Business – 10.1 Financial statements – Statement of financial position | e-Consult
10.1 Financial statements – Statement of financial position (1 questions)
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Model Answer:
Impact on the statement of financial position:
- Inventory increase (£20,000): This raises current assets, specifically inventory, by £20,000. Total assets increase by the same amount.
- Long‑term loan (£50,000): This adds a non‑current liability of £50,000. Total liabilities increase, and consequently total equity (reserves & equity) remains unchanged, so total assets must increase by £50,000 to keep the balance sheet in equilibrium.
- Overall, the balance sheet expands: total assets rise by £70,000 (£20,000 + £50,000) and total liabilities rise by £50,000, leaving the equity portion unchanged.
Effect on ratios:
- Current ratio (Current assets ÷ Current liabilities):
- Before the change, assume current assets = C and current liabilities = L.
- After the inventory increase, current assets become C + £20,000 while current liabilities are unchanged.
- Therefore, the current ratio improves (increases) because the numerator is larger while the denominator is unchanged.
- Debt‑to‑equity ratio (Total liabilities ÷ Equity):
- Equity is unchanged.
- Total liabilities increase by the £50,000 long‑term loan.
- Thus the debt‑to‑equity ratio rises, indicating higher financial leverage.
In summary, the inventory addition strengthens short‑term liquidity (higher current ratio), whereas the new long‑term borrowing weakens the firm’s leverage position (higher debt‑to‑equity ratio).