The following are extracts of the Income Statement and Balance Sheet for Umar plc.
Extract Balance Sheet at 30 June
20X2 20X1
£'000 £'000 £'000 £'000
Current assets
Inventories 84 74
Trade receivables 58 46
Bank 6 10 148 130
Current liabilities
Trade payables 72 82
Taxation 20 20
92 102
Net current assets 56 -
Extract Income Statement for the year ended 30 June
20X2 20X1
£'000 £'000 £'000 £'000
Turnover 418 392
Opening inventory 74 58
Purchases 324 318
398 376
Closing inventory (84) (74)
104 314
302 90
Gross profit
Calculate and comment on the following ratios for Umar plc:
1 Current ratio
2 Quick ratio
3 Inventory days
4 Trade receivable days
5 Trade payable days
6 Working capital cycle in days
Solution:
1 Current ratio = 148 / 92 = 1.61 for 20X2
=130 / 102 = 1.27 for 20X1
Current ratio has increased, meaning that organisation is more liquid. This is because of the fact that inventory and trade receivables have increased (which are non-productive assets) and trade payables have been reduced. While this may be better for the current ratio, it may not necessarily mean that company is operating more efficiently. Has it increased its inventory piles since it anticipates higher sales and doesn't want to run out? Is it offering its credit customers longer time to pay to increase sales? Why are they paying their suppliers quicker? Certainly it would be better to take as long as possible?
2 Quick ratio = (148 -84) / 92 = 0.70 for 20X2
= (130 -74) / 102 = 0.55 for 20X1
In 20X2 current liabilities are better covered than 20X1. Bad management of working capital perhaps...investigate further.
3 Inventory days= (74 + 84) x 0.5 / 314 x 365 days = 91.8 days for 20X2
= (58 + 74) x 0.5 / 302 x 365 days = 79.8 days for 20X1
Inventory is taking longer to sell; this could indicate poor inventory management. Why have inventory levels risen? Maybe company is taking a cautious approach and wants to ensure enough is available to meet customer needs. Though this is resulting in additional costs (unproductive asset)
4 Trade receivable days = 58/ 418 x 365 days = 50.6 days for 20X2
= 46 / 392 x 365 days= 42.8 days for 20X1
The collection of debts is worsening. Have the credit terms been extended to increase sales. Are there new customers who weren't screened properly, resulting in delayed payments? Is there a delay in issuing invoices, lack of screening new customers? Are the yearend figures representatives of year? Perhaps there are seasonal fluctuations which need to be considered. Further investigation required as yet again this is an unproductive asset.
5 Trade payable days = 72 / 324 x 365 = 81.1 days for 20X2
= 82 / 318 x 365 = 94.1days for 20X1
(Alternatively could have used cost of sales)
Suppliers are being paid quicker, which is good for relationship with suppliers though bad for cash flow purposes. It is still quite high and might jeopardise supplier relationship, discounts foregone etc. Trade credit is a free source of finance and company should try to maximise this.
6 Working capital cycle
20X2 20X1
Inventories days 91.8 79.8
Plus
Trade receivables days 50.6 42.8
Minus
Trade payables days (81.1) (94.1)
Equals
Working capital cycle (in days) 61.3 28.5
In 20X2, working capital cycle increased to 61.3 days from 28.5 days in 20X1. Company is taking longer to covert its inventories into cash. Management of inventories, receivables and payables has deteriorated and this needs to be investigated and corrected.