Cambridge IGCSE and O Level Business Studies Section 5 Financial information and decisions

Exam-style case study 5b answers

The answers have been written by the authors and aim to provide a summary of appropriate content for answering each question.
However, the suggestions provided are not intended to be a definitive guide to all acceptable answers; each response should
be assessed on its own merits. Marking guidance for case study questions has been provided in the answers document for
case study 1a. This can be used as a basis for marking this case study. Please note, the way marks are awarded may differ in
examination to the guidance provided in this resource.

Case study 5b: Phacto Engineering (PE)

Question 1a Explain two disadvantages to PE of using an overdraft.

Possible Relevant points

answers could • repayable on demand
include: • repayable within a year
• security may be required
• interest payable

Sample explanation

Interest is payable, which increases the expenses and cash outflows. This is an issue at a time when
having cash-flow problems. Interest must be paid, otherwise the lender has the right to cancel the overdraft
immediately and the business could struggle to pay its other creditors as well.

Question 1b Explain how the following three profitability ratios can be used to assess PE’s profitability. Which ratio do
you think is most useful? Justify your answer.

Possible Gross profit margin • 2016 (100 ÷ 300) × 100 = 33.3%

answers could • 2017 (150 ÷ 420) × 100 = 35.7%
include: • improved indicating the margin has increased

Profit margin • 2016 13.3%

• 2017 (50 ÷ 420) × 100 = 11.9%
• ratio has decreased which shows less able to control its expenses

Return on capital • 2016 20%

employed (ROCE) • 2017 (50 ÷ 220) × 100 = 22.72%
• ratio improved so business used its resources better to generate profit

Conclusion • ratios look at different elements of profitability

• ROCE shows amount of profit for each dollar invested – shows how efficiently capital
is used – this is very important to managers as provides an overview of business
operations so profitability can be said to have improved

Question 2a Explain the purpose of two financial statements produced by PE’s accountant, Suraiya. Calculate the profit
margin and return on capital employed (ROCE) for 2017. Compare your two ratio results with those of 2016 in
Appendix 1.

Possible Relevant points

answers could • Profit margin = (50 ÷ 420) × 100 = 11.9%
include: • ROCE = (50 ÷ 220) × 100 = 22.72%

© Cambridge University Press 2018 Exam-style case study answers – 5b

 Cambridge IGCSE and O Level Business Studies Section 5 Financial information and decisions

Sample explanation

Profit margin – ratio has decreased, which shows less able to control its expenses. ROCE improved, so
business used its resources better to generate profit.

Question 2b Explain how the following three stakeholders might use PE’s accounts. Which stakeholder do you think is
likely to find the accounts most useful? Justify your answer.

Possible Government • want to know level of profits which has increased by $10 000 – pay more tax
answers could • how secure are the 50 full-time jobs in community or expansion? – implications for
include: government policies

Lenders • ability to repay capital/interest when borrowing $50 000 for new equipment – so use
liquidity ratios/acid test ratio
• able to pay interest on time as often needed to use its overdraft – liquidity ratio and cash
flow

Suppliers • how secure is their money – as trade receivables is high – profitability ratio
• want to know if business is able to pay for inventory on time as takes more than 30 days
for some of PE’s customers to pay and cash balance ($10 000) last month – so do they
have sufficient cash to pay them – liquidity ratio and cash flow
• owed money so keen to see size of other debts of business and what security
exists – assess risk of default

Conclusion • government will be able to obtain helpful information about objectives and how business is
doing, but key information such as taxation can also be obtained through other methods
• suppliers will be interested in ability to pay – so cash flow and reputation could be useful
rather than ratios
• lenders, like suppliers, are likely to find information helpful as likely to lend larger sums of
money for projects so on this basis could find information more helpful as risk greater

Question 3a Explain two sources of finance PE could use for the new machinery.

Possible Relevant points

answers could • retained profit
include: • leasing
• bank loan

Sample explanation

Leasing. Then the brothers do not have to borrow money at a time when cash flow is negative. This means
they can use their money for other uses, such as exporting. The sales from this could be used to generate
revenue which can then cover the cost of leasing.

Question 3b State the advantages and disadvantages of the following three methods that PE could use to improve its
cash-flow position. Which method should PE choose? Justify your answer.

Possible Buy lower level of • reduce cash outflow below ($10 000)
answers could inventory • could be n problem as may not be able to meet orders so may not be feasible to export
include: products to Country Y

Ask suppliers for • delays cash outflow – allows time for customers to pay as some take more than 30 days
more time to pay • damage relations with suppliers – less willing to supply parts in future

© Cambridge University Press 2018 Exam-style case study answers – 5b

 Cambridge IGCSE and O Level Business Studies Section 5 Financial information and decisions

Increase prices • increase revenue and improve financial position as increases cash inflow
• risk of being less competitive with other component producers – could lose customers
to competitors

Conclusion • identified inventory as issue – so area to address but need to ensure have sufficient so
not delay production which would impact on cash inflow
• suppliers may not be willing to offer more time so may depend on credit history – will
delay cash outflow but may not solve underlying problem
• increasing prices will increase cash inflow but offering customer 30 days to pay may
not see benefit immediately and higher prices could discourage sales, lowering inflow
which will not improve cash flow

Question 4a Explain two reasons why managing cash flow is important to PE.

Possible Relevant points

answers could • cash flow needed to pay day-to-day expenses
include: • business could fail due to lack of cash
• reduces need for finance
• able to predict/plan for cash-flow problems
• helps a business get a loan

Sample explanation

Business could fail due to lack of cash so it is important to be able to anticipate potential cash-flow issues,
such as the problems caused by trade receivables. This will allow the brothers time to find an appropriate
solution to ensure their otherwise profitable business does not fail.

Question 4b Explain how the following two changes might affect PE’s choice of finance for the new equipment. Which
change do you think is likely to have the most effect? Justify your answer.

Possible Large order from Country Y • order can support ability to pay – which can improve chance of loan being
answers could for its products given (or at a lower interest rate) as seen as lower risk
include: • large order could remove need to borrow from bank
• payment for order could be delayed so could influence source – as delay
could put pressure on cash flow and interest payments may be difficult to
manage

Interest rates increase by • increase cost of borrowing – higher repayments if use loans to purchase the
5% in Country X additional machinery – negative impact on expenses and cash flow
• loans become more expensive and internal sources such as retained profit
may have to be considered
• higher interest could increase the value of any cash reserves but as balance
is negative throughout the six months – this is unlikely to be significant
factor

Conclusion • order can help support application or may be sufficient to change the type
of finance used
• interest rates will only affect external sources such as loans, which is a
fixed cost, and as they need $50 000 its impact is likely to be significant

© Cambridge University Press 2018 Exam-style case study answers – 5b