Understanding Current Ratio and Gearing

What does the Current Ratio measure in a business?

• The proportion of long-term debt to equity

• A firm's ability to pay its short-term debts using its current assets

• The total revenue generated by a business

• The profitability of a business

Answer explanation

The Current Ratio measures a firm's ability to pay its short-term debts using its current assets, indicating liquidity and financial health.

What is considered an ideal Current Ratio for a business?

• 0.5:1

• 1:1

• 2:1

• 3:1

Answer explanation

An ideal Current Ratio for a business is typically 2:1. This indicates that for every dollar of liability, the business has two dollars of assets, suggesting good short-term financial health.

If a business has a Current Ratio of less than 1, what does it indicate?

• The business has excellent short-term liquidity

• The business may have potential liquidity problems

• The business is highly profitable

• The business has too much money tied up in current assets

Answer explanation

A Current Ratio of less than 1 indicates that a business's current liabilities exceed its current assets, suggesting potential liquidity problems in meeting short-term obligations.

What does a Gearing Ratio of more than 50% indicate about a business?

• The business is low-risk

• The business is highly geared

• The business has excellent liquidity

• The business is risk-averse

Answer explanation

A Gearing Ratio of more than 50% indicates that a business relies heavily on debt financing compared to equity, making it highly geared. This suggests increased financial risk due to higher interest obligations.

Which of the following is a key point about a highly geared business?

• It is less vulnerable to economic shocks

• It has lower interest payments

• It implies greater financial risk due to debt

• It is considered a low-risk proposition

Answer explanation

A highly geared business has a significant amount of debt, which increases its financial risk. This means it is more vulnerable to economic downturns, making the correct choice "It implies greater financial risk due to debt."

What is the formula for calculating the Current Ratio?

Answer explanation

The Current Ratio is calculated using the formula \(\frac{\text{Current Assets}}{\text{Current Liabilities}}\). This ratio measures a company's ability to pay short-term obligations, making the second choice the correct one.

What does a Gearing Ratio of 45.78% suggest about Jessie Cartright's business?

• It is a low-risk proposition for lenders

• It is a highly geared business

• It is a prudent level of gearing

• It has no debt

Answer explanation

A Gearing Ratio of 45.78% indicates a balanced level of debt relative to equity, suggesting that Jessie Cartright's business is not overly reliant on debt, making it a prudent level of gearing.

Why might a very high Current Ratio, such as 7:1, be a concern for a business?

• It indicates excellent profitability

• It suggests too much money is tied up in current assets

• It shows the business is highly geared

• It means the business has no liabilities

Answer explanation

A very high Current Ratio, like 7:1, suggests that too much money is tied up in current assets, which may indicate inefficiency in asset management rather than strong financial health.

What is the significance of maintaining a sensible Current Ratio for a business?

• It ensures the business is highly profitable

• It helps the business avoid liquidity problems

• It guarantees high market share

• It reduces the need for long-term debt

Answer explanation

Maintaining a sensible Current Ratio is crucial as it helps the business avoid liquidity problems, ensuring it can meet short-term obligations and operate smoothly.

Which of the following is a potential disadvantage of a highly geared business?

• It has lower interest payments

• It is less affected by rising interest rates

• It may face increased expenses and decreased future profits

• It is considered a low-risk investment

Answer explanation

A highly geared business relies heavily on debt, which can lead to increased expenses due to interest payments. This financial strain may result in decreased future profits, making it a potential disadvantage.