IB Biz - Ratios & Investment Appraisal

If a business has debtors of $35 000, cash of $50 000, stock of $15 000, and current liabilities of $13 000, what is its current ratio? 

• 13%

• $92.31

• 7.69

• .87

Gross profit margin measures a company’s: 

• Efficiency

• Liquidity

• Profitability

• Gearing

Answer explanation

The gross profit margin is a percentage which measures the proportion of gross profit earned in relation to sales revenue.

Crown Incorporated had annual sales of $750 000. Their gross profit was $450 000.

Therefore, Crown Incorporated’s gross profit margin is __.

• 20%

• 40%

• 60%

• 1.67

Answer explanation

Gross profit margin = gross profit ÷ sales revenue × 100

Gross profit margin = $450 000 ÷ $750 000 × 100

Gross profit margin = 0.6 × 100

Therefore, the gross profit margin for Crown Incorporated is 60%.

Which of the following is a strategy to improve the gross profit margin?

• Reducing the credit period for customers

• Lowering expenses

• Reducing non-current liabilities

• Lowering the cost of goods sold

Answer explanation

As the gross profit margin considers gross profit as a percentage of sales revenue, an effective strategy to improve the result is to lower the cost of goods sold. This would lead to the percentage of sales revenue that becomes gross profit to be higher. As the gross profit margin considers the cost of goods sold and not expenses, lowering the expenses would have no effect on the result. It would instead improve the profit margin. As the gross profit margin does not consider non-current liabilities or whether trade receivables have paid, these strategies would have no impact on the result either. 

Which of the following is the recommended ratio range for the current ratio?

• 1.5 to 2:1

• 3 to 4:1

• 1:1

• 1:1.5 to 2.1

Answer explanation

To ensure that a business has sufficient current assets (that will be converted into cash) to cover their current liabilities, the ideal current ratio range is 1.5 to 2:1. This means that the business will have 1.5 to 2 current assets for every 1 current liability. 

ARR helps companies to understand their __; on a future investment

• Profitability

• Debt

• Costs

• Interest payable

Answer explanation

Since ARR calculates the return over the initial investment for its entire lifetime, it gives the business a measure of the profitability of the investment. 

A company invests $1.5 million in a new factory. The annual net cash flows arising from the investment are $300,000 per annum and the factory is expected to stay operational for 20 years. Annual depreciation on the factory is to be charged at $50,000 to the profit and loss account.

What is the project's payback period?

• 5 years

• 10 years

• 15 years

• 20 years

Answer explanation

The payback period for the new factory is 5 years. The formula for payback period is: Initial investment cost ÷ Annual net cash flow from investment. In this case, the initial investment of $1,500,000 divided by the annual net cash flow of $300,000 gives a payback period of 5 years. Depreciation doesn’t directly affect the payback period.

Which investment appraisal method calculates the annual profit of an investment project, expressed as a percentage of the initial sum of money invested in the project?

• Payback Period

• Average Rate of Return

• Net Present Value

Decide whether the following statements are true or false.
(1) The payback period is the amount of time it takes to recover the initial cost of an investment project.

(2) The payback method of investment appraisal ignores the overall profitability of an investment.

• (1) False (2) True

• (1) True (2) False

•   (1) True (2) True

• (1) False (2) False

Answer explanation

The payback period is the amount of time to recover the initial cost of an investment project, so statement (1) is true. Unlike the average rate of return, it ignores the overall profitability of an investment, so statement (2) is true. Hence, the correct answer is both statements are true.

What is the correct formula for calculating the payback period?

• Gross profit ÷ total sales revenue × 100

• Initial investment cost ÷ annual cash flow from investment

• Annual cash flow from investment ÷ initial investment cost

• Annual cash flow from investment – original cost of investment

Answer explanation

The formula to calculate the payback period is: initial investment cost ÷ annual cash flow from the investment. The payback period estimates the length of time for the cash inflows from an investment to recover the initial project cost.