Interpreting a Company's Results Before a Loan Application
Tshwaro Ltd applies for a bank loan. Extracts for the year: revenue P2,400,000; cost of sales P1,560,000; operating expenses P540,000; interest P60,000; tax P60,000. Current assets: inventory P420,000, receivables P360,000, cash P40,000. Current liabilities P600,000, of which bank overdraft P150,000. Non-current liabilities P500,000; equity P700,000. Last year the current ratio was 1.8:1 and inventory turnover was 5 times. This year inventory holding has lengthened and receivables days have risen from 45 to 60. The bank requires a current ratio of at least 1.5:1 and gearing below 45%.
1. Calculate gross profit margin, operating profit margin, the current ratio and gearing, and assess whether Tshwaro Ltd meets the bank's conditions.
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Gross profit = 2,400,000 - 1,560,000 = P840,000. Gross margin = 840,000 / 2,400,000 = 35.0%. Operating profit = 840,000 - 540,000 = P300,000. Operating margin = 300,000 / 2,400,000 = 12.5%. Profit before tax = 300,000 - 60,000 = P240,000. Profit after tax = P180,000.
Current ratio = current assets / current liabilities = (420,000 + 360,000 + 40,000) / 600,000 = 820,000 / 600,000 = 1.37:1. This is below the 1.5:1 covenant and below last year's 1.8:1.
Gearing: debt / (debt + equity) = 500,000 / (500,000 + 700,000) = 41.7%. This meets the below-45% condition, but only narrowly. If the overdraft is treated as debt, gearing = 650,000 / 1,350,000 = 48.1%, which breaches the covenant - the definition matters and should be clarified with the bank.
Conclusion: the liquidity covenant fails on the current ratio, and gearing is borderline depending on definition. The loan should not be recommended without corrective action.
2. Explain what the movements in inventory turnover and receivables days reveal, and quantify the cash tied up.
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Inventory turnover = cost of sales / inventory = 1,560,000 / 420,000 = 3.71 times, down from 5 times. Inventory days = 420,000 / 1,560,000 x 365 = 98 days, versus about 73 days at 5 times. Slower turnover means cash is locked in stock and there is a greater risk of obsolescence.
Receivables days = 360,000 / 2,400,000 x 365 = 54.75 days on a 365-day basis, or 54 days on 360 days. The question states a rise from 45 to 60; using the stated 60 days, receivables at 60 days would be 2,400,000 x 60/365 = P394,521, so the P360,000 balance suggests the stated figure is approximate or calculated on a different basis. Either way, the direction is clear: customers are paying more slowly, so more cash is tied up and bad-debt risk rises.
The combination explains the weak current ratio despite a healthy gross margin: profit is being converted into inventory and receivables rather than cash. The bank will see a profitable business with a cash-conversion problem, which is a classic overtrading signal.
3. Recommend three actions to improve the position before resubmitting the application, and explain the risk of each.
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Tighten credit control: introduce discounts for early payment, credit checks and firm follow-up. Reducing receivables days from 60 to 45 would release roughly 2,400,000 x 15/365 = P98,630 of cash. Risk: aggressive chasing may lose customers, and offering discounts reduces gross margin.
Reduce inventory: cut slow-moving lines and order more frequently. Reducing inventory days from about 98 to 75 would release approximately 1,560,000 x 23/365 = P98,300. Risk: stock-outs could lose sales, and clearance discounting would hit margin.
Restructure the overdraft into a term loan or inject equity. Converting the P150,000 overdraft to long-term debt improves the current ratio to (820,000)/(450,000) = 1.82:1, comfortably above the covenant. Risk: it raises gearing and interest cost, and on the debt/(debt+equity) definition gearing would rise to 650,000/1,350,000 = 48.1%, breaching the other covenant. Injecting equity avoids that but dilutes existing shareholders.
The overall message: the company is profitable but poorly liquid. Fixing working capital, not borrowing more, is the priority; a loan used to fund further slow-moving stock would worsen the problem.