Interpreting a Deteriorating Liquidity Position
You are drafting the accounts of Halverston Trading Ltd for the year ended 31 March. Extracts (£000):
| Year 2 | Year 1 | |
|---|---|---|
| Revenue | 4,800 | 4,200 |
| Gross profit | 1,152 | 1,092 |
| Operating profit | 384 | 420 |
| Inventories | 720 | 480 |
| Trade receivables | 960 | 700 |
| Cash | 60 | 150 |
| Trade payables | 640 | 520 |
| Bank overdraft | 380 | 120 |
| Long-term loan | 900 | 900 |
The finance director says the 20% fall in operating profit is 'just a margin issue' and that the overdraft is a timing matter. The bank has asked for a commentary on working capital before renewing the facility.
1. Calculate the operating cycle and the cash operating cycle for both years (use year-end balances and a 365-day year) and explain what has driven the change.
Read the worked answer
Formulae: Inventory days = inventory/revenue × 365 (or /COS); receivable days = receivables/revenue × 365; payable days = payables/COS × 365. Use COS = revenue − gross profit: Year 2 £3,648; Year 1 £3,108.
| Year 2 | Year 1 | |
|---|---|---|
| Inventory days (on COS) | 720/3,648×365 = 72.0 | 480/3,108×365 = 56.4 |
| Receivable days | 960/4,800×365 = 73.0 | 700/4,200×365 = 60.8 |
| Operating cycle | 145.0 | 117.2 |
| Payable days | 640/3,648×365 = 64.0 | 520/3,108×365 = 61.1 |
| Cash operating cycle | 81.0 days | 56.1 days |
Interpretation: the cycle has lengthened by ~25 days. Inventory days rose 15.6 days - stock is building faster than sales, consistent with obsolete or slow-moving lines and a real risk of write-down. Receivable days rose 12.2 days, suggesting looser credit control or weaker customers. Payables only stretched 2.9 days, so suppliers are not financing the gap. The business is funding ~25 extra days of working capital from the overdraft. Note the gross margin fell from 26.0% to 24.0% while revenue grew 14.3% - growth is being bought with margin and working capital, not efficiency. The FD's 'timing' framing is not supported: the deterioration is structural and repeats each month the cycle stays at 81 days.
2. Assess the liquidity position using at least two ratios and advise the bank on what conditions, if any, to attach to renewal.
Read the worked answer
Current ratio: Year 2 current assets (720+960+60) = £1,740 vs current liabilities (640+380) = £1,020 → 1.71. Year 1: (480+700+150)=£1,330 vs (520+120)=£640 → 2.08.
Quick (acid test) ratio: Year 2 (960+60)/1,020 = 1.00. Year 1 (700+150)/640 = 1.33.
Cash ratio: Year 2 60/1,020 = 0.06. Year 1 150/640 = 0.23.
Commentary: headline current ratio still looks acceptable, but it is flattered by £720k of inventory that takes 72 days to convert. The quick ratio has fallen to 1.00 and cash cover is effectively nil - the overdraft is now permanent working capital, not a seasonal swing. Operating cash generation is weak: operating profit £384k against a £460k increase in inventory plus receivables (£260k + £200k = £500k gross, less £120k payables increase = £380k absorbed), so the business is consuming cash while reporting profit.
Recommendation to the bank: renew but on conditions - (1) a covenant requiring the cash operating cycle to fall below 65 days within two quarters; (2) an inventory ageing report and a board-approved stock provisioning review; (3) monthly receivables ageing with a cap on debt over 90 days; (4) a reduced facility limit with a clear amortisation path, or a term loan converting part of the overdraft to match the permanent working capital need. Declining outright is not warranted while the quick ratio is 1.00 and the loan is serviced, but an unconditional renewal would reward deterioration.