CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: TEACHER’S RESOURCE

EQUITY and LIABILITIES

Current liabilities:

Trade payables 1

Overdraft 2.5
3.5
Non-current liabilities:

Long-term loans 5
5
TOTAL LIABILITIES 8.5
Shareholders’ equity:

Share capital 6

Retained earnings 2.7

8.7
TOTAL EQUITY and LIABILITIES 17.2

Exam-style questions
Decision-making questions
1 Midas Toys Ltd
Year ending 30 September 2021 $m
Revenue 6
Cost of sales 2.55
Gross profit 3.45
Overhead expenses 0.75
Profit from operations 2.7
Tax 0.54
Profit for the year 2.16
Dividends 0.5
Retained earnings 1.66

cost − residual value 1 000 000 − 100 000

2 Annual depreciation charge = =
expected useful life 3
= $300 000
3 $1m − (0.3m × 2) = $0.4m

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4 $000 $000
ASSETS
Non-current assets:

Property 10 700

Equipment 3 000

Intangible assets 350

14 050
Current assets:

Inventories 210

Trade receivables 640

Cash 80
930
TOTAL ASSETS 14 980
EQUITY and LIABILITIES
Current liabilities:

Trade payables 525

Overdraft 320
845
Non-current liabilities:

Long-term loans 4 500

TOTAL LIABILITIES 5 345
Shareholders’ equity:

Share capital 6 000

Retained earnings 3 635

Other reserves 0
9 635
TOTAL EQUITY and LIABILITIES 14 980

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Exam-style questions and sample answers have been written by the authors. In examinations, the way marks are awarded may
be different.

Coursebook answers
Most of the answers are in ‘outline’ form indicating the appropriate points and skills that learners need
to include in their answers. They provide the necessary guidance to allow learners to develop and extend
the points for a fuller answer that contains the relevant skills. In many instances, there may be other valid
approaches to answering the question.

Chapter 34
Business in context
Learners’ discussion might include:
Problems in comparing performance
• There is insufficient data to identify trends. Data on growth of revenue, profit etc. is needed
for comparison.
• It is also important to know targets, and whether profits match the objectives set for the year.
• Other information is also required, e.g. capital investment being made. A high level of investment
might reduce current profits but boost future profits and growth.
Usefulness of comparing profit with capital invested into a business
• This provides the return on investment, a key measure for evaluating the success of investment.
• It gives an indication of how effectively each dollar of investment has been used to generate profit.
• This can be compared to other investment opportunities to identify which is best.

Activities
Activity 34.1
1 Current ratio = current assets ÷ current liabilities
2018 = (18 134 + 81 513 + 36 795) ÷ 232 951 = 136 442 ÷ 232 951 = 0.59:1
2019 = (20 737 + 125 700 + 26 103) ÷ 232 847 = 172 540 ÷ 232 847 = 0.74:1
2 Acid test ratio = liquid assets ÷ current liabilities
2018 = (81 513 + 36 795) ÷ 232 951 = 118 308 ÷ 232 951 = 0.5:1
2019 = (125 700 + 26 103) ÷ 232 847 = 151 803 ÷ 232 847 = 0.65:1
3 Air Mauritius’s (AM) liquidity, as measured by the current ratio, has improved from 0.59:1 to 0.74:1.
However, AM still has insufficient current assets to cover its short-term debt. This means AM may
struggle to meet its debt obligations. Although the current ratio has improved, the amount of trade
receivables has increased by 50%. This could indicate that the business is giving too much credit
to customers.
4 Sell off fixed assets for cash. AM could sell planes or property to raise cash. However, it can only sell
assets that are no longer required to generate revenue. Planes are likely to be needed for generating
sales. Selling assets quickly can result in the assets not realising their true value.

