A Bank Deciding on an Overdraft
Fola Adebimpe has run a household goods shop for six years and now wants a ₦4,000,000 overdraft to fund stock for a second outlet. He gives the bank the following summary.
Year to 31 December 2024: revenue ₦24,000,000; cost of sales ₦16,800,000; profit before tax ₦1,440,000; inventory ₦3,200,000; trade receivables ₦2,600,000; trade payables ₦2,100,000; current assets ₦6,300,000; current liabilities ₦2,900,000; long-term loan ₦4,000,000; equity ₦5,600,000. Inventory and receivables at 1 January 2024 were ₦2,100,000 and ₦1,900,000.
Year to 31 December 2023: revenue ₦20,000,000; gross profit ₦6,800,000; profit before tax ₦1,600,000; inventory ₦2,100,000; receivables ₦1,900,000.
Sales are 60% cash and 40% on credit. Fola expects sales to rise 25% with the new outlet and says the overdraft will be repaid from the extra sales.
1. Compute the gross margin, net margin, inventory days, receivables days, current ratio, quick ratio and gearing for 2024, with 2023 comparatives where the data allows.
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| Ratio | 2024 | 2023 |
|---|---|---|
| Gross margin | 7,200,000/24,000,000 = 30.0% | 6,800,000/20,000,000 = 34.0% |
| Net margin | 1,440,000/24,000,000 = 6.0% | 1,600,000/20,000,000 = 8.0% |
| Inventory days | 3,200,000/16,800,000 × 365 = 69.5 days | 2,100,000/13,200,000 × 365 = 58.1 days |
| Receivables days | 2,600,000/9,600,000 × 365 = 98.8 days | 1,900,000/8,000,000 × 365 = 86.7 days |
| Current ratio | 6,300,000/2,900,000 = 2.17:1 | not available |
| Quick ratio | (6,300,000 − 3,200,000)/2,900,000 = 1.07:1 | not available |
| Gearing | 4,000,000/(4,000,000 + 5,600,000) = 41.7% | not available |
The critical technical point is the receivables denominator: only credit sales of 40% × ₦24,000,000 = ₦9,600,000 (2023: ₦8,000,000) turn into receivables. Using total revenue gives 39.5 days and 34.7 days and makes collection look three times faster than it is. Inventory days likewise use cost of sales, not revenue.
2. Interpret the trend and advise the bank on whether to grant the overdraft.
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The growth is being bought, not earned. Revenue rose 20% but gross margin fell four points (34% to 30%), so gross profit rose only 5.9% and profit before tax fell 10% to ₦1,440,000. Discounting or a shift to cheaper, lower-margin lines is paying for the volume.
Working capital is absorbing the cash. Inventory days up 11.4 days and receivables days up 12.1 days together mean roughly ₦0.7m more stock and ₦0.4m more debtors than the old ratios would have required at the new sales level. Adding stock for a second outlet on top of an already slower cycle is precisely the use of funds that turns an overdraft into a permanent loan.
Liquidity looks adequate but is thin in quality. Current ratio 2.17:1 is comfortable only because inventory is nearly half of current assets; the quick ratio of 1.07:1 shows the shop is genuinely liquid but with almost no buffer. Gearing of 41.7% is moderate, though the overdraft is not yet in the figures and would push it higher.
Recommendation: do not decline outright, but do not grant an unsecured ₦4,000,000 either. Offer a smaller limit or a staged facility, conditional on: monthly management accounts and a 13-week cash flow; an aged receivables and inventory report; a covenant to bring receivables days back under 75 and inventory days under 60; a personal guarantee and a fixed charge; and evidence that the margin has stabilised. Fola's assumption that extra sales repay the overdraft is unsupported while margins fall and collection slows.
3. State the limitations of this analysis and the additional information you would request.
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Limitations
- Single-year balance sheet data for 2023 means the current, quick and gearing ratios have no trend; a point-in-time ratio can be distorted by year-end window dressing (stock held back, cheques delayed).
- Year-end figures may not represent the year - a retailer's stock and receivables peak before Christmas and fall in January, so days computed at 31 December can be flattering or harsh depending on the trade.
- Ratios are unadjusted: no allowance for obsolete stock, doubtful debts or the overdraft itself, and there is no cash flow statement, which is the statement that matters for a repayment decision.
- There are no industry benchmarks; 30% gross margin may be strong or weak for household goods. The second outlet has no trading history at all, so its projected 25% uplift is an assumption, not data.
- No payables days for 2023, so we cannot see whether supplier credit is being stretched to fund the stock build.
Request: cash flow statement and bank statements for 24 months; aged receivables and inventory listing; details of the ₦4,000,000 long-term loan (rate, covenants, repayment profile); drawings; capital commitments for the new outlet; supplier terms; and the projected profit and cash flow for the new outlet with the assumptions behind them.