Accounting Question Thread

[eeps]

It's from the Cambridge VCE TEXTBOOK... it was Ex. 19.11 Q. b

Here's a copy of the question and the corresponding solution to it. (below.)

[_avO]

yea now that makes so much more sense

Stock management means that it now takes an additional 15 days to get the stock out of the business from when you prepared it for sale as compared to 2009 stats

It is worse then debtor management because debtors are actually repaying 5 days before the actual credit terms which is favourable.

[eeps]

LOL. right... Thanks! I probably should have posted this earlier to save all the confusion and fuss, apologises.

[eeps]

HAS anyone done Interest Cover yet? I found this to be the most random-est of formulas in Liquidity. There was literally like half-a-page dedicated to it and that was it...

[pooshwaltzer]

Allow me to indulge in a little rant about INTEREST COVERAGE...

We have ... [Net Earnings before Interest] / [Periodic Interest Payments]

Note for the time being that:
(1) Numerator is a composite accrual of sorts (revenue vs. expenses)
(2) Denominator is the current portion of a perennial liability (interest component = CL; principal = NCL)

Interest Cover is not a "random" formula per se. The rationale can be derived intuitively in the sense that interest expense is just another addendum to the business' operating expenditures and therefore would take another chunk out of the bottom line.

We use this ratio on the basis that financing charges should ideally be considered separately from operational expenses.

To exemplify, a hardware store is in the business of sourcing hardware inventory from distributors/wholesalers and then offering to supply retail customers as a service. That's the revenue generating business model. Buy HW ---> Sell HW.
The store may require debt financing at certain stages throughout it being a going concern but fundamentally it's not in the business of borrowing funds. Debt is one of the means to an end but not the end in itself.

Now, said HW store will sell its wares at x% markup, take out COGS to arrive at gross then make other miscellaneous revenue (discount) adjustments.
Typical expenses from ordinary course of operations: salaries, office supplies, depreciation, utility bills, insurance, delivery/courier...
Take aggregate expenses away from the adjusted gross and we get our subtotal EBIT.
Creditors have precedence in terms of claims over this raw profit figure; equity holders have residual claim only. The business will look at its raw EBIT and determine how many times it can use that sum to pay off its loan interest liabilities AS AND WHEN THEY FALL DUE. Interest cover is a measure of redundancy and determines how probable it would be for the business to remain solvent. The more times the cover, the greater the certainty of future going concern.

Potential Issues:

1. Negative EBIT, ie. loss/deficit. The ratio becomes negative meaningless. A negative Int Cvr ratio suggests how many times the lender would need to pay you (the borrower) the interest payments which you owe them in order for you to nullify that loss.

2. The nature of accruals being that they're earned but not necessarily realized. If the Int Cvr ratio was [cash at bank] / [interest payments] then they'd be no issue.
However, if the business' trade debtors decide to delay payment of their invoices to the extent that cash inflows become an operating CONSTRAINT then that would have reverberating ramifications on your ability to pay your creditors; in particular, those of the institutional lending kind.
The business will still register the revenue as earned on their books but the Int Cvr ratio is no longer INFORMATIVE in the sense that said revenue and profit have not been realized in order to meet interest (as well as other) obligations of the liability kind as and when they fall due.

...I'm done.

[eeps]

LOL. THANKS for that...

[eeps]

Question:

Has anyone done the VCAA 2005 Unit 4 PAPER... Q. 1.3...

At 31 December 2005 the accountant provided the following information relating to stock.

Stock turnover (Average Stock * 365/Cost of Goods Sold) and in 2004 it took 61 days, while in 2005 it took 74 days...

Explain how the change in stock turnover could have a:

- negative effect on liquidity (I've done this one already.)
- positive effect on Net Profit. (I need help with is ONE!)

Thanks.

[eeps]

According to the 2005 Assessment/Examiner's Report, a suggested solution(s) could have been:

It could have a positive effect on Net Profit because...

• could improve if longer stock turnover is due to carrying a better stock mix/variety of stock which leads to an increase in sales
  
• bought stock cheaper in bulk and able to earn a greater profit margin on sales

THE answers given seem logical, but I'm not sure about the first dot point... how can you assume that the business has a "better" stock mix/variety of stock, just because their STOCK TURNOVER is longer... I was thinking that it was a pretty big assumption to be making. I don't think I saw this info/answer in my textbook anywhere. :\

[darcy42]

Stock turnover, not debtors turnover.

This generally unfavourable trend in Stock Turnover can have a positive effect on profit IF the business purchased a high amount of stock in bulk, in an agreement resulting in a cheaper cost, during the period. Although this would inflate the stock control figure and therefore worsen Stock Turnover rate, higher profit margins may be made on this stock, as it has a cheaper purchase price and no modification of the sale price is necessary.

It's a bit silly but makes sense when you think about it.

[darcy42]

OH, I think that first dot point pretty much just means that the business has invested in a different line(s) of stock that they believe will improve future sales. So they have their old stock, perhaps on top of a new mixture of stock, which again inflates the stock control figure etc, but will make up for this in the next period by increasing sales revenue.

[eeps]

Oh... right... Thanks! that makes sense when you put it that way...

[eeps]

Question:

VCAA 2006 Unit 4 Exam... Q. 1.2.3

Explain one possible negative effect of improving the business's Stock Turnover. (2 marks)

• In 2004, it took 94 days.
• In 2005, it took 82 days.
• In 2006, it took 65 days.

Cheers.

[darcy42]

If the business sells a great amount of stock in a period, its Stock Turnover is seen to improve, however this may result in the business lacking stock supplies. This, in turn, could lead to the business not being able to supply good to customers at certain times, which inevitably leads to a decline customer satisfaction and an eventual decline in sales.

Some of these answers assume quite a bit haha.

[eeps]

LOL... that isn't a bad answer... in my textbook it says "Although the business would be generating high sales, it may be because the selling price is too low, and this would be a loss of potential revenue (and profit). + costs such as delivery may be higher (because deliveries are more frequent) and the business could lose the possibility of earning discounts for buying in bulk..."

COULD I use any of the above as my ANSWER? LOL.

[eeps]

LOL. oh... right... their answers were:

Negative effects of improving the business’s Stock Turnover included:

• not always being able to guarantee supply to customer (possible loss of customer goodwill)
• less stock variety on offer
• may lose discounts offered by supplier on bulk purchasers

Many students linked their response to a decrease in selling price to improve Stock Turnover. As this was a constraint in Question 1.2.1, such responses were not considered correct. Better responses discussed a potential loss of customers due to less stock being held. Other responses discussed a possible increase in Bad Debts if the business relaxed credit terms in order to improve Stock Turnover through increased sales.

THAT answers my question.