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Increase loans. Borrowing from financial institutions would inject cash into the business and improve
liquidity. However, it would also increase gearing, the ratio of debt to equity finance. This would
increase the risk of being unable to meet the interest payments associated with borrowing. Interest
payments are an expense and therefore reduce profit margins.
Judgement is needed about the most appropriate way to improve liquidity in this case.
5 Learners’ own answers.

Activity 34.2
1 2018 2016 2014
Gross profit 39 636 ÷ 1 063 744 × 100 22 525 ÷ 677 940 × 100 36 824 ÷ 1 187 639 × 100 =
margin (GPM) = 3.7% = 3.3% 3.1%
RoCE 31 870 ÷ 115 617 × 100 = 22 826 ÷ 99 902 × 100 41 972 ÷ 83 805 × 100 =
27.6% = 22.8% 50.1%

2 Over the time period as a whole, PSO’s profitability has decreased. Although there has been a small
increase in the GPM from 3.1% to 3.7%, the RoCE has decreased by nearly 23 percentage points. In
2014 and 2016, the profit from operations was greater than the gross profit, which indicates that PSO
must have other sources of income. Gross profit and profit from operations vary significantly between
2014 and 2018 because of changes in revenue. Revenue in 2016 is much lower than in 2014 or 2018, and
this leads to much lower profit and a lower GPM and RoCE.
3 Learners’ answers might include:
• A price increase will increase the profit on each item sold and therefore increase the GPM.
However, this is a dynamic market and it is likely that PSO has competition from other sellers
of oil. As the product is difficult to differentiate, it is likely that demand is relatively price elastic.
Therefore, any increase in price will lead to a more than proportionate decrease in quantity
demanded. This will reduce revenue and, although the GPM will increase, total profit could fall.
• Reducing marketing expenses will reduce overheads and could therefore increase the operating
profitability of PSO. However, reduced marketing could result in reduced sales and therefore lower
total profits for PSO. This will depend on the promotional elasticity of demand.
• Judgement is needed about the most appropriate way to improve profitability in this case.
4 Learners’ own answers.

Activity 34.3
1 Gross profit margin = gross profit ÷ revenue × 100
Operating profit margin = profit from operations ÷ revenue × 100

Gross profit margin Operating profit margin

Ahmed 100 000 ÷ 350 000 × 100 = 28.6% 20 000 ÷ 350 000 × 100 = 5.7%
Flash Builders (FB) 150 000 ÷ 600 000 × 100 = 25% 60 000 ÷ 600 000 × 100 = 10%

2 Relevant points include:

• Ahmed generates $0.286 of gross profit compared to FB’s $0.25 for every $1 of sales.
• Ahmed generates $0.057 of profit from operations compared to FB’s $0.10 for every $1 of sales.
• Ahmed’s business has a higher gross profit margin (GPM), suggesting that his business has been
effective in controlling the cost of sales. This indicates either that he is charging a high price for his
work and/or that he has bought materials at a relatively low price compared to FB. It may also be
a result of better control of direct labour costs.
• However, the profit margin for Ahmed Builders is much lower than for FB. This indicates that
Ahmed’s business has relatively high overheads. There has been a failure to control those costs
effectively. Consequently, Ahmed is less effective in turning sales into profit from operations.

