The Shop That Grew Too Fast
Nadia's stationery shop has the following summarised figures:
| Year 1 | Year 2 | |
|---|---|---|
| Revenue | 180,000 | 300,000 |
| Gross profit | 54,000 | 78,000 |
| Profit for the year | 14,400 | 12,000 |
| Inventory | 22,000 | 58,000 |
| Trade receivables | 15,000 | 60,000 |
| Trade payables | 18,000 | 24,000 |
| Bank | 9,000 (Dr) | 6,000 (Cr) |
Nadia is baffled: sales are up 67% but profit has fallen. She has not changed her selling prices or her mark-up policy. She asks whether she should simply raise prices to restore profit.
1. Calculate the gross margin and mark-up for each year and comment on what they reveal.
Read the worked answer
Gross margin = gross profit ÷ revenue
- Year 1: 54,000 ÷ 180,000 = 30.0%
- Year 2: 78,000 ÷ 300,000 = 26.0%
Mark-up = gross profit ÷ cost of sales
- Year 1: 54,000 ÷ 126,000 = 42.9%
- Year 2: 78,000 ÷ 222,000 = 35.1%
Nadia says her pricing policy is unchanged, so the fall in margin must come from cost of sales rising faster than revenue - higher purchase prices, more shrinkage/wastage, or discounting that she has not acknowledged. A 4-percentage-point fall in gross margin on $300,000 of revenue costs about $12,000 of gross profit. This is the first place to investigate, before raising prices.
2. Calculate the inventory turnover period and receivables collection period for each year, and assess the liquidity position.
Read the worked answer
Inventory turnover = inventory ÷ cost of sales × 365
- Year 1: 22,000 ÷ 126,000 × 365 = 63.7 days
- Year 2: 58,000 ÷ 222,000 × 365 = 95.4 days
Receivables collection = receivables ÷ revenue × 365
- Year 1: 15,000 ÷ 180,000 × 365 = 30.4 days
- Year 2: 60,000 ÷ 300,000 × 365 = 73.0 days
Payables payment = payables ÷ cost of sales × 365
- Year 1: 18,000 ÷ 126,000 × 365 = 52.1 days
- Year 2: 24,000 ÷ 222,000 × 365 = 39.5 days
Assessment: cash is trapped. Inventory now sits for 95 days and customers take 73 days to pay, while suppliers are paid in 40 days. Nadia is financing nearly a month and a half of extra stock and over two months of unpaid customer bills out of her own pocket - hence the $6,000 overdraft. The working capital cycle has stretched from about 42 days to about 129 days. The business is profitable at gross level but is overtrading.
3. Advise Nadia on whether raising prices is the right response, and recommend two alternative actions.
Read the worked answer
Raising prices is the wrong first move. The problem is not weak revenue - revenue grew 67%. The problem is that gross margin fell (costs rose) and that cash is locked in stock and receivables. Raising prices would likely reduce volume and worsen the cash position without fixing the causes.
Recommended actions:
Tighten credit control. Introduce credit limits, invoice promptly, and offer a small discount for early payment. Cutting the collection period from 73 days back towards 30 days would release roughly $35,000 of cash (43 days × $300,000/365 ≈ $35,300) - more than enough to clear the overdraft.
Review stock. Inventory at 95 days suggests over-ordering or slow-moving lines. Identify obsolete stock, reduce reorder quantities, and target a return to about 64 days, releasing around $19,000.
She should also investigate why cost of sales rose - supplier price increases or theft - before adjusting selling prices, and negotiate longer supplier credit, since paying in 40 days while customers take 73 is the opposite of what the cash cycle needs.