- 20 Marks
FM – L2 – Q118 – Working Capital Management
Assess if AquaPure Ltd is overtrading using financial data and compute relevant ratios.
Question
AquaPure Ltd is a leading producer of mineral water in Zamora. The company sells all of its output to wholesalers on credit terms net 40. The company’s collection policy is somewhat relax, and so the receivables turnover days is currently 53 days. This fairly liberal credit policy has resulted in significant increases in sales revenue in recent years. However, the company has been facing cash flow problems as a significant number of customers take longer than the credit period to settle their accounts. The company typically falls on overdraft facilities from its bankers when it fails to generate adequate cash flows from operations to meet working capital requirements. The average cost of the overdraft facilities is 15% per annum.
Last week, the management team met and discussed the company’s cash flow and liquidity problems with a view to finding solutions to the problems. In that meeting, two proposals were offered to help solve the problems:
Proposal 1: Introduce early settlement discount of 1.5% on accounts that are settled within 10 days in which invoice is sent while the current credit period is maintained. It is estimated that 60% of accounts will be paid within the discount period.
Proposal 2: Switch from financing working capital requirements using the bank overdraft facilities at 15% interest to financing working capital requirements using supplier’s trade credit. Suppliers are willing to supply on credit terms 1/10, net 40. Proponents of the proposals believe that the implementation of their proposal will improve on the company’s financial situation.
Set out below are the company’s statement of profit or loss and statement of financial position for the past three years:
Statement of profit or loss for the year ended 31st December
| 20X5 (GH¢’000) | 20X6 (GH¢’000) | 20X7 (GH¢’000) | |
|---|---|---|---|
| Revenue | 40,000 | 60,000 | 122,000 |
| Cost of sales | (15,000) | (31,000) | (58,000) |
| Gross profit | 25,000 | 29,000 | 64,000 |
| Selling and administrative expenses | (11,000) | (17,500) | (24,000) |
| Operating profit | 14,000 | 11,500 | 40,000 |
Statement of financial position as at 31st December
| 20X5 (GH¢’000) | 20X6 (GH¢’000) | 20X7 (GH¢’000) | |
|---|---|---|---|
| Noncurrent assets: | |||
| Property, plant and equipment | 13,400 | 19,000 | 22,500 |
| Current assets: | |||
| Inventory | 8,000 | 15,500 | 25,500 |
| Trade receivables | 6,900 | 11,210 | 24,210 |
| Cash | 1,110 | – | – |
| Total current assets | 16,010 | 26,710 | 49,710 |
| Total assets | 29,410 | 45,710 | 72,210 |
| Equity: | |||
| Stated capital | 100 | 100 | 100 |
| Income surplus | 18,510 | 28,110 | 36,810 |
| Shareholders’ equity | 18,610 | 28,210 | 36,910 |
| Non-current liabilities: | |||
| Medium-term loan | 3,000 | 2,500 | 2,000 |
| Current liabilities: | |||
| Trade payables | 2,200 | 3,500 | 8,600 |
| Dividend payable | 5,600 | 6,400 | 7,500 |
| Bank overdraft | – | 5,100 | 17,200 |
| Total current liabilities | 7,800 | 15,000 | 33,300 |
| Total liabilities | 10,800 | 17,500 | 35,300 |
| Total equity and liabilities | 29,410 | 45,710 | 72,210 |
Required:
(a) Considering the background information and financial data provided above, would you conclude that AquaPure Ltd is experiencing overtrading? Explain with relevant computations.
(b) Appraise the proposal for early settlement discount (i.e. Proposal 1) and advise on whether it should be accepted for implementation or not. Your appraisal should focus on how the discount policy will influence the company’s profitability. Show all relevant computations.
(c) Appraise the proposal to switch from financing working capital needs using bank overdraft to using suppliers’ trade credit, and advise management accordingly. Show all relevant computations.
(d) Assuming AquaPure Ltd cannot raise additional funds from external sources such as borrowing and new share offer, suggest to management three steps they can take to ease the cash shortages the company is facing.
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