1 Indicate, by clicking in the relevant boxes, whether the following statements are true or false.

Statement

True False
Working capital should increase as sales increase
An increase in the cash operating cycle will decrease
profitability
Overtrading is also known as under‐capitalisation

2 Which of the following is NOT usually associated with overtrading?

A An increase in the current ratio
B A rapid increase in revenue
C A rapid increase in the volume of current assets
D Most of the increase in current assets being financed by credit

3 Which TWO of the following would be implied by a decrease in a company’s operating

gearing ratio?
A The company is less profitable.
B The company is less risky.
C The company has a lower proportion of costs that are variable.
D The company has profits which are less sensitive to changes in sales volume.

4 Which of the following statements is part of the traditional theory of gearing?

A There must be taxes
B There must exist a minimum WACC
C Cost of debt increases as gearing decreases
D Cost of equity increases as gearing decreases

5 Which TWO of the following are most likely to result in a company’s financial gearing being
high?
A Low taxable profits
B High tax rates
C Inexpensive share issue costs
D Intangible assets being a low proportion of total assets

6 If a company that currently pays its workforce on a piece rate system were to automate its
production line, which of the following responses would it expect of operating gearing?
A Decrease
B Increase
C Remain the same
D Increase or decrease depending on the nature of the production process
7 The following are extracts from the statement of profit or loss for Champ Co:
$
Sales income 180,000
Cost of sales (100,000)
Profit before interest and tax 80,000
Interest (25,000)
Profit before tax 55,000
Tax (15,000)
Profit after tax 40,000

70% of the cost of sale is variable costs.

What is the operational gearing of Champ Co to one decimal place?

? times

8 An analysis of the financial statements of a business reveals the following financial ratios:
1. A higher than average inventory holding period
2. A higher than average payment period for trade payables
3. A lower than average current ratio
4. A lower than average sales to working capital ratio
Which TWO of the above is consistent with a business being over-capitalised?
A 1 and 2
B 1 and 4
C 2 and 3
D 3 and 4

9. Dunelm (Engineering) Co buys raw materials from suppliers on four weeks’ credit and they are delivered
immediately.
When the raw materials are received, they are held in the warehouse for five weeks before being used in
production.
The production process takes one week and the completed goods are held for two weeks before finally being
sold to credit customers. These customers are allowed a maximum credit period of six weeks but pay after three
weeks in order to obtain a discount for prompt settlement.
What is the opening cash cycle of the business?
A 7 weeks
B 10 weeks
C 11 weeks
D 12 weeks
10 The forecast balance sheet of Charon plc for the forthcoming year is based on the following relationships:
Current ratio 2:1
Sales: current assets 5:1
Acid-test ratio 1·5:1

If sales for the coming year are expected to be £30 million, what is the value of stocks that will appear in
theforecast balance sheet?

A £1·5m
B £3·0m
C £4·5m
D £10·5m

11 Which one of the following equations describes the operating cash cycle?
A Average stock turnover period + average creditor payment period – average debt collection period
B Average stock turnover period + average debt collection period – average creditor payment period
C Average cash balance + average debt collection period – average creditor payment period
D Average cash balance – average debt collection period + average creditor payment period

12 Consider the following:

1. Altay Co has a current ratio of 1·5:1 and an operating cash cycle of 35 days and the company has decided to
increase the operating cash cycle by five days.

What will happen (increase/decrease) to the current ratio of Altay if these changes are made?
Current ratio of Altay Co
A Increase
B Increase
C No effect
D Decrease

13 Joe is supervisor of the Receivables Team at X Ltd. He has been told that he is responsible for
managing ‘credit risk’.
Identify which THREE of the following directly determine the level of credit risk to which X is
exposed.
A The total volume of sales
B The total volume of credit sales
C The time allowed to customers to pay
D Debt collection procedures
E Joe’s management style

14. Operational Gearing helps in analysis of:

(a) Business Risk,
(b) Financing Risk,
(c) Production Risk,
(d) Credit Risk

15. High degree of financial Gearing means:

(a) High debt proportion,
(b) Lower debt proportion,
(c) Equal debt and equity,
(d) No debt
16. Operational Gearing arises because of:
(a) Fixed Cost of Production,
(b) Fixed Interest Cost,
(c) Variable Cost,
(d) None of the above

17. Financial Gearing arises because of:

(a) Fixed cost of production,
(b) Variable Cost,
(c) Interest Cost,
(d) None of the above

18. Operational Gearing is calculated as:

(a) Contribution ÷ EBIT,
(b) EBIT÷PBT,
(c) EBIT ÷Interest,
(d) EBIT ÷Tax

19. Which combination is generally good for firms?

(a) High OG, High FG,
(b) Low OG, Low FG,
(c) High OG, Low FG,
(d) None of these
Question:
Required:
(a) Explain what is meant by overtrading, and discuss how it might be recognised in a company. (5
marks)

(b) One of Donac's managers has suggested that the company would be more efficient if it reduced its
operating cycle to the minimum possible period of time.
(i) Explain what is meant by the operating cycle of a company and calculate it for 20X1.
(6 marks)
(ii) Discuss how a company could try to reduce the operating cycle and whether it should always be
reduced to the minimum possible period. (4 marks)
(Total: 15 marks)
Operational and Financial Gearing
15 All else equal, an entity's sensitivity to swings in the business cycle is higher when:
A variable and fixed costs are roughly in the same proportion
B the firm has low operating leverage
C fixed costs are the highest portion of its expenses
D variable costs are the highest portion of its expenses