Kumbali Hardware: Profit Without Cash
Kumbali Hardware Supplies made a net profit of MK4.2 million last year on sales of MK38 million, yet the owner spent most of December negotiating a higher bank overdraft. Stock sits in the yard for 95 days on average before it is sold, and trade customers take 45 days to pay. Suppliers are paid in 20 days because they offer a 3 per cent discount for early settlement. The overdraft stands at MK6.5 million and costs 28 per cent interest a year. The business also pays MK1.8 million a year to rent a second yard holding slow-moving cement and roofing sheets bought two years ago at prices nobody will now pay. Sales are steady, but the largest customer, a building contractor, has asked to extend credit from 45 to 75 days in exchange for a 20 per cent increase in order volume.
1. Explain, using the figures, how Kumbali can be profitable and still need a larger overdraft.
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Profit is measured over a period; cash is a matter of timing. The cash operating cycle here is stock days plus receivable days minus payable days: 95 + 45 − 20 = 120 days. Every kwacha spent on stock takes about four months to return as cash. On sales of MK38 million, roughly 38m × 120/365 ≈ MK12.5 million is tied up in working capital at any moment. The MK6.5 million overdraft is therefore financing the gap between paying suppliers quickly and being paid slowly, not covering trading losses.
The supplier discount deserves a proper test rather than the assumption that early payment drains cash. Giving up the discount would mean paying 3 per cent more for 25 extra days of credit, an annualised cost of about 3% × 365/25 ≈ 44 per cent - far above the 28 per cent overdraft. Taking the discount is rational; the problem lies in stock and receivables, not payables.
The second yard is the clearest leak. Cement and roofing sheets bought two years ago have converted cash into stock that will not sell at cost, while the overdraft costs 28 per cent, about MK1.82 million a year in interest alone, plus MK1.8 million in rent. The profit and loss account looks healthy while the balance sheet is stuffed with slow stock and unpaid invoices. The remedy is working capital management, not more sales.
2. Evaluate the contractor's request to extend credit from 45 to 75 days in return for 20 per cent more volume.
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The relevant comparison is the extra financing cost against the extra contribution, not against net profit margin, because fixed costs do not change.
Assume, for illustration, that the contractor accounts for MK9.5 million of the MK38 million (25 per cent). A 20 per cent increase adds MK1.9 million of sales, taking the contractor to MK11.4 million. Current receivables from the contractor are about 9.5m × 45/365 ≈ MK1.17 million. At 75 days they become 11.4m × 75/365 ≈ MK2.34 million, so an extra MK1.17 million is financed at 28 per cent, costing about MK328,000 a year.
The extra sales must therefore earn a contribution margin of at least 328,000 ÷ 1,900,000 ≈ 17.3 per cent to break even. The firm's net margin of 11 per cent is not the right benchmark because it absorbs fixed costs; the gross margin on hardware is normally well above 17.3 per cent, so the deal probably pays. Note that the answer must be recalculated with the contractor's actual share of sales - the conclusion is sensitive to it.
Conditions matter as much as the arithmetic. The contractor is already the largest customer, so a 20 per cent increase worsens concentration risk: if it fails, Kumbali carries both the lost sales and the unpaid balance. Accept in stages - 60 days now, 75 after three clean cycles - with a credit limit, written terms, interest on overdue amounts and monthly statements. Also anticipate that other trade customers will hear of the new terms.
3. Recommend two actions to improve Kumbali's cash position, stating the trade-off the owner accepts with each.
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Action 1: liquidate and stop repeating the slow stock. Sell the cement and roofing sheets at whatever the market will pay, even below cost, stop reordering those lines, and give notice on the second yard, saving MK1.8 million a year in rent. Trade-off: selling below cost crystallises a loss and may upset customers who bought the same items at full price, and giving up the yard reduces the range and the appearance of being a large supplier. Against that, holding stock that will not move while paying 28 per cent interest is a certain loss, and the space saved is worth more than the stock.
Action 2: cut stock days from 95 towards 60 and tighten credit control. Reduce the number of product lines, order more frequently in smaller quantities, and set a credit limit per customer with statements at day 30 and a stop on supply at day 50. Trade-off: a narrower range may send some customers to a competitor who stocks everything, and strict credit control may cost the goodwill of long-standing trade customers. The owner can mitigate both by keeping fast-moving lines deep and slow lines to order only, and by telephoning large debtors before stopping supply rather than issuing a formal demand.
A supporting measure is to keep taking the supplier discount and fund it from the overdraft, since 44 per cent is far more expensive than 28 per cent. Success should be measured by the cash operating cycle falling from 120 days and the overdraft falling below MK6.5 million without sales collapsing.