Cambridge IGCSE and O Level Accounting

Coursebook answers
Chapter 22
Answers to test yourself questions

Test yourself 22.1

1 The two main groups of ratios are profitability ratios and liquidity ratios.
2 Working capital is the difference between the current assets and the current liabilities and is
the amount available for the day-to-day running of the business.
3 Capital owned is the amount owed by a business to the owner(s) of that business on a
certain date.
4 Capital employed may be calculated as the owner’s capital plus any non-current liabilities, or as
the non-current assets plus the net current assets (current assets minus current liabilities).

Test yourself 22.2

1 The rate of return on capital employed shows the profit earned for every $100 used in the
business in order to earn that profit.
2 Two from:
• increasing selling prices
• obtaining cheaper supplies
• changing the proportions of different types of goods sold.
1
3 The percentage of expenses to revenue is the difference between the gross margin and the
profit margin, so is 11%.

Test yourself 22.3

1 Two from:
• cannot meet immediate liabilities when they are due
• experience difficulties in obtaining further supplies on credit
• cannot take advantage of cash discounts
• cannot take advantage of business opportunities when they arise.
2 Two from:
• introducing further capital by the owner(s)
• obtaining long-term loans / non-current liabilities
• selling surplus non-current assets
• delaying purchasing non-current assets
• increasing profit
• reducing drawings by the owner(s) (or reduction in dividends).
3 The current ratio compares the assets which are in the form of cash (or which can be turned into
cash relatively easily within the next 12 months) with the liabilities which are due for repayment
within that period of time. The liquid (acid test) ratio compares the assets which are in the
form of money (or which will convert into money quickly) with the liabilities which are due for
repayment in the near future. The difference between the ratios is that the liquid (acid test) ratio
excludes inventory as this is not regarded as a liquid asset.

© Cambridge University Press 2018

Cambridge IGCSE and O Level Accounting

Test yourself 22.4

Cost of sales
1
Average inventory
2 Two from:
• a reduction in sales
• over-purchasing of inventory
• too high selling prices
• falling demand
• slowing down of business activity
• business inefficiency.
Trade receivables 365
3 ×
Credit sales 1
4 The trader would not be satisfied as the trade receivables are taking, on average, ten days more
than the period of credit allowed. The trader has to wait longer to be repaid and the risk of
irrecoverable debts is increased.
5 One advantage from:
• has the use of the money for a longer period of time
• is able to make use of the money within the business / pay expenses / settle other
commitments.
One disadvantage from:
• loss of cash discount
• damage relationship with the supplier
• the supplier may refuse further supplies. 2

• the supplier may refuse credit in the future.

Test yourself 22.5

1 Four from:
1 The businesses may use different accounting policies. Using different policies such as
different methods of depreciation will affect the profit and the book value of the
non-current assets, so a comparison is difficult.
2 The business may operate different operating policies. For example, one business may rent
premises and the other may own premises, or one business may have long-term finance in
the form of capital only whereas the other business may also have a long-term loan. The
different policies will affect the profit and also the statement of financial position.
3 The financial statements only include monetary items. There are many non-monetary
items which affect the success of the business. These cannot be measured in money and
consequently make a comparison of businesses more difficult.
4 It is not always possible to obtain all the information about another business. For example,
the financial statements do not show details of the age and condition of the non-current
assets. The results of any comparison may be flawed.
5 The information about the other business may be for one financial year only, so trends cannot be
calculated. Also, that year may not be a typical year, so any comparison may not be appropriate.
6 If the financial years end on different dates a comparison can be difficult as one business
may have a year-end when inventories are particularly high, the year-end for the other
business may be at a time when inventories are particularly low.
7 The financial statements are based on historic cost and do not show the effects of inflation.
Identical non-current assets purchased at different times will be recorded as different costs
in the accounting records. This also affects the comparison.