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• These figures are only for one year. To judge his success more fully, Ahmed would need to consider
trends in profitability to assess whether his performance is improving or worsening.
3 Increase prices. Increasing the differential between price and unit cost will increase the operating profit
margin. However, Ahmed faces competition from other builders such as FB and, therefore, there may
be a loss of sales, leading to a fall in total profit. This will depend on the price elasticity of demand. As
Ahmed specialises in quality fitting out of shops and has to work to tight deadlines, the price elasticity
of demand may be quite low.
Reduce costs. This may be done in several different ways:
• Cut stock levels. Ahmed keeps stocks of important materials but this will increase his costs as
stock requires storage space. However, reducing stock levels may adversely affect Ahmed’s ability
to meet the tight deadlines imposed by his customers. If customers are lost because of that,
revenue will fall.
• Use cheaper materials and fittings. As Ahmed provides a service for internationally famous
retailers, this may not be a suitable option. His customers will expect a high-quality finish and
therefore good-quality materials are needed. However, it may be possible to find cheaper suppliers
of these materials.
• Reduce overhead costs. As the GPM for Ahmed is higher than for FB, this appears to be an
area that needs attention. Ahmed should analyse where overhead costs are incurred and look to
make savings. For example, it may be possible to move the location of his head office and thus
reduce the rent paid. Ahmed should review the structure of the business to see if it has too many
administrative and managerial positions. If so, delayering could be used to reduce management
costs without affecting the quality of service offered to customers.
Evaluation should include a judgement about the most appropriate way to improve operating profit
margin in this case.
4 Current ratio = current assets ÷ current liabilities
Acid test ratio = liquid assets ÷ current liabilities. Note: liquid assets = current assets − inventory

Current ratio Acid test ratio

Ahmed 100 000 ÷ 45 000 = 2.22 (100 000 – 50 000 ) ÷ 45 000 = 1.11
Flash Builders 150 000 ÷ 120 000 = 1.25 (150 000 – 60 000) ÷ 120 000 = 0.75

5 Learners’ answers might include:

• Ahmed’s business has no apparent problem with liquidity. The current ratio indicates that there is
$2.22 of current assets for every $1 of short-term debt. The acid test ratio shows that there is $1.11 of
liquid assets for every $1 of short-term debt. Therefore, the business should have no problem paying
creditors and other short-term debt holders. It might be argued that Ahmed’s business holds a little
too much stock, shown in the big difference between the current ratio and the acid test ratio.
• FB has less liquidity. Both the current ratio and the acid test ratio are slightly below the textbook
ideal. Thus, the firm may have difficulty paying short-term debt.
6 Sell fixed assets for cash. If FB has unutilised land and property, it could be sold to release working
capital. However, if the business needs all of its fixed assets, it would have to lease the assets back and
in the long term this would increase costs and reduce profit margins. To realise a healthy price for fixed
assets, FB would need to take time over their sale.
Sell off inventories. Selling stock for cash will improve the acid test ratio for FB but have no effect
on the current ratio. The problem of selling stock is that, like Ahmed, FB may have to work to tight
deadlines for customers and therefore need to hold stock. FB already holds relatively low stock levels
compared to Ahmed. If FB adopts a just-in-time stock control policy, this would improve the acid test
ratio by reducing cash outflows.
Evaluation should include a judgement about the most appropriate way to improve liquidity in
this case.

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Activity 34.4
1 Ratio Calculation Company A Company B
Return on capital employed Profit from operations ÷ capital employed × 100 25% 12.5%
Gross profit margin Gross profit ÷ revenue × 100 27.5% 25%
Rate of inventory turnover Cost of sales ÷ average inventory 7.25 6.43

Cost of sales = revenue − gross profit

Current ratio Current assets ÷ current liabilities 0.86:1 1:1
Acid test ratio Liquid assets ÷ current liabilities 0.57:1 0.5:1

Liquid assets = current assets − inventory

2 Profitability. Both companies have similar GPM. However, Company A has a return on capital
employed which is double that of Company B. It returns $0.25 in profit for every $1 invested compared
to only $0.125 for Company B. This suggests that Company A’s profitability is superior to that of B.
Financial efficiency. Inventory turnover is higher at Company A. This means that inventory is held
for a shorter period of time, around 50 days at Company A compared to 57 days at Company B. The
results are similar and may reflect the particular nature of the industry in which they compete.
Liquidity. Company A has a very low current ratio, having only $0.86 of current assets for every $1
of short-term debt. This may indicate that Company A will have difficulty paying its debts. Although
Company B has a stronger current ratio, due to its higher relative level of inventory (the least liquid
current asset) it has a weaker acid test ratio. This shows that Company B also has a precarious
liquidity situation.
Evaluation should include a brief assessment of which company has the more favourable profitability,
financial efficiency and liquidity.

