So the 12th question was similar to Q5 so I didn't bother writing another answer. I'm unsure whether they would get full marks or not, but I'm especially iffy about Q7. I just didn't really know how to write something coherent and logical for it. Hope to receive some feedback from all of you!
1. Discuss the different methods of depreciation and why it is not recommended that the method be changed regularly. Refer to 1 Accounting Principle and 1 Qualitative Characteristic in your answer 6 MarksAccounting Principle: Consistency
Qualitative Characteristic: Comparability
The straight-line method of depreciation should be used if the asset is expected to contribute to revenue evenly over its useful life. While the reducing balance method of depreciation should be used if the asset is expected to contribute to revenue greater in its earlier life. It is not recommended that the method of depreciation be changed regularly as this contravenes with Consistency and Comparability. The accounting principle consistency demands that once a depreciation method is chosen, it should be used from one period to the next. This ensures that reports can be compared from one period to the next, and upholds the qualitative characteristic of Comparability in accounting reports. Changing depreciation methods is possible if the current method of depreciation is not ensuring that the revenue the asset earns is being matched by its depreciation expense, but the change must be clearly shown in reports.
2. Discuss the effect the movement of the debt ratio has on the profitability and liquidity of the business
6 MarksThe Debt Ratio assesses the relationship between total liabilities and total assets. A higher Debt Ratio means there is a greater risk that the business will be unable to repay its debts and meet their interest payments. This is because the business will have taken on a greater amount of debt to fund its purchasing of assets. Thus, interest expense will increase and the liquidity will decrease. However, as assets are being purchased via borrowed funds instead of the owner’s personal funds, the Return on Owner’s Investment should increase and thus profitability should increase. A lower Debt Ratio means that there is less risk that the business will be unable to repay short-term debts as they fall due, which is favourable for liquidity. However, it also means that the majority of the finance used to purchase assets has been funded by the owner, and thus Return on Owner’s Investment will be lower, which is unfavourable for profitability. Overall, the owner should judge the Debt Ratio carefully in order to maximise the return to the owner’s investment without putting too much pressure on liquidity.
3. Discuss how Stock Cards follow Accounting Principles (Hint: There are 2 principles to discuss)
4 MarksConservatism: This principle states that as soon as a loss is anticipated (i.e. in the form of a stock loss/stock write-down) it is recognised immediately to ensure assets (stock) is not overstated.
Historical Cost: The stock in the Stock Card is recorded at the cost price and not the selling price because the original purchase price is verified by a source document.
4. Discuss the limitations of using Financial Indicators to determine performance
4 MarksOwners should not rely on financial indicators alone to determine performance due to its limitations. Financial reports use historical data; these do not guarantee what will happen in the future. Additionally, many of these indicators rely on averages which conceal details about individual items. Furthermore, firms will use different accounting methods, which can undermine the comparability of reports and these financial indicators. Therefore, non-financial information (items not reported in a financial report) such as the current state of the economy and the firm’s relationship with its customers are just as important in determining performance as financial indicators.
5. Discuss the benefits of preparing budgets for business performance
4 MarksBudgeting is the process of preparing reports that predict the financial consequences of likely future transactions. They assist planning by predicting what is likely to occur in the future and aid decision-making by providing a standard benchmark for which actual performance can be measured against. Additionally, they set benchmarks for indicators which assess liquidity, stability and profitability. By preparing a budget at the beginning of the reporting period, a variance report at the end of the period can be prepared to compare actual and budgeted figures, highlighting variances so problems can be identified and rectified appropriately to improve business performance for future reporting periods.
6. Discuss the reasons for Sales Returns and the benefits of offering them to customers
4 MarksA sales return is the return of stock to the firm by a trade debtor. Sales Returns occur when stock is faulty/damaged or the wrong model/colour. Other common reasons for a sales return are when too many items have been purchased or customers have just changed their mind. Damaged/faulty stock must be accepted for return, provided the customer has the source document as proof of purchase and the business is satisfied that the fault lies with the product rather than how it was used. Businesses that accept returns can generate greater sales, with customers being more willing to purchase if they have the comfort of knowing that they can return the product if it is unsuitable. Additionally, Sales Returns can also be an indicator of customer satisfaction of the stock being sold. If Sales Returns are high, it may indicate that customers aren’t satisfied with the quality of goods being sold.
7. Discuss strategies that a business could employ to improve liquidity
4 MarksLiquidity refers to the ability of a business to meet its short-term debts as they fall due.
Liquidity can be assessed on two factors: The level and speed of liquidity.
