Subject: Advanced Diploma of Accounting
Part A – Written or Oral Questions
1. a. What is the financial risk? (1 mark)
Financial risk can be referred to the possibility that shareholders or relevant business stakeholders may face monetary loss when investing in a debt-ridden company and cash flow of the organisation fails to meet the financial obligations (Melicher, Norton and Town, 2015).
b. What factors may affect the type and extent of an organisation’s exposure to financial risks? (3 marks)
There are several factors that may influence the types and exposure of an organisation to financial risks such as the relationship with the creditors and debtors, the financial health of the debtors, changes in the market factors, natural calamities, and changes in the share market rate (Melicher, Norton and Town, 2015). The natural calamities and relationship with the debtors may lead to liquidity risk for the firm, on the other hand, relationship with the creditors and the financial bank may lead to credit risks. However, the changes in the market factors and share market stability may lead to market risks.
c. List and describe THREE possible financial risks an organisation may face. (9 marks)
The three possible financial risks that a company may face are a market risk, credit risk, and liquidity risk as described below:
Market Risk: Market risk can be identified as a type of financial risk that involves the risk of changing the market environment in which a business organisation In the current scenario, online shopping tendency of consumers can be produced as an example of market risk due to which the revenue growth of a business may experience a negative impact (Melicher, Norton and Town, 2015).
Credit Risk: Credit risk is another type of financial risk that incurs by extending credit to relevant stakeholders such as customers. Credit risk may also signify own credit risk with suppliers of an organisation. Due to such risk, the financial burden of a firm may incur.
Liquidity Risk: Liquidity risk can be addressed as the risk related to asset liquidity and operations funding-oriented liquidity risk. In such a risk scenario, a company may find itself in a position in which the firm does not have enough reserve cash to fund the regular operations and expenses. Hence, cash flow management is crucial to avoid such risk.
2. a. What is liquidity risk? (1 marks)
Liquidity risk is a financial risk that an organization may be incapable to meet financial demands for a short-term phase. In such a risk scenario, a business organization does not have the cash flow to maintain regular operations (Venkat and Baird, 2016).
b. List and explain ONE method you may use to measure the organization’s exposure to liquidity risk. (3 marks)
The liquidity risks of a firm can be measured using the liquidity gap analysis, which focuses on evaluating the firm’s ability to meet the volatile liability by using its liquid assets (Venkat and Baird, 2016). The gap can be measured by using various liquidity analysis ratios such as liquidity ratio that presents the comparison of the firm’s current assets and current liabilities.
c. Describe ONE method you may use to manage the liquidity risk. (4 marks)
In order to manage and reduce liquidity risk of a company, cash flow forecasting can be termed as one of the most effective methods to be taken into consideration. The method involves continuous monitoring of the expected cash flow of a business organization and making a comparison of the stated cash flows against the yearly operating budget of the firm (Schönborn, 2010). By comparing cash flows with the budget, irregularities and variances can be determined so that corrective measures can be taken to avoid liquidity scenario of the firm.
3. List and describe THREE ratios you may use to determine effects on liquidity. (9 marks)
The three ratios that can be used to measure the liquidity of firms are presented in details herein below:
Current ratio: The current ratio is the most reliable and highly used measurement for the liquidity of a firm (Venkat and Baird, 2016). It indicates the organization’s ability to pay its current liabilities by using its current assets. The formula of the current ratio is presented herein below:
Acid test Ratio: The second ratio that is used to evaluate the liquidity is known as the acid ratio or quick ratio, which helps to identify the ability of the firm to convert its liquid assets into cash (Venkat and Baird, 2016). It is important to note that acid ratio calculations do not consider the stock in hand because it takes time to convert the stock into liquid cash. The formula of the acid ratio is presented herein below:
Cash Ratio: The third ratio is known as cash ratio that evaluates the ability of the firm to meets its short-term debts using cash and cash equivalents such as cash in hand and cash at bank (Venkat and Baird, 2016). The formula of cash ratio is presented herein below:
Melicher, R., Norton, E. and Town, L. (2015). Finance. 4th ed. Hoboken, NJ: Wiley.
Schönborn, J. (2010). Financial Risk Management. 3rd ed. Hamburg: Diplomica Verlag.
Venkat, S. and Baird, S. (2016). Liquidity risk management. 4th ed. Hoboken, New Jersey: John Wiley & Sons, Inc.
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