Activity 34.5
1 PPP has borrowed more than 50% of its capital. Therefore, PPP has a relatively high level of debt to
service (i.e. to pay interest on). This increases risk to the business as, if trading conditions are difficult,
PPP may struggle to cover interest payments. The cancellation of two major sporting events has
reduced PPP’s demand and revenue. However, the borrowing costs from expanding facilities still have
to be covered. With lower profits now expected and reduced cash inflows, PPP is in trouble because of
the increased borrowing.
2 Issue share capital. This will increase total capital and inject cash into the business. Gearing will be
reduced and the increased financing will enable PPP to restructure its debt. However, PPP may find it
difficult to attract investors due to the problems it currently faces and investors may lack confidence in
the management of the company.
Sell assets to raise finance. PPP could sell land to raise finance to pay off the loans. PPP is likely to
have valuable land and this could be sold for housing development. However, this would depend on
whether planning permission is possible for building housing, and on the location of the land. Selling
land might mean a fall in the number of visitors attracted to the park each year, which would affect
revenue. An alternative would be to use sale and leaseback of land or facilities. However, this would
increase long-term costs and reduce the assets owned by the business.
Evaluation should include a judgement about the most appropriate way to reduce gearing in this case.

Activity 34.6
Learners’ own answers.

Activity 34.7
1 PepsiCo 55.1%, Coca-Cola 60.8%
2 PepsiCo 15.3%, Coca-Cola 27.1%

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3 Coca-Cola is more profitable than PespiCo. Coca-Cola is much more effective at generating profit
from each dollar of sales. However, the RoCE is similar for both companies: PepsiCo 17.4% and
Coca-Cola 17%.
4 PepsiCo 0.85:1, Coca-Cola 0.76:1
5 PepsiCo 0.7:1 Coca-Cola 0.64:1
6 PepsiCo has better liquidity. However, liquidity for both companies is low. This is unlikely to be a
concern as both companies are likely to have strong cash inflows from sales and debtors.
7 Rate of inventory turnover: PepsiCo 9.3, Coca-Cola 4.5
Trade receivables turnover: PepsiCo 42.5 days, Coca-Cola 39 days
8 Coca-Cola has a much lower rate of inventory turnover. It keeps inventory for an average of 81 days
compared to PepsiCo’s 39 days. This suggests greater financial efficiency at PepsiCo as it has less
finance tied up in inventories.
9 Learners’ own answers.

Exam-style questions
Decision-making questions
1 Bhopal Paper Products plc (BPP)
1
2021 2020

Current ratio 0.89:1 1:1

Acid test ratio 0.48:1 0.7:1

Trade receivables turnover 81 days 86 days

P/E ratio 10.7 9.9

Gearing ratio 50% 46%

Gross profit margin 70% 70%

Operating profit margin 8.75% 10%

RoCE 11.7% 12.7%

Dividend yield 6.25% 5.2%

2 There has been a slight decrease in profitability. Although revenue has risen, expenses have
increased more quickly, leading to a decrease in the profit margin. Profit from operations has
increased by 6.1%, but total capital has increased by 15.4%. This has decreased the RoCE.
Evaluation could include an assessment of whether the profitability is improving or not.
3 Reduce the time given to customers to pay. This would reduce the trade receivables turnover
in days. However, there is a risk that it might reduce revenue, as credit terms are an important
attraction for customers.
Maintain a debtor collection list. This ensures BPP will chase up debtors who are late paying debts.
Delay payment to suppliers. If this is done without the agreement of suppliers, there is a risk that
suppliers will withhold supplies in the future.
Evaluation could include an assessment of the best way to improve financial efficiency.
4 Sell assets that are no longer required. This will raise finance to pay back loans. As BPP has
grown rapidly in recent years, it might not have any unused assets. However, if it has bought new
machinery, there may be fixed assets to dispose of.

