Question 10.SE.1: Hercules Wholesalers Ltd has been particularly concerned wit...
Hercules Wholesalers Ltd has been particularly concerned with its liquidity position in recent months. The most recent income statement and statement of financial position of the business are as follows:
| Income statement for the year ended 31 December last year | ||
| £000 | £000 | |
| Sales revenue | 452 | |
| Cost of sales | ||
| Opening inventories | 125 | |
| Purchases | \underline{341} | |
| 466 | ||
| Closing inventories | (\underline{143}) | (\underline{323}) |
| Gross profit | 129 | |
| Expenses | (\underline{132}) | |
| Loss for the year | (\underline{3}) | |
| Statement of financial position as at 31 December last year | |
| £000 | |
| ASSETS | |
| Non-current assets | |
| Property, plant and equipment | |
| Property at valuation | 280 |
| Fixtures and fittings at cost less depreciation | 25 |
| Motor vehicles at cost less depreciation | \underline{52} |
| \underline{357} | |
| Current assets | |
| Inventories | 143 |
| Trade receivables | \underline{163} |
| \underline{306} | |
| Total assets | \underline{663} |
| EQUITY AND LIABILITIES | |
| Equity | |
| Ordinary share capital | 100 |
| Retained earnings | \underline{158} |
| \underline{258} | |
| Non-current liabilities | |
| Borrowings – loans | \underline{120} |
| Current liabilities | |
| Trade payables | 145 |
| Borrowings – bank overdraft | \underline{140} |
| \underline{285} | |
| Total equity and liabilities | \underline{663} |
The trade receivables and payables were maintained at a constant level throughout the year.
Required:
(a) Explain why Hercules Wholesalers Ltd is concerned about its liquidity position.
(b) Calculate the operating cash cycle for Hercules Wholesalers Ltd based on the information above.
(c) State what steps may be taken to improve the operating cash cycle of the business.
Hercules Wholesalers Ltd
(a) The business is probably concerned about its liquidity position because:
● it has a substantial overdraft, which together with its non-current borrowings means that it has borrowed an amount roughly equal to its equity (according to statement of financial position values);
● it has increased its investment in inventories during the past year (as shown by the income statement); and
● it has a low current ratio of 1.1:1 (that is, 306/285) and a low acid test ratio of 0.6:1(that is, 163/285).
(b) The operating cash cycle can be calculated as follows:
| Number of days | |
| Average inventories holding period: \frac{[(Opening inventories + Closing inventories)/2] × 365}{Cost of inventories} = \frac{[(125 + 143)/2] × 365}{323} |
=151 |
| Add Average settlement period for receivables: \frac{Trade receivables × 365}{Credit sales revenue }= \frac{163}{452} × 365 |
=\underline{132} 283 |
| Less Average settlement period for payables: \frac{Trade payables × 365}{Credit purchases} = \frac{145}{341} × 365 |
=(\underline{155}) |
| Operating cash cycle | =\underline{128} |
(c) The business can reduce the operating cash cycle in a number of ways. The average inventories holding period seems quite long. At present, average inventories held rep-resent about five months’ inventories usage. Reducing the level of inventories held can reduce this period. Similarly, the average settlement period for receivables seems long at more than four months’ sales revenue. Imposing tighter credit control, offering dis-counts, charging interest on overdue accounts and so on may reduce this. However, any policy decisions concerning inventories and receivables must take account of current trading conditions.
Extending the period of credit taken to pay suppliers would also reduce the operating cash cycle. However, for the reasons mentioned in the chapter, this option must be given careful consideration.