Reading the Signals: A Ratio Analysis That Tells Two Stories
You are analysing the draft financial statements of Meridian Retail Ltd for the year ended 31 December 20X4, ahead of a bank covenant review. Extracts:
| 20X4 | 20X3 | |
|---|---|---|
| Revenue | £4,800,000 | £4,000,000 |
| Gross profit | £1,200,000 | £1,120,000 |
| Operating profit | £360,000 | £400,000 |
| Inventories | £720,000 | £480,000 |
| Trade receivables | £960,000 | £600,000 |
| Trade payables | £540,000 | £500,000 |
| Current assets | £1,900,000 | £1,300,000 |
| Current liabilities | £1,000,000 | £750,000 |
The bank covenant requires a current ratio of at least 1.5 and gearing (debt/equity) no higher than 60%. The finance director has told the board that 'the current ratio has improved, so the covenant is comfortably met'.
1. Calculate the gross margin, operating margin, current ratio, quick ratio and the working capital ratios (inventory days, receivable days, payable days) for both years.
Read the worked answer
Margins:
- Gross margin: 20X4 £1,200/£4,800 = 25.0%; 20X3 £1,120/£4,000 = 28.0% (down 3 pts)
- Operating margin: 20X4 £360/£4,800 = 7.5%; 20X3 £400/£4,000 = 10.0% (down 2.5 pts)
Liquidity:
- Current ratio: 20X4 £1,900/£1,000 = 1.90; 20X3 £1,300/£750 = 1.73 (improved)
- Quick ratio: 20X4 (£1,900 − £720)/£1,000 = 1.18; 20X3 (£1,300 − £480)/£750 = 1.09 (improved)
Working capital (using 365 days):
- Inventory days: 20X4 720/3,600 × 365 = 73 days; 20X3 480/2,880 × 365 = 61 days
- Receivable days: 20X4 960/4,800 × 365 = 73 days; 20X3 600/4,000 × 365 = 55 days
- Payable days: 20X4 540/3,600 × 365 = 55 days; 20X3 500/2,880 × 365 = 63 days
(Cost of sales = revenue − gross profit: 20X4 £3,600k; 20X3 £2,880k.)
2. Evaluate the finance director's claim that the covenant is comfortably met, and explain the risk the ratios reveal.
Read the worked answer
Evaluate the FD's claim:
- The current ratio has improved to 1.90, above the 1.5 covenant - so on the face of it the FD is right.
- But the improvement is driven almost entirely by inventory (+£240k) and receivables (+£360k) - i.e. by working capital building up, not by cash generation. The quick ratio (1.18 vs 1.09) improved only modestly, confirming the cushion is largely inventory.
The risk the ratios reveal:
- Inventory days rose 61 → 73 - stock is turning more slowly. Possible obsolescence, over-ordering or slowing demand. Inventory is the least liquid current asset and may not be worth book value.
- Receivable days rose 55 → 73 - customers are taking nearly three weeks longer to pay. This ties up cash and raises the risk of bad debts. A £960k receivables balance against £4.8m revenue is a significant exposure.
- Payable days fell 63 → 55 - the company is paying suppliers faster while collecting slower, a double squeeze on cash.
- Margins are falling (gross 28% → 25%; operating 10% → 7.5%) - the growth in revenue (£4.0m → £4.8m, +20%) has been bought with lower margins and looser credit terms. Revenue is up but operating profit is down.
Conclusion: The covenant may be met on the current ratio today, but the quality of the current assets is deteriorating. If inventory is written down or receivables prove uncollectible, the current ratio could fall sharply. The FD's reassurance is complacent - the ratios tell a story of growth funded by working capital and margin erosion, not of improving financial health. Recommend a receivables review, inventory ageing analysis, and a cash flow forecast before the covenant review.