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Issue more share capital. The expansion of the business could make it attractive to investors.
Expansion has been achieved despite a competitive market and the Indian economy is growing so
the prospects for BPP may be positive. However, a share issue would dilute ownership and control,
so might be opposed by shareholders.
Evaluation should include a final judgement about the most suitable way to reduce gearing in
this context.
5 For investment:
• Share price has risen in the last 12 months. Capital gains are possible for shareholders.
• Dividends paid to shareholders have increased by $5m. Dividend per share is now $0.25.
• P/E ratio has increased to 10.7 from 9.9. Although this means that it takes over ten years to
recover investment, it shows market confidence in the future profitability of BPP.
• Revenue has increased by 21% in the last 12 months despite a competitive market.
• The Indian economy is growing so BPP should also be able to continue to increase sales.
• Dividend yield has increased to 6.25%.
Against investment:
• Declining profit margin. The RoCE and operating profit margin have decreased in the last
year. Despite a large increase in sales, profit has increased by only 6.1%.
• Increase in gearing increases the risk of investment. BPP is highly geared, with 50% of capital
from borrowing.
Evaluation: investors would need further information before making a decision, e.g. the RoCE in
other similar businesses. The attitude of the investor to risk is important. A company that is highly
geared gives the opportunity for shareholders to benefit more if the business is able to increase
profit, as there are fewer shareholders with whom to share the profits.
2 Habib Manufacturing Ltd (HM)
1 Learners’ answers might include:
• The gross profit margin (GPM) has increased as a result of the firm reducing the cost of sales
by using cheaper raw materials and buying in bulk to benefit from purchasing economies.
• Although the GPM has increased, the operating profit margin has decreased. This could be
the result of ineffective advertising and promotional expenditure, which has doubled. This
would increase HM’s expenses but may have had a limited impact on sales, and therefore the
profit margin would decrease.
2 Declining liquidity. HM may have problems paying short-term debts (e.g. trade creditors).
This could lead to suppliers refusing to give further credit and insisting on cash payments for
components and raw materials. Liquidity problems can, ultimately, lead to bankruptcy.
Declining rate of inventory turnover. This can have a negative impact on profit as HM will have
to pay for the cost of stock holding, thus increasing expenses. There is also the possibility of
obsolescence becoming an issue, although this should be less of a problem in the ovens market.
3 Increase prices. Higher prices will increase the GPM. However, if demand is price elastic, there will
be a more than proportionate fall in sales and therefore revenue will fall. Profit margins could still
be higher but the business may make less profit in total.
As Asif would have to target the oven at higher-income groups, he may need to increase promotional
activity to raise customer awareness. Quality may also have to be improved to support the higher price.
Asif has previously moved to using cheaper materials and might have to reverse that decision.
Reduce other overheads. Asif’s plan to relocate the factory will lead to a reduction in overheads,
as business rents will be lower outside the city centre. This may also benefit distribution of the
finished product and delivery of raw materials. As the new location is 20 km away, this may have a
negative impact on employees.
Evaluation could include a judgement about which method Asif should use in this case.

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3 Financial efficiency and gearing ratios

