Rapid growth, stretched working capital and rising gearing at a listed food processor
Serendib Foods PLC processes snack foods. Extracts from its financial statements (Rs '000):
| 2023 | 2024 | |
|---|---|---|
| Revenue | 12,000 | 15,600 |
| Gross profit | 3,600 | 4,212 |
| Profit before tax | 1,200 | 1,170 |
| Finance cost | 120 | 390 |
| Inventories | 1,800 | 3,120 |
| Trade receivables | 2,000 | 3,900 |
| Trade payables | 1,200 | 2,340 |
| Total assets | 9,000 | 13,500 |
| Equity | 4,500 | 4,950 |
| Non-current liabilities (bank loans) | 2,000 | 4,500 |
Current assets were Rs 4,300,000 in 2023 and Rs 7,350,000 in 2024; current liabilities were Rs 1,900,000 and Rs 3,200,000. All sales and purchases are on credit.
The finance director told shareholders that the 30% rise in revenue proves the expansion strategy is working and that the company is 'in the strongest position in its history'. A minority shareholder has written to the board asking why, if that is true, the company has had to double its bank borrowings and why profit before tax actually fell.
1. Calculate for both years: gross profit margin, profit before tax margin, inventory holding period, receivable collection period, payable payment period and the working capital cycle.
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Cost of sales = 12,000 − 3,600 = 8,400 (2023); 15,600 − 4,212 = 11,388 (2024).
| Ratio | 2023 | 2024 |
|---|---|---|
| Gross profit margin | 3,600/12,000 = 30.0% | 4,212/15,600 = 27.0% |
| Profit before tax margin | 1,200/12,000 = 10.0% | 1,170/15,600 = 7.5% |
| Inventory days (closing inventory/COS x 365) | 78 days | 100 days |
| Receivable days (receivables/revenue x 365) | 61 days | 91 days |
| Payable days (payables/COS x 365) | 52 days | 75 days |
| Working capital cycle | 78 + 61 − 52 = 87 days | 100 + 91 − 75 = 116 days |
Workings for 2024: inventory 3,120/11,388 x 365 = 100.0; receivables 3,900/15,600 x 365 = 91.3; payables 2,340/11,388 x 365 = 75.0.
The cycle has lengthened by 29 days: every extra day of growth now needs more cash tied up in stock and debtors.
2. Assess the finance director's claim using liquidity, gearing and interest cover as well as the ratios above.
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| Ratio | 2023 | 2024 |
|---|---|---|
| Current ratio | 4,300/1,900 = 2.26 | 7,350/3,200 = 2.30 |
| Quick ratio | (4,300−1,800)/1,900 = 1.32 | (7,350−3,120)/3,200 = 1.32 |
| Gearing (debt/equity) | 2,000/4,500 = 44% | 4,500/4,950 = 91% |
| Interest cover (PBIT/finance cost) | 1,320/120 = 11.0 times | 1,560/390 = 4.0 times |
| Return on capital employed | 1,320/6,500 = 20.3% | 1,560/9,450 = 16.5% |
Assessment. The headline current and quick ratios barely move (2.26 to 2.30 and 1.32 to 1.32), which is exactly the trap. That apparent stability comes from piling inventory and receivables onto the balance sheet while relying on the bank and on stretched suppliers to fund them. The underlying quality of liquidity has deteriorated:
- The working capital cycle has gone from 87 to 116 days, so growth is absorbing cash rather than generating it.
- The quick ratio of 1.32 is only maintained because receivables rose 95% - and those receivables are now 91 days old, so their realisable value is doubtful.
- Gearing has doubled to 91% and interest cover has fallen from 11 times to 4 times. A further fall in PBIT of about 75% would still be covered, but the trend is clearly downwards.
- Margins and ROCE have fallen, so the extra capital is earning less than the capital already in the business.
The finance director is describing revenue growth, not financial strength. The shareholder is right to ask questions: sales grew 30% but profit before tax fell, and the company is financing debtors and stock with borrowed money.
3. Recommend three actions the board should take, and explain one limitation of this analysis.
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Recommendations
- Tighten credit control. Impose credit limits, invoice immediately, charge interest on overdue accounts and stop supplies to slow payers. Reducing receivable days from 91 back to 61 would release roughly 30/365 x 15,600 ≈ Rs 1,282,000 - enough to repay a large part of the new loan.
- Review inventory. 100 days of stock in a snack-food business is far too long; shorten product ranges and link production to orders. Cutting stock days back to 78 would free about Rs 670,000.
- Rebuild the margin and reduce dependence on debt. Investigate why gross margin fell 3 points (discounting to win volume, input price rises, wastage) and slow the expansion until it can be funded from retained profit or a share issue rather than bank borrowings. Negotiating longer credit from suppliers is only a stopgap - payable days have already stretched from 52 to 75 and further delay risks supply.
Limitation. Ratio analysis uses year-end figures, which may not represent the year (receivables at the year end may be unusually high or low), and it is based on historical cost data distorted by inflation. It also says nothing about cash: profit of Rs 1,170,000 says nothing about whether the company can meet next month's payroll, which is why a statement of cash flows is needed to confirm the picture - here the rise in inventory and receivables strongly suggests operating cash flow is negative.