If the level of liquidity is unsatisfactory as indicated by the Cash Flow Cover as well as the Working Capital and Quick Assets Ratios, then the business could increase Net Cash Flows from Operations proportionately greater than Average Current Liabilities by collecting owing debt from debtors earlier (sending reminder notices to debtors approaching the end of credit terms, offering discounts on early payment), selling more stock using greater advertising, and delaying payments to creditors to a later date. Not only would this improve the Cash Flow Cover, the Working Capital and Quick Asset ratios too would improve as there is a greater amount of cash available to meet short-term debts and less idle assets (excess debt and stock). Additionally, this would decrease both the Stock and Debtors Turnover. Consequently, the speed of liquidity: the time it takes for a business to sell stock and collect cash, is reduced, and the business’ liquidity should improve.
8. Discuss strategies that a business could employ to improve profitability
5 MarksProfitability is the ability of the business to earn profit, as compared against a base such as Sales, assets or Owner’s Equity. A firm’s profitability is dependent on its ability to earn revenue and control its expenses. Greater revenue can be generated through an increase in advertising to generate additional sales or the changing the stock mix so products which are in demand are kept on hand while slow moving lines are replaced with fast-moving lines of stock. A firm can improve its expense control with greater management of stock by seeking an alternative supplier who can provide cheaper/better quality stock to lower cost of sales/sales returns. Another method could be implementing a better stock recording system (perpetual system of stock recording) using stock cards, and physical stocktakes. Deciding which strategy a business should employ to improve profitability will be dependent on the current circumstances of the business.
9. Discuss why it is necessary to calculate the cash flow cover when analysing liquidity in addition to using Working Capital and Quick Asset Ratios
4 MarksThe Working Capital Ratio measures the ratio of current assets to current liabilities to assess the firm’s ability to meet short-term debts. Meanwhile, the Quick Asset Ratio measures the ratio of quick assets to quick liabilities to assess the firm’s ability to meet its immediate debts using its immediate assets. However, both these ratios rely on static items to measure future cash flows; both ratios come from the Balance Sheet and provide no indication of the cash flows of the business. Therefore, it is necessary to calculate the Cash Flow Cover to identify the actual cash that the business generates and its ability of the generated cash to meet its financial obligations. Cash Flow Cover, determined by measuring the number of times Net Cash Flows from Operations covers average Current Liabilities, shows the ability of the firm to pay its short-term debts as they fall due using its operating cash flows. If the Cash Flow Cover shows that the business is not generating sufficient cash from its operating activities, then the business may require capital contributions to meet its short-term debts as they fall due.
10. Discuss the importance of calculating debt ratio in addition to analysing Return on Owner's Investment
4 MarksBy calculating debt ratio in addition to analysing Return on Owner’s Investment in order to determine whether the business has relied on owner’s capital to purchase assets which boost profit, or has instead relied on borrowed funds. The debt ratio measures the percentage of a firm’s assets which are financed by liabilities/loans, indicating the reliance of a business on debt to purchase its assets. While the ROI indicates how effectively the firm has used its owner’s funds to earn profit. A higher Debt Ratio means the firm has a greater reliance on borrowed funds than it is on owner’s capital which is a means of increasing ROI without increasing profit. This is because the business is using someone else’s funds to buy the assets to earn profit, but the owner still receives all of the profit. Meanwhile, a low Debt Ratio means that the firm is not reliant on borrowed funds, and is thus at a low risk of being unable to repay its debts. However this also means that most assets have been financed with the personal funds of the owner and thus a lower ROI will ensue. Therefore, it is important to calculate the Debt Ratio in addition to analysing ROI in order for the owner to judge carefully whether the ROI is being maximised by the debt ratio or not.
11. The owner is satisfied with the firm's performance because his Working Capital Ratio is 6:1. Discuss the validity of this statement.
The owner’s statement is valid in the sense that its level of liquidity is satisfactory, and the firm should not have trouble generating cash to meet its short-term debts as they fall due.
However, although it is beneficial for the Working Capital to be above 1:1, the firm’s 6:1 Working Capital Ratio may indicate that the business has an excess of current assets which are idle and not being employed effectively. For example, a large amount of stock could incur additional storage costs, and increase the possibility of stock loss, damage and obsolescence. This also indicates that the business is not selling its stock frequently, and may have trouble meeting its immediate short-term debts. Another example would be an increasing amount of debtors which would indicate an increasing amount of “bad debts”, which in turn means that the business may not be able to generate cash from its debtors to meet short-term debts as they fall due. Consequently, the owner’s statement is invalid.
If you see any improvements which can be made (I'm sure there are) then please please please reply! Thank you!
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