Ratio analysis -Task 3

Question 1

Kaplan exam kit mock
aurel Limited has been trading with Hardy Limited for several years and has, until recently,
always paid to terms. Laurel has contacted Hardy Limited to request an increase in their credit limit from £50,000 to £100,000. Laurel Limited has supplied the accounts below. The sales manager has reviewed the latest information provided by Laurel Limited and has made
the following comments:
1 The company turnover has increased by 19% from £5.38 million to £6.68 million. This is a strong sign of overtrading.
2 The operating profit has decreased from £950,000 to £860,000. This means that less cash is available to pay debts.
3 The current ratio should be 2 which means that the company is insolvent.
4 The trade receivables balance has increased by £310,000 which supports the conclusion of overtrading.
5 The trade payables are down from 94 days to 80 days implying the company is struggling to
get credit from its suppliers.
6 The inventory has increased by £50,000 which supports the conclusion of overtrading.
7 Gearing has decreased which means that the banks are not happy to lend money to the
business.
8 My conclusion is that credit should not be given
Write a brief note dealing with each comment that the sales manager has made.
Explain
your reasoning and conclude as to whether credit should be given.

Answer 1

The company turnover has increased by 19% from £5.38 million to £6.68 million. This is a
strong sign of overtrading.
* The revenue has increased but by 24% not 19%.
* This is not necessarily a strong sign of overtrading as many indicators have to be
considered to demonstrate overtrading – including reduced margins, increased
current assets, trade cycle days and cash flow.
The operating profit has decreased from £950,000 to £860,000. This means that less cash
is available to pay debts.
* This does not mean that less cash is available to pay debts. It all depends on where
the profit has gone for the period – has it been invested or tied up in inventory,
receivables or non-current assets?
* To consider the liquidity of a company, changes in assets and liabilities have to be
investigated.
* Profit has fallen as revenue has increased which indicates that revenue has been
chased at the detriment of profit. There is a decline in the gross profit margin which
may indicate some changes to production cost.
The current ratio should be 2 which means that the company is insolvent.
* This is a common misunderstanding. It is not possible to state that there is a perfect
ratio. All that can be said is that the higher the ratio is the better.
* The current ratio has increased and the company is not using its overdraft facility but
most of the cash is tied up in receivables. This may indicate a credit control issue.
The trade receivables balance has increased by £310,000 which supports the conclusion
of overtrading.
* The trade receivables balance has increased and the trade receivable collection
period has increased which supports that the company may have credit control
issues.
The trade payables are down from 94 days to 80 days implying the company is struggling
to get credit from its suppliers.
* The way this could be interpreted is that the company are taking less time to pay
their debts, which is a positive sign.
The inventory has increased by £50,000 which supports the conclusion of overtrading.
* Inventory levels need to increase to support increasing sales, but there has only been
a 9% increase in inventory compared to a 24% increase in sales.
Gearing has decreased which means that the banks are not happy to lend money to the
business.
* Gearing decreasing could be an indication that the company is less debt financed and
more equity financed. It is believed that equity finance is less risky as you do not
have to pay a dividend to the shareholders but you do have to pay interest on a loan.
My conclusion is that credit should be given.