Meenakshi Stores: A Better Gross Profit Ratio and a Worse Operating Cycle
Meenakshi Stores has supplied the following figures to its bank for an overdraft review. Year ended 31 March 2023: revenue from operations ₹30,00,000, gross profit ratio 20%, opening inventory ₹2,00,000, closing inventory ₹2,80,000, average trade receivables ₹2,50,000, average trade payables ₹3,10,000, purchases ₹24,80,000. Year ended 31 March 2024: revenue from operations ₹24,00,000, gross profit ratio 25%, opening inventory ₹2,80,000, closing inventory ₹3,60,000, average trade receivables ₹3,00,000, average trade payables ₹2,00,000, purchases ₹18,80,000. The proprietor argues that performance has improved, because the gross profit ratio has risen by five percentage points while the gross profit amount is unchanged at ₹6,00,000 in both years. The bank has nevertheless reduced the overdraft limit, saying the account has become 'slower'. The firm sells only on credit to wholesalers.
1. Compute the gross profit ratio, inventory turnover, receivables turnover, payables turnover and the operating cycle in days for both years.
Read the worked answer
Cost of goods sold: 2023 = 30,00,000 × 80% = ₹24,00,000; 2024 = 24,00,000 × 75% = ₹18,00,000.
| Ratio | 2022-23 | 2023-24 |
|---|---|---|
| Gross profit ratio (GP/Revenue) | 20% | 25% |
| Average inventory | ₹2,40,000 | ₹3,20,000 |
| Inventory turnover (COGS/Avg stock) | 10.0 times | 5.63 times |
| Inventory holding days | 37 | 65 |
| Receivables turnover (Revenue/Avg debtors) | 12.0 times | 8.0 times |
| Collection days | 30 | 46 |
| Payables turnover (Purchases/Avg creditors) | 8.0 times | 9.4 times |
| Payment days | 46 | 39 |
| Operating cycle (stock + debtors − creditors) | 21 days | 72 days |
Days are computed as 365 ÷ turnover; e.g. 2024 inventory days = 3,20,000 ÷ 18,00,000 × 365 = 64.9. The cycle has lengthened by about 51 days even though the gross profit ratio improved - the two facts are not in conflict, they measure different things.
2. Reconcile the proprietor's claim with the bank's view, and quantify the working capital that has been locked up.
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Both parties are right about different questions. The proprietor is measuring profitability per rupee of sales; the bank is measuring cash conversion. Gross profit is indeed ₹6,00,000 in both years, but it now takes 72 days of trading to earn it instead of 21.
Why: the firm raised its margin to 25%, sales volume fell from ₹30,00,000 to ₹24,00,000, and stock in hand rose from ₹2,80,000 to ₹3,60,000 - slower-moving, higher-margin goods. Debtors also slowed from 30 to 46 days, so each sale is collected later.
Working capital blocked:
| 2022-23 ₹ | 2023-24 ₹ | |
|---|---|---|
| Inventory + receivables | 5,30,000 | 6,60,000 |
| Less: trade payables | 3,10,000 | 2,00,000 |
| Net working capital | 2,20,000 | 4,60,000 |
The increase of ₹2,40,000 has to be financed, and since profit has not grown at all, it must be financed by the bank. The tighter overdraft is a rational response: an extra ₹2,40,000 of borrowing is now supporting the same ₹6,00,000 of gross profit, so the return on the bank's money has fallen sharply.
3. The bank asks for one improvement before restoring the limit. If receivables are brought back to 30 days, what happens to the operating cycle and to the cash position? Which single measure should the bank watch monthly, and what is the main limitation of your cycle calculation?
Read the worked answer
If collection returns to 30 days: receivables would be 24,00,000 × 30/365 = ₹1,97,260 instead of ₹3,00,000, releasing about ₹1,02,700 of cash. The cycle becomes 65 + 30 − 39 = 56 days, an improvement of 16 days but still far worse than the 21 days of 2022-23, because inventory of 65 days remains the real drag. Cutting stock to 40 days would release 25 days of COGS, roughly ₹1,23,000, and would matter more than chasing debtors harder.
What the bank should watch: the operating cycle in days, not the gross profit ratio. A rising margin on a lengthening cycle is precisely the pattern that precedes a liquidity crisis; the margin tells the bank how much is earned per sale, the cycle tells it when the cash arrives.
Limitations to disclose: the calculation assumes purchases and sales are evenly spread through the year, uses 365 days, and relies on average balances that may not represent a seasonal business; the bank overdraft itself is excluded from creditors, which flatters payment days. A monthly watch on inventory days alone would be a simpler and more robust early warning.