1
Trade receivables turnover = trade receivables ÷ credit sales × 365
Company X = 112m ÷ 1 008m × 365 = 41 days
Company Y = 319m ÷ 1 314m × 365 = 89 days
Trade payables turnover = trade payables ÷ credit purchases × 365
Company X = 106m ÷ 580m × 365 = 67 days
Company Y = 270m ÷ 750m × 365 = 131 days
Rate of inventory turnover = cost of sales ÷ average inventory
Company X = 560 ÷ 73 = 7.67
Company Y = 730 ÷ 150 = 4.87
Gearing ratio = non-current liabilities ÷ capital employed × 100
Company X = 500m ÷ 1 575m × 100 = 31.7%
Company Y = 1 025m ÷ 2 050m × 100 = 50%
2 Both companies have trade payables turnover (days) that is greater than trade receivables turnover
(days), i.e. customers repay debt more quickly than the companies pay creditors. This will help
both companies with cash flow. However, Company Y takes 131 days to pay its suppliers (i.e. over
four months). This could result in suppliers being unwilling to offer further credit to Company Y.
Company X has a higher rate of inventory turnover compared to Company Y. Therefore, its
inventory holding costs are relatively lower than those of Company Y. This suggests that Company
X has better financial efficiency.
3 a Company Y has $150m of inventory, so it could finance the expansion by reducing inventories.
Company Y has a lower rate of inventory turnover than Company X, which might indicate
that Company Y could reduce inventory holding and still meet customer needs. However,
as the business expands it may need greater levels of inventory to meet customer demand.
Reducing inventory and using the cash to finance the expansion would also reduce the
liquidity of the business and consequently it may struggle to pay its short-term debts.
b Capital employed will increase to 2 050m + 75m = $2 125m
Long-term loans = 1 025m + 75m = $1 100m
Gearing = 1 100m ÷ 2 125m × 100 = 51.8%
Relevant points include:
• A bank loan is suitable as it is an appropriate source of finance for expansion.
• Company Y is highly geared. It has a high ratio of debt finance to equity finance.
• High gearing means a high level of interest payments. Servicing debt may be difficult if
trading conditions are difficult.
• The strain of paying back high debts could leave the firm with a lack of liquidity.
• Banks may be reluctant to lend more money, due to the interest burden.
• Knowledge of the firm’s current ability to cover interest payments from operational profits
would be useful.
• Current levels of interest will be important. The availability of retained profits is also
a consideration.
• Evaluation should include a final justified recommendation/advice on the best source of
finance to use in this context.

7 Cambridge International AS & A Level Business – Stimpson & Farquharson © Cambridge University Press 2021
 CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: TEACHER’S RESOURCE

Exam-style questions and sample answers have been written by the authors. In examinations, the way marks are awarded may
be different.

Coursebook answers
Most of the answers are in ‘outline’ form indicating the appropriate points and skills that learners need
to include in their answers. They provide the necessary guidance to allow learners to develop and extend
the points for a fuller answer that contains the relevant skills. In many instances, there may be other valid
approaches to answering the question.

Chapter 35
Business in context
Learners’ discussion might include:
• Profit is usually the most important objective for business.
• The primary duty of a business is to its shareholders.
• Directors have more to gain from increasing profit than from reducing environmental impact, as their
bonuses are often linked to company performance and share price.

Activities
Activity 35.1
1 a Sales will depend on the state of the economy, as the cars are luxury products.
b It is difficult to predict uptake of services as they are new.
c The sample size is small and could be unrepresentative, so estimates of usage of the sports centre
may prove inaccurate.
d Costs for major infrastructure often go above budget, as unexpected construction problems can
be encountered.
e The price of oil is subject to large fluctuations over time and these changes are difficult to predict.
The price of oil will impact cash outflows.

Activity 35.2
1 30 000 ÷ 5 000 = 6 years
2 $3 million returned after 2 years. 1m ÷ 1.5m × 12 months = 8 months. So 2 years 8 months.
3 $240 000 returned after 3 years. 10 000 ÷ 80 000 × 12 months = 1.5 months. So 3 years 1.5 months.

Activity 35.3
1 Payback for Project X = 2 years and 3 months (number of months into the third year = 5 000 ÷
20 000 × 12)
Payback for Project Y = 2 years
2 Project Y has a quicker payback and should be selected. A quicker payback reduces risk and is
important to businesses that have limited finance available.
3 ARR = average annual profit ÷ average investment × 100
For Project X: profit = $40 000. Therefore, average profit = 40 000 ÷ 5 = $8 000

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