2) Financial analysis of customer accounts

Question 1

What do the liquidity indicators show?

Answer 1

These indicators show the ability of the business to repay short-term debt from liquid or semi-liquid assets, and also to turn over its current assets such as inventory and trade receivables.

Question 2

Current ratio

Answer 2

current assets / current liabilities

Question 3

Quick ratio or acid test ratio

Answer 3

current assets - inventory / current liabilities

Question 4

Accounts receivable collection period (days)

Answer 4

trade receivables x 365 / sales revenue

Question 5

Accounts payable payment period (days)

Answer 5

trade payables x 365 / cost of sales

Question 6

Inventory holding period (days)

Answer 6

inventory x 365 / cost of sales

Question 7

What do profitability indicators show?

Answer 7

These indicators show the ability of the business to generate profit which will enable it to repay its debts in the longer term.

Question 8

Gross profit margin

Answer 8

gross profit x 100 / sales revenue

Question 9

Operating profit margin

Answer 9

profit from operations x 100 / sales revenue

Question 10

Net profit margin

Answer 10

profit x 100 / sales revenue

Question 11

Interest cover

Answer 11

profit before interest and tax (PFO) / Interest

Question 12

Return on capital employed (ROCE)

Answer 12

profit from operations x 100 / capital employed (total equity + non-current liabilities)

Question 13

What does gearing ratio analyses?

Answer 13

Analyses the financial position of businesses in terms of the proportion of debt to capital. Gearing shows the extent to which the company is financed by debt.

Gearing = total debt x 100 / Total debt + equity

Question 14

What are the three main criteria used in credit assessment?

What question is asked for each criteria?

Answer 14

1) Liquidity: does the business have sufficient short-term resources to repay debt?
2) Profitability: does the business have the longer-term ability to generate cash to repay debt?
3) Gearing: how much debt is there already in relation to the capital resources of the company?

Question 15

What is the working capital?

Answer 15

Is the part of the net resources of the business that is made up of current assets minus current liabilities.

It is also known as “net assets”.

Question 16

What involves working capital?

What is the relation with credit control?

Answer 16

Working capital involves the circulation of the elements of inventory, receivables, cash, and payables, and the value of these elements will typically change on a daily basis.

Adequate credit control procedures must be in place to ensure that monies from receivables come into a business on a regular basis.

Question 17

What is the cash cycle?

Explain the relationship between the elements

Answer 17

The circulation of working capital can be illustrated by the cash cycle:

   Payables – Inventory – Receivables – Cash

Payables (or suppliers) provide goods for resale on credit in the form of inventory.

When the inventory is sold on credit, this generates an increase in the amount of receivables.

As the receivables pay the amounts owing to the business, this increases the cash balance of the business.

This means that cash is then available to pay the suppliers.

Question 18

How is the working capital cycle calculated?

Answer 18

Working capital cycle = inventory holding period + receivables collection period – payables payment period

Question 19

What is a credit rating system?

What does it mean a high or low score?

Answer 19

Credit rating is a system which gives a numerical value to the results of the performance indicators calculated and the total of these values then indicates the level of credit risk shown by the financial statements.

Normally a high score will indicate a low risk, and a low score a high risk.

Question 20

What is overtrading?

Answer 20

Overtrading is the situation where a business expands its level of sales and then finds it has a shortage of working capital and not enough cash available to support that increased level of sales.

Question 21

How does overtrading is recognised?

Answer 21

It is important for the credit controller to be able to recognise the signs of overtrading by a customer or a prospective customer. This is done by monitoring and analysing financial information and the key performance indicators.

Question 22

When can overtrading occur ?

Answer 22

Overtrading can occur when a business expands rapidly: increased sales requires more inventory and creates a higher level of receivables. The increased value of payables does not compensate for this and so the amount of cash is reduced.

Question 23

What may be the consequence of overtrading?

What are the warning signs of overtrading?

Answer 23

Overtrading can occur even if the business is profitable, and it can result in the business having to cease trading.

These are the usual warning signs:

1) Rapidly increasing sales without an increase in resources (new capital being introduced)
2) A reduction in the level of credit control, resulting in lengthening credit periods and trade receivables not paying on time, or at all
3) A consequent increase in irrecoverable debts
4) Cash balances reducing and the bank account going overdrawn on a regular or a permanent (“hard core”) basis
5) Suppliers not being paid on time
6) Profit margins falling

Question 24

What are the remedies for ovetrading?

Answer 24

1) Reducing sales levels to a manageable level
2) Managing the sales ledger accounts more effectively
3) Tightening credit control processes
4) Increasing resources through the introduction of fresh capital

Question 25

Which ones are the liquidity indicators?

Answer 25

1) Current ratio
2) Quick ratio or acid test ratio
3) Accounts receivable collection period (days)
4) Accounts payable payment period (days)
5) Inventory holding period (days)

Question 26

Which ones are the profitability indicators?

Answer 26

1) Gross profit margin
2) Operating profit margin
3) Net profit margin
4) Interest cover
5) Return on capital employed (ROCE)

Question 27

What does EBITDA stand for?

How is it calculated?

Answer 27

Earnings Before Interest, Tax, Depreciation and Amortisation

Is calculated by adding back the Interest, Tax, Depreciation and Amortisation deductions in the Statement of Profit or Loss to the bottom-line net income.

Question 28

What does EBITDA ratio show?

Answer 28

It gives an indication of the operational profitability of a business from its day to day normal trading activities, ignoring finance costs, tax and depreciation.

It is a very broad indication of the company’s ability to generate cash from operations. It represents its “cash profits”.