© Cambridge University Press 2018

Cambridge IGCSE and O Level Accounting

Test yourself 22.6

1 Three from:
• Owner. The owner is interested in all aspects of the business – both profitability and
liquidity in order to assess the performance and progress.
• Manager(s). Like owners they are interested in all aspects of the business. They may use
ratios to assess past performance, plan for the future and take remedial action where
necessary.
• Bank managers. If a business requests a bank loan or an overdraft facility, the bank
manager will need to know whether there is adequate security to cover the amount of the
loan or overdraft, whether it can be repaid when due and whether interest can be paid
when due.
• Other lenders. Anyone who had made a loan to the business will be interested in the
security available, whether the loan can be repaid when due and whether the interest can
be paid when due.
• Trade payables. They are interested in the liquidity position and the trade payables
turnover. These will be considered when determining the credit limit and the length of
credit allowed.
• Potential buyers of the business. They are interested in the profitability of the business and
the market value of the assets of the business.
• Customers. They are interest in ensuring the continuity of supplies.
• Employees and trade unions. They want to know that the business is able to continue
operating and so maintain jobs and continue to pay adequate wages (and, in some cases,
contribute to pension schemes).
• Government departments. They may want information for purposes such as compiling
3
business statistics and checking that the correct amount of tax is being paid.
2 Three from:
• Time factor. Accounting statements are a record of what has happened in the past, not a
guide to the future. Additionally, there is a gap between the end of the financial year and
the preparation of the accounting statements. In that time significant events may have
taken place.
• Historic cost. The only way to record financial transactions is to use the actual cost price.
However, comparing transactions taking place at different times can be difficult because of
the effect of inflation.
• Accounting policies. All businesses should apply the accounting principles, but there are
several acceptable accounting policies which may be applied. Where businesses use
different policies it is difficult to make comparisons. Similarly, where a business changes its
policy a comparison with the results of previous years is difficult.
• Different definitions. If a business has borrowed money it may calculate the profit from
operations and then deduct finance costs; another business will not make this distinction.
Also there can be different definitions of profit used when calculating accounting ratios.
• Money measurement. Accounts only record information which can be expressed in
monetary terms. This means that there are many important factors which influence the
performance of a business which will not appear in the accounting statements.

© Cambridge University Press 2018

Cambridge IGCSE and O Level Accounting

Answers to exam-style questions

1 C
2 a Working capital: 4 620 + 5 340 − 4 150 − 2 110 − 2 000 = 1 700
b Two from:
• cannot meet liabilities when they are due
• experience difficulties in obtaining further supplies on credit
• cannot take advantage of cash discounts
• cannot take advantage of business opportunities when they arise.
c Proposal 1 Working capital increases by 5 000 as bank overdraft changes to positive balance.
Proposal 2 No change to working capital as one current liability is exchanged for another.
Proposal 3 No change to working capital as one current asset is exchanged for another.
Proposal 4 Working capital increases by 83 as current liabilities reduce by 4 150 and bank
reduces by 4 067.
d Two from:
• obtain additional long-term loan
• sell any surplus non-current assets
• delay purchase of non-current assets
• increase profit
• reduce drawings.
3 B
4 a G
 ross margin 26.00%, profit margin 8.50%, return on capital employed 5.47%, rate of
inventory turnover 8.28 times 4
b Two from:
• trading in different type of goods
• furniture has higher selling price per unit than food
• furniture has higher gross profit margin than food
• food business is cutting prices to sell more
• food business not passing on higher costs to customers.
c AK Limited had better control of the expenses. The expenses as a percentage of revenue
were 8.25% and the same ratio for Vijay was 17.50%.
d Two from:
• trading in different type of goods
• food sells faster than furniture
• food is in daily demand, furniture is not
• food is cheaper than furniture
• cost of goods is higher for furniture
• value of inventory is higher for furniture.

© Cambridge University Press 2018

Cambridge IGCSE and O Level Accounting

e Four from:
• dealing in different goods – furniture and food
• Vijay is a sole trader, the other business is a limited company
• Vijay has been in business three years, the other business was established many
years ago
• the capital of the businesses will be different
• the size of the businesses will be different
• the sources of long-term funds will differ (Vijay has a loan; no detail provided about
AK Limited)
• the financial year may end at different times of the trading cycle
• the businesses may have different types of expenses (e.g. one may rent, the other own
premises)
• the financial statements do not show non-monetary factors
• it may not be possible to obtain all the information needed to make comparisons.
5 B
6 a Current assets − Inventory: Current liabilities
b (2 650 + 2 960) : (3 670 + 2 500) = 0.91 : 1
c Immediate assets are slightly below the immediate liabilities and this would be generally
regarded as satisfactory. Rita can almost pay all the current liabilities from the cash at bank
and the trade receivables without having to sell inventory.
d The liquid ratio is a more reliable measure of liquidity as it excludes inventory which is not as
immediate an asset as actual money and money due from credit customers. It is two steps
away from being money. 5
e Item 1 Current ratio decrease, liquid (acid test) ratio decrease
Item 2 Current ratio no effect, liquid (acid test) ratio decrease
Item 3 Current ratio increase, liquid (acid test) ratio increase
f Four from:
Manager to assess performance, plan for the future and
take remedial action if necessary
Bank manager / lender to assess whether any loan/overdraft and the
interest on this would be repaid on time and the
security available
Trade payables to assess the liquidity position and the
likelihood of the debt being repaid on time and
to determine the credit limit and the length of
credit allowed
Potential buyers to assess the profitability of the business and the
market value of the business assets
Customers to assess the likelihood of continuity of supplies
Employees / trade unions to assess whether the business will be able to
continue and so maintain jobs and continue to
pay adequate wages
Government departments for compiling statistics and tax purposes

© Cambridge University Press 2018