Interpreting a 'record year' at Tumas Hardware Ltd
Tumas Hardware Ltd runs builders' merchant outlets in Malta. The 2024 accounts show the following extracts.
| €'000 | 2024 | 2023 |
|---|---|---|
| Revenue | 1,200 | 1,000 |
| Gross profit | 240 | 250 |
| Operating profit | 96 | 85 |
| Finance cost | 24 | 10 |
| Inventory | 180 | 100 |
| Trade receivables | 260 | 150 |
| Cash | 10 | 45 |
| Trade payables | 150 | 120 |
| Bank overdraft | 175 | 40 |
| Long-term loan | 300 | 100 |
| Share capital and reserves | 250 | 220 |
During 2024 the company opened a second outlet and won a national housebuilder as a customer on 60-day terms; that customer now provides 35% of revenue. Inventory was deliberately built up because of expected supply delays. The overdraft is repayable on demand. The long-term loan was increased in March 2024 to fund the new outlet and carries interest at 8%. The directors' report calls 2024 'a record year' because revenue passed €1 million for the first time.
1. Calculate, for both years, the gross profit percentage, operating profit percentage, return on capital employed, current ratio, gearing, interest cover and the cash operating cycle.
Read the worked answer
Capital employed is taken as share capital and reserves plus the long-term loan. The cash operating cycle is receivable days plus inventory days less payable days, using 365 days and closing figures.
| Ratio | 2024 | 2023 |
|---|---|---|
| Gross profit % (GP/Revenue) | 240/1,200 = 20.0% | 250/1,000 = 25.0% |
| Operating profit % | 96/1,200 = 8.0% | 85/1,000 = 8.5% |
| ROCE (operating profit/capital employed) | 96/550 = 17.5% | 85/320 = 26.6% |
| Current ratio | 450/325 = 1.38 | 295/160 = 1.84 |
| Gearing (loan/equity) | 300/250 = 120% | 100/220 = 45% |
| Interest cover | 96/24 = 4.0 times | 85/10 = 8.5 times |
| Receivable days | 260/1,200 x 365 = 79 days | 150/1,000 x 365 = 55 days |
| Inventory days | 180/960 x 365 = 68 days | 100/750 x 365 = 49 days |
| Payable days | 150/960 x 365 = 57 days | 120/750 x 365 = 58 days |
| Cash operating cycle | 79 + 68 - 57 = 90 days | 55 + 49 - 58 = 46 days |
Working: current assets 2024 = 180 + 260 + 10 = 450; current liabilities = 150 + 175 = 325. For 2023: 295 and 160. Cost of sales = revenue less gross profit, i.e. 960 and 750.
2. Evaluate the directors' claim that 2024 was 'a record year'. Identify the two most serious risks revealed by the figures.
Read the worked answer
Revenue is a record, but almost every measure of quality and profitability has deteriorated.
- Margin. Gross margin fell five points, from 25.0% to 20.0%. Revenue rose €200,000 but gross profit actually fell €10,000. The extra turnover was bought, most likely with discounts to win the national housebuilder. On the 2023 margin, €1,200,000 of revenue would have produced €300,000 of gross profit; the company gave away €60,000 of margin to get there.
- Returns. ROCE fell from 26.6% to 17.5%. Capital employed rose 72% (€320,000 to €550,000) while operating profit rose only 13%. The new outlet is not yet earning its keep.
- Bottom line. Despite record revenue, profit before tax fell from €75,000 to €72,000, because the finance cost more than doubled.
- Risk. Interest cover has halved to 4.0 times, and gearing has risen from 45% to 120%. A fall in operating profit of about 75% would wipe out cover entirely.
- Liquidity. The current ratio fell from 1.84 to 1.38 and the quick ratio from 1.22 to 0.83, so current liabilities now exceed the assets that can quickly turn into cash. The operating cycle has lengthened from 46 to 90 days, driven by 79 receivable days against 60-day terms and a speculative inventory build.
The two most serious risks are:
- Customer concentration and credit risk. One customer provides 35% of revenue and is taking 79 days to pay against 60-day terms. If that customer fails or delays, roughly €260,000 of receivables and a third of turnover are exposed.
- Funding and refinancing risk. A €175,000 overdraft repayable on demand is financing inventory and receivables that turn over every 90 days. The bank can call it at any time, and the company has no cash buffer (€10,000).
The word 'record' describes turnover only; on profit, returns and liquidity the year was worse than 2023.
3. The company has asked its bank to increase the overdraft to €250,000. Advise the bank, setting out the conditions you would attach and the information you would require.
Read the worked answer
Assessment. The request is understandable but the trend is against the company. The overdraft has already risen from €40,000 to €175,000 in one year, and the extra borrowing would be funding a working capital cycle that has doubled in length rather than a proven expansion. Gearing at 120% and interest cover of 4.0 times leave limited room for a bad year.
What the bank should require before agreeing:
- A cash flow forecast for the next twelve months, month by month, showing how and when the overdraft will be reduced.
- Aged receivable and payable listings, with the housebuilder's payment record and its latest accounts, since a third of turnover and most of the receivables depend on it.
- A breakdown of the inventory build, distinguishing stock that will sell from obsolete lines.
- Management accounts for the second outlet to show whether it is approaching break-even.
- Confirmation that the 60-day terms are being enforced and a plan to bring receivable days back towards 60.
Conditions likely to be attached:
- A lower peak limit with a scheduled reduction, for example €250,000 falling to €150,000 over twelve months.
- A secured charge over inventory and receivables, or a personal guarantee.
- A covenant on minimum interest cover or maximum gearing, tested quarterly.
- No further dividends or capital spending without consent.
- A requirement to reduce reliance on the single housebuilder or to insure the receivable.
Conclusion. Subject to the forecasts and security, a time-limited increase is defensible: the company is profitable at the operating level and is not insolvent. An open-ended increase without covenants would simply fund a lengthening cash cycle, and the bank would be taking the risk that the housebuilder's payment behaviour creates.