Profit growth versus liquidity at Blue Lagoon Catering
Blue Lagoon Catering Ltd operates a chain of cafés. The bank is considering a €500,000 five-year loan for a second outlet. The directors point to profit before tax rising from €118,000 in 2023 to €210,000 in 2024 and to revenue growth of 18.6% to €1.85m. The 2024 profit includes a €130,000 gain on the sale and leaseback of the company's only freehold kitchen; rent has risen by €70,000 a year as a result. Gross margin fell from 34% to 28%, inventory days rose from 45 to 78, receivable days from 38 to 62, and payable days from 30 to 55. The current ratio fell from 1.8 to 1.1 and the quick ratio from 0.9 to 0.4. The bank overdraft increased from €90,000 to €410,000 and dividends of €60,000 were paid. Interest cover is 2.1 times, compared with 4.5 times in 2023. The company has no overdraft facility headroom and the freehold property was its only uncharged asset.
1. Calculate the cash operating cycle for both years and explain what the change suggests about working capital management.
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Cash operating cycle = inventory days + receivable days − payable days.
2023: 45 + 38 − 30 = 53 days. 2024: 78 + 62 − 55 = 85 days.
The cycle has lengthened by 32 days. The company is holding stock for 33 more days and collecting from customers 24 days more slowly, while paying suppliers 25 days more slowly. The payable extension masks part of the deterioration, but it is not a sustainable source of finance: suppliers may withdraw credit, demand cash on delivery or charge interest.
Using 2024 cost of sales of €1,332,000 (72% × €1.85m), one day of the cycle ties up about €3,649, so the 32-day deterioration absorbs roughly €116,800 of cash. That is consistent with the overdraft rising from €90,000 to €410,000. Management should investigate slow-moving stock, tighten credit control and stop relying on late payment to suppliers.
2. Assess the quality and sustainability of the 2024 profit improvement, distinguishing one-off gains from trading performance.
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Reported profit before tax rose by €92,000, but €130,000 of the 2024 figure is a one-off gain on the sale and leaseback of the freehold kitchen. Removing it gives underlying profit before tax of €80,000, which is €38,000 lower than 2023 - a fall of about 32%. Trading performance has therefore deteriorated, not improved.
Revenue grew by 18.6%, but gross profit fell from €530,400 (34% of €1.56m) to €518,000 (28% of €1.85m). The margin fall is partly explained by the €70,000 increase in rent, which is now a permanent cost. Interest cover has fallen from 4.5 to 2.1, so more profit is being absorbed by finance costs. The sale and leaseback also removed the company's only unencumbered asset and replaced ownership with a fixed rent obligation.
The quality of earnings is poor: the improvement is non-recurring, while the costs it created are recurring. A bank should not extrapolate the 2024 profit figure when assessing the loan application.
3. Advise the bank on whether to grant the loan and what conditions or additional information it should require.
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Recommendation
Do not grant the loan on the present information, or grant only a reduced amount with strict conditions. The company has weak liquidity (current ratio 1.1, quick ratio 0.4), a €410,000 overdraft with no headroom, interest cover of 2.1 and no unencumbered asset for security. Profit is flattered by a one-off gain, and underlying trading profit has fallen.
Conditions if the bank decides to support the business
- A material equity injection from the directors.
- A revised business plan and a 12-month cash flow forecast for the second outlet.
- Covenants covering minimum current ratio, minimum interest cover and a ban on dividends until the loan is reduced.
- No further borrowing without the bank's consent, and assignment of the lease or a personal guarantee.
- Monthly management accounts plus aged receivable and inventory reports.
Additional information needed
Aged analyses of receivables and inventory; the lease terms and rent review clauses; the reasons for the inventory and receivable build-up; whether year-end balances were window-dressed, for example by temporarily reducing stock or chasing debtors just before 31 December; and a statement of cash flows. The bank should also ask whether the €60,000 dividend was paid out of the one-off gain while the overdraft was rising.