Question 6.S-TQ.1: Helsim Ltd is a wholesaler and distributor of electrical com...
Helsim Ltd is a wholesaler and distributor of electrical components. The most recent draft financial statements of the business revealed the following:
| Income statement for the year | ||
| £m | £m | |
| Sales revenue | 14.2 | |
| Opening inventories | 3.2 | |
| Purchases | \underline{8.4} | |
| 11.6 | ||
| Closing inventories | \underline{(3.8)} | \underline{(7.8)} |
| Gross profit | 6.4 | |
| Administration expenses | (3.0) | |
| Distribution expenses | \underline{(2.1)} | |
| Operating profit | 1.3 | |
| Finance costs | \underline{(0.8)} | |
| Profit before taxation | 0.5 | |
| Tax | \underline{(0.2)} | |
| Profit for the period | \underline{0.3} | |
| Statement of financial position as at the end of the year | ||
| £m | ||
| ASSETS | ||
| Non-current assets | ||
| Property, plant and equipment | ||
| Land and buildings | 3.8 | |
| Equipment | 0.9 | |
| Motor vehicles | \underline{0.5} | |
| \underline{5.2} | ||
| Current assets | ||
| Inventories | 3.8 | |
| Trade receivables | 3.6 | |
| Cash at bank | \underline{0.1} | |
| \underline{7.5} | ||
| Total assets | \underline{12.7} | |
| £m | ||
| EQUITY AND LIABILITIES | ||
| Equity | ||
| Share capital | 2.0 | |
| Retained earnings | \underline{1.8} | |
| \underline{3.8} | ||
| Non-current liabilities | ||
| Loan notes (secured on property) | \underline{3.5} | |
| Current liabilities | ||
| Trade payables | 1.8 | |
| Short-term borrowings | \underline{3.6} | |
| \underline{5.4} | ||
| Total equity and liabilities | \underline{12.7} | |
Notes
- Land and buildings are shown at their current market value. Equipment and motor vehicles are shown at their written-down values (that is, cost less accumulated depreciation).
- No dividends have been paid to ordinary shareholders for the past three years.
In recent months, trade payables have been pressing for payment. The managing director has therefore decided to reduce the level of trade payables to an average of 40 days out-standing. To achieve this, he has decided to approach the bank with a view to increasing the overdraft (the short-term borrowings comprise only a bank overdraft). The business is currently paying 10 per cent a year interest on the overdraft.
Required:
- (a) Comment on the liquidity position of the business.
- (b) Calculate the amount of finance required to reduce trade payables, from the level shown on the statement of financial position, to an average of 40 days outstanding.
- (c) State, with reasons, how you consider the bank would react to the proposal to grant an additional overdraft facility.
- (d) Identify four sources of finance (internal or external, but excluding a bank overdraft) that may be suitable to finance the reduction in trade payables, and state, with rea-sons, which of these you consider the most appropriate.
Helsim Ltd
(a) The liquidity position may be assessed by using the liquidity ratios discussed in Chapter 3:
Current ratio = \frac{Current assets}{Current liabilities} =\frac{ £7.5m}{£5.4m} = 1.4
Acid test ratio = \frac{Current assets (excluding inventories)}{Current liabilities} = \frac{£3.7m}{£5.4m }= 0.7
These ratios reveal a fairly weak liquidity position. The current ratio seems quite low and the acid test ratio very low. This latter ratio suggests that the business does not have sufficient liquid assets to meet its maturing obligations. It would, however, be useful to have details of the liquidity ratios of similar businesses in the same industry in order to make a more informed judgement. The bank overdraft represents 67% of the current liabilities and 40% of the total liabilities of the business. The continuing support of the bank is therefore important to the ability of the business to meet its commitments.
(b) The finance required to reduce trade payables to an average of 40 days outstanding is calculated as follows:
| £m | ||
| Trade payables at the date of the statement of financial position | 1.8 | |
| Trade payables outstanding based on 40 days’ credit (40/365 × £8.4m (that is, credit purchases)) |
\underline{(0.92)} | |
| Finance required | \underline{0.88} (say £0.9m) | |
(c) The bank may not wish to provide further finance to the business. The increase in over-draft will reduce the level of trade payables but will increase the risk exposure of the bank. The additional finance invested by the bank will not generate further funds (it will not increase profit) and will not therefore be self-liquidating. The question does not make it clear whether the business has sufficient security to offer the bank for the increase in overdraft facility. The profits of the business will be reduced and the interest cover ratio, based on the profits generated last year, would reduce to about 1.6* times if the additional overdraft were granted (based on interest charged at 10% each year). This is very low and means that only a small decline in profits would leave interest charges uncovered.
* Existing bank overdraft (3.6) + extension of overdraft to cover reduction in trade payables (0.9) + loan notes (3.5) = £8.0m. Assuming a 10% interest rate means a yearly interest payment of £0.8m. The operating profit was £1.3m. Interest cover would be 1.63 (that is, 1.3/0.8).
(d) A number of possible sources of finance might be considered. Four possible sources are as follows:
● Issue ordinary (equity) shares. This option may be unattractive to investors. The return on equity is fairly low at 7.9% (that is, profit for the year (0.3)/equity (3.8)) and there is no evidence that the profitability of the business will improve. If profits remain at their current level the effect of issuing more equity will be to reduce further the returns to equity.
● Make other borrowings. This option may also prove unattractive to investors. The effect of making further borrowings will have a similar effect to that of increasing the overdraft. The profits of the business will be reduced and the interest cover ratio will decrease to a low level. The gearing ratio of the business is already quite high at 48% (that is, loan notes (3.5)/(loan notes + equity (3.5 + 3.8)) and it is not clear what security would be available for the loan. The gearing ratio would be much higher if the overdraft were to be included.
● Chase trade receivables. It may be possible to improve cash flows by reducing the level of credit outstanding from customers. At present, the average settlement period is 93 days (that is, (trade receivables (3.6)/sales revenue (14.2)) × 365), which seems quite high. A reduction in the average settlement period by approximately one-quarter would generate the funds required. However, it is not clear what effect this would have on sales.
● Reduce inventories. This appears to be the most attractive of the four options. At present, the average inventories holding period is 178 days (that is, (closing inventories (3.8)/cost of sales (7.8)) × 365), which seems very high. A reduction in this period by less than one-quarter would generate the funds required. However, if the business holds a large amount of slow-moving and obsolete items, it may be difficult to reduce inventories levels.