Dylan Rhys wants to buy one of two cafes, each of which trades inside a community library in Cardiff, Wales. Both owners have given him the summary below fo...
Question 1 Report
Dylan Rhys wants to buy one of two cafes, each of which trades inside a community library in Cardiff, Wales. Both owners have given him the summary below for the year ended 31 March 2025. Trade payables are the only current liability of either cafe.
| Cwrt Cafe $ | Llan Cafe $ | |
|---|---|---|
| Revenue | 180,000 | 240,000 |
| Cost of sales | 108,000 | 168,000 |
| Operating expenses | 46,800 | 45,600 |
| Non-current assets | 55,000 | 90,000 |
| Inventory | 6,000 | 12,000 |
| Trade receivables | 4,500 | 9,600 |
| Bank | 9,500 | 2,400 |
| Trade payables | 10,000 | 20,000 |
| Loan repayable in 2031 | 15,000 | 30,000 |
| Capital | 50,000 | 64,000 |
Capital employed is capital plus the loan. Dylan has enough money to buy either cafe outright.
- Set out, side by side for the two cafes, five measures each: return on capital employed, profit for the year as a percentage of revenue, gross profit as a percentage of revenue, the current ratio and the liquid ratio. Percentages should carry two decimal places (20)
- Recommend which cafe Dylan should buy. Justify your recommendation using the ratios you have calculated (5)
Answer Details
The two cafes have identical gross profits of $72,000, which is the trap in the question. Llan needs $240,000 of revenue to earn that $72,000 while Cwrt needs only $180,000, and it takes $94,000 of capital to do it against Cwrt's $65,000. Ratios are the tool that exposes that difference, because absolute figures alone would suggest the larger business is the better one.
The figures each ratio needs.
| Cwrt Cafe $ | Llan Cafe $ | |
|---|---|---|
| Gross profit (revenue - cost of sales) | 180,000 - 108,000 = 72,000 | 240,000 - 168,000 = 72,000 |
| Profit for the year (gross profit - operating expenses) | 72,000 - 46,800 = 25,200 | 72,000 - 45,600 = 26,400 |
| Current assets (inventory + receivables + bank) | 6,000 + 4,500 + 9,500 = 20,000 | 12,000 + 9,600 + 2,400 = 24,000 |
| Current liabilities (trade payables only) | 10,000 | 20,000 |
| Capital employed (capital + loan) | 50,000 + 15,000 = 65,000 | 64,000 + 30,000 = 94,000 |
(a) The five measures, side by side [20]
| Ratio | Cwrt Cafe | Llan Cafe |
|---|---|---|
| Return on capital employed | 25,200 / 65,000 x 100 = 38.77% | 26,400 / 94,000 x 100 = 28.09% |
| Profit margin (profit for the year as a share of revenue) | 25,200 / 180,000 x 100 = 14.00% | 26,400 / 240,000 x 100 = 11.00% |
| Gross profit margin | 72,000 / 180,000 x 100 = 40.00% | 72,000 / 240,000 x 100 = 30.00% |
| Current ratio | 20,000 / 10,000 = 2.00:1 | 24,000 / 20,000 = 1.20:1 |
| Liquid ratio | (20,000 - 6,000) / 10,000 = 1.40:1 | (24,000 - 12,000) / 20,000 = 0.60:1 |
Two points of method. Capital employed is capital plus the loan, as the question directs, because the profit is struck before any return to the long term lender is separated out, so the capital measured must be all the long term finance. And the loan is not a current liability: it is repayable in 2031, so it stays out of both liquidity ratios.
(b) Recommendation [5]
Dylan should buy Cwrt Cafe. Every one of the five ratios favours it.
- Cwrt keeps 40.00% of each dollar of revenue as gross profit against Llan's 30.00%. Llan has to sell a third more to reach the same $72,000, which means either lower prices or higher food costs. That is a structural weakness in the way Llan trades, not a one off.
- Cwrt turns 14.00% of revenue into profit against Llan's 11.00%. Llan's expenses are actually slightly lower in dollars, at $45,600 against $46,800, so the whole difference comes from the weaker margin.
- Cwrt earns 38.77% on capital employed against 28.09%. This is the decisive figure for a buyer, because it answers the only question that matters to Dylan: how hard will my money work? Llan makes barely $1,200 more profit but needs $29,000 more capital to do it.
- Llan's liquid ratio of 0.60:1 is a warning. Stripping out inventory, Llan holds $12,000 of receivables and bank against $20,000 owed to suppliers. It cannot pay its trade payables without first selling inventory, and it has only $2,400 in the bank. Cwrt stands at 1.40:1 with $9,500 in the bank.
- Llan's only advantage is size. Revenue of $240,000 against $180,000 sounds impressive, but it has not converted into either profitability or safety. Buying revenue rather than return is the mistake this question is designed to test.
One qualification a full answer should note: these are one year's figures from the owners themselves, with no comparison to a previous year and no explanation of why Llan's margin is so much thinner. Before completing the purchase Dylan should ask whether Llan has cut prices to win business that could be re-priced, and whether Cwrt's premises are on a secure lease, since a single year's ratios cannot show either.
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