The Case Study: The Analysis
Having signed the agreement on January 1st to purchase £10,000 stock monthly on three months credit, my friend did sell everything on the market by the end of each month for cash at a 50 per cent mark-up. So, if he was so clever, did he let the money lie idle?
Of course not, nor were the proceeds withdrawn. As any economist will tell you, once one profitmaximising opportunity exhausts itself, you should search for another and diversify your operations.
My friend thought "buy to let" property represented a sound investment. So, from each month's revenue throughout the first year, he committed all maximum free cash inflow to purchasing and refurbishing a small flat in the student quarter of the city. By the end of the following January, the property was rented to students he knew from his old degree course who also frequented the market stall. Thereafter, his grand design was to acquire further properties from his increasing stock of wealth. Just like a game of Monopoly!
1. Prepare the actual beginning and end of month Balance Sheets to April 1st and for January 1st of the following year as a basis for analysis (assuming that periodic free cash inflow is invested in property at the beginning of the following month).
2. Calculate the sequential ratios for profitability (the return, profit margin and asset utilization), working capital (solvency and liquidity) to April 1st and the corresponding ratios for January 1st of the following year, plus the venture's operating and financing cycles, expressed in monthly terms based on its "terms of trade".
3. Provide a commentary that interprets all the information contained in the two data sets.
An Indicative Outline Solution
1. The Balance Sheets
Table 4.2: Actual Statements of Monthly Financial Position
2. The Ratios
Table 4.2 can be reformulated using a selection of financial ratios within a coherent framework as a basis for interpretation.
If you are in any doubt about financial ratio analysis, or the derivation of a data set such as Table 4.3) please refer back to Chapter Three of either "Working Capital and Strategic Debtor Management", or "Working Capital Management: Theory and Strategy"(2013) from my bookboon series, for guidance.
Table 4.3: The Financial Ratios
3. The Data Set Commentary.
Table 4.3 summarizes my friend's progress throughout the first year by referencing:
- Profitability in terms of return on assets (ROCE), net profit margins and asset utilization,
- Working capital, using current asset (solvency) and quick asset (liquidity) ratios,
- The operating cycle (stock turnover),
- The financing cycle (creditor turnover).
Rather than let cash lie idle (or pay creditors early) he maximized his reinvestment potential by diversification to increase future profits without compromising debt paying ability. But a conventional interpretation of the Balance Sheets using ratio analysis fails to reflect the underlying economic reality of this business strategy.
Whilst the profit margin remains unchanged, sales to assets and hence the return on assets fluctuate during the first quarter, thereafter rising to the year end, even though the terms of trade are constant. Moreover, the business is definitely more profitable in absolute terms by the 1st March compared to the 31st January, although the return percentage remains the same. Consequently, apart from the profit margin, conventional ratio analysis suggests significant variations in efficiency (quite wrongly) depending upon when the Balance Sheet is "struck".
Equally worrying from a traditional Accounting perspective are the dynamics of working capital. After three months, the solvency and liquidity ratios fall to 1:3 and zero respectively, contravening the current asset conventions of 2:1 and 1:1. However, the decline in working capital is a consequence of a build up of creditors and an efficient transformation of cash into fixed assets. By February, working capital is therefore negative and liquidity has evaporated. But the business venture is neither insolvent, nor illiquid, unless my friend was to cease trading altogether.
Given the terms of trade (three months credit relative to one month's cash sales) the business can meet its financial obligations when they fall due (from April onwards). The only constraint is that having reinvested £15,000 in property from January and February respectively, only £5,000 can be reinvested from March onwards on a monthly basis. Otherwise, creditors would be knocking on the door.
Finally, it is no accident that the relationship between current assets and current liabilities stabilizes at 1:3 by the end of the first quarter. Nor, is this a cause for concern. Stock turnover (the conversion of assets to cash) termed the operating cycle is one month. Creditor turnover (the repayment period granted by suppliers) termed the financing cycle is three months. In other words, inventory is converted into cash three times quicker than debts need legitimately to be repaid.
So, within the context of efficient financial management, did my friend perform well?
Summary and Conclusions
This Chapter's Case Study vividly illustrates that if a firm's over-arching objective is a combination of investment and financing decisions that generate maximum net cash inflows at minimum cost, it follows that:
o The efficient management of working capital should be determined by an optimum investment in current assets and current liabilities, dictated by its "terms of trade".
o The accounting convention that firms should strive to maintain a 2:1 working capital ratio underpinned by a liquidity ratio of 1:1 may be sub-optimal and misleading.
o Management's objective should be to maximize current liabilities and minimize current assets compatible with their debt paying ability, based upon future cash profitability.
In an ideal world all firms would prefer to hold no inventory, sell everything for cash on delivery (COD) rather than credit and not leave the balance lying idle. Conversely, they would prefer to purchase all stocks on credit. As a consequence, they would hold no current assets but finance their reinvestment activities through suppliers.
Given these criteria, checks and balances, my friend did perform well. So much so, that today in the UK, he is a household name leading a large organization with corporate status!
Working Capital and Strategic Debtor Management, 2013.
Working Capital Management: Theory and Strategy, 2013.