Ruhunu Hardware: Growth Without Profit
Ruhunu Hardware is a sole trader's building-materials shop. Mr Weerasinghe supplies the following extracts.
| Year to 31 Dec 2024 (LKR) | Year to 31 Dec 2025 (LKR) | |
|---|---|---|
| Revenue | 8,000,000 | 9,600,000 |
| Cost of sales | 5,600,000 | 7,200,000 |
| Expenses (excluding cost of sales) | 1,600,000 | 1,760,000 |
| Inventory at 31 December | 700,000 | 1,200,000 |
| Trade receivables at 31 December | 900,000 | 1,500,000 |
| Purchases during the year | not given | 7,700,000 |
Mr Weerasinghe says: 'Sales are up 20% and I have kept expenses almost flat, so this must have been my best year.' He has recently begun allowing three large contractors 60 days' credit to win their orders, and a supplier has offered him 3% off any invoice paid within 10 days. He takes drawings of LKR 600,000 a year and has no long-term borrowing.
1. Calculate gross profit margin, mark-up, net profit margin, inventory turnover (on average inventory) and receivables collection period for both years, and present them side by side.
Read the worked answer
| Ratio | 2024 | 2025 |
|---|---|---|
| Gross profit (LKR) | 2,400,000 | 2,400,000 |
| Gross profit margin | 2,400,000/8,000,000 = 30.0% | 2,400,000/9,600,000 = 25.0% |
| Mark-up on cost | 2,400,000/5,600,000 = 42.9% | 2,400,000/7,200,000 = 33.3% |
| Net profit (LKR) | 800,000 | 640,000 |
| Net profit margin | 800,000/8,000,000 = 10.0% | 640,000/9,600,000 = 6.67% |
| Average inventory (LKR) | 700,000 (closing only) | (700,000 + 1,200,000)/2 = 950,000 |
| Inventory turnover | 5,600,000/700,000 = 8.0 times | 7,200,000/950,000 = 7.58 times |
| Inventory holding period | 365/8 = 45.6 days | 365/7.58 = 48.1 days |
| Receivables collection period | 900,000/8,000,000 × 365 = 41.1 days | 1,500,000/9,600,000 × 365 = 57.0 days |
Reasoning note: inventory turnover must use average inventory for 2025 because opening stock (LKR 700,000) is available; the 2025 closing stock reconciles with purchases: 700,000 + 7,700,000 − 7,200,000 = 1,200,000, confirming the cost of sales figure. Collection period uses year-end receivables against the year's revenue.
2. Evaluate Mr Weerasinghe's claim that 2025 was his best year. Support your answer with at least three figures and explain the most likely cause of the change.
Read the worked answer
The claim is wrong on profit. Revenue rose 20% (8.0m to 9.6m) but cost of sales rose 28.6% (5.6m to 7.2m), so gross profit was unchanged at LKR 2,400,000. Because fixed and other expenses rose by LKR 160,000, net profit fell from LKR 800,000 to LKR 640,000 - a 20% fall. Net margin dropped from 10.0% to 6.67%.
What the extra sales were worth. Had the 30% gross margin been held, gross profit on LKR 9,600,000 would have been LKR 2,880,000. The business therefore gave away about LKR 480,000 of gross profit to gain LKR 1,600,000 of extra revenue - a very poor trade. Expenses were indeed controlled (up only 10% against 20% sales growth), so the whole problem sits above the gross profit line.
Likely cause: the three contractors were won by discounting and by 60-day credit, shifting sales towards a lower-margin, slower-paying customer group; mark-up fell from 42.9% to 33.3%, which is consistent with price concessions or with supplier cost increases not being passed on.
Working capital evidence. Receivables rose from 41 to 57 days, tying up roughly 16 × (9,600,000/365) ≈ LKR 421,000 of extra cash, while inventory rose from 45.6 to 48.1 days and stock value rose by LKR 500,000. Growth has consumed cash as well as margin.
Conclusion: 2025 was a year of growth in turnover but deterioration in profitability and cash generation; 2024 was the better year.
3. Recommend two decisions Mr Weerasinghe should take, using the figures, and explain how each affects profit or cash.
Read the worked answer
Decision 1 – Re-price the contractor business. The contractor orders are the likely source of the margin fall. He should either restore prices towards the 30% margin on new orders, or keep the low price only where it produces repeat volume that covers the fixed costs. A useful test: at 25% margin each LKR 1,000,000 of sales earns LKR 250,000 gross profit; at 30% it earns LKR 300,000, so at least 20% more volume is needed before the discount is worthwhile, and volume growth has already tied up stock and receivables. Recovering even 3 percentage points of margin on LKR 9,600,000 is worth about LKR 288,000 of gross profit.
Decision 2 – Tighten credit and take the supplier discount. Cut contractor credit from 60 days towards 30–40 days, invoice promptly and charge interest on overdue accounts. Returning to 41 days would release roughly LKR 421,000 of cash. In parallel, compare the 3% settlement discount (LKR 30,000 saved per LKR 1,000,000 of purchases, i.e. about LKR 231,000 a year on purchases of LKR 7,700,000) with the cost of the finance needed to pay early; at an overdraft rate well below 3% for 20 days' early payment, the discount is clearly worth taking. Cash released from debtors can fund it.
Caution: drawings of LKR 600,000 exceed the year's net profit of LKR 640,000 only marginally after the cash tied up in stock and debtors, so drawings should not be increased until collection improves.