accurate decision making.

Question 29

Going Concern

Answer 29

"Assumes the business will continue operating into the foreseeable future." Expenses are recognised normally because the business is expected to continue trading and earning revenue in future periods. EXAMPLE A business pays rent for 12 months in advance. Only the portion relating to this period is recorded as an expense in this year’s income statement.

Question 30

Faithful Representation

Answer 30

All financial information must be complete, free from material error and non-biased to reflect the true performance of the business. The revenue of [sum] and expenses of [sum] must be accurate for accurate calculation of profit which is used for decision making.

Question 31

Explain a reason why the dividends yield differs from the earnings yields

Answer 31

Not all the profits are paid to shareholders in the form of dividends. 70% of the profits are retained by the company in reserve for future expansion. For this reason, the dividend yield is lower than the Earnings yield.

Question 32

Why, for almost all companies, will the earnings yield be higher than the dividend yield?

Answer 32

Companies generally prefer to use a portion of their profits, as reserves or retained profits. These could be used to finance future expansion or be sure to pay a future dividend in future years should the company experience a downturn in profitability.

Question 33

Explain whether the above Income Statement relates to a trading or service entity. (1 marks)

Answer 33

Trading business as there is a COGS present showing the cost of sale of inventory – Service businesses do not sell inventory.