Question 3.SE.2: Amsterdam Ltd and Berlin Ltd are both engaged in wholesaling...
Amsterdam Ltd and Berlin Ltd are both engaged in wholesaling, but they seem to take a different approach to it according to the following information:
| Ratio | Amsterdam Ltd | Berlin Ltd |
| Return on capital employed (ROCE) | 20% | 17% |
| Return on ordinary shareholders’ funds (ROSF) | 30% | 18% |
| Average settlement period for trade receivables | 63 days | 21 days |
| Average settlement period for trade payables | 50 days | 45 days |
| Gross profit margin | 40% | 15% |
| Operating profit margin | 10% | 10% |
| Average inventories turnover period | 52 days | 25 days |
Required:
Describe what this information indicates about the differences in approach between the two businesses. If one of them prides itself on personal service and one of them on competitive prices, which do you think is which and why?
Amsterdam Ltd and Berlin Ltd
The ratios for Amsterdam Ltd and Berlin Ltd reveal that the trade receivables settlement ratio for Amsterdam Ltd is three times that for Berlin Ltd. Berlin Ltd is therefore much quicker in collecting amounts outstanding from customers. There is not much difference, however, between the two businesses in the time taken to pay trade payables.
It is interesting to compare the difference in the trade receivables and payables settlement periods for each business. As Amsterdam Ltd allows an average of 63 days’ credit to its customers, yet pays suppliers within 50 days, it will require greater investment in working capital than Berlin Ltd, which allows an average of only 21 days to its customers but takes 45 days to pay its suppliers.
Amsterdam Ltd has a much higher gross profit margin than Berlin Ltd. However, the operating profit margin for the two businesses is identical. This suggests that Amsterdam Ltd has much higher overheads (as a percentage of sales revenue) than Berlin Ltd. The inventories turnover period for Amsterdam Ltd is more than twice that of Berlin Ltd. This may be due to the fact that Amsterdam Ltd maintains a wider range of inventories in an attempt to meet customer requirements. The evidence therefore suggests that Amsterdam Ltd is the one that prides itself on personal service. The higher average settlement period for trade receivables is consistent with a more relaxed attitude to credit collection (thereby maintaining customer goodwill) and the high overheads are consistent with incurring the additional costs of satisfying customers’ requirements. Amsterdam Ltd’s high inventories levels are consistent with maintaining a wide range of inventories, with the aim of satisfying a range of customer needs.
Berlin Ltd has the characteristics of a more price-competitive business. Its gross profit margin is much lower than that of Amsterdam Ltd; that is, a much lower gross profit for each £1 of sales revenue. However, overheads have been kept low, the effect being that the operating profit margin is the same as Amsterdam Ltd’s. The low inventories turnover period and average settlement period for trade receivables are consistent with a business that wishes to minimise investment in current assets, thereby reducing costs.