Topic list Syllabus reference

Formula to learn
Accounts payable payment period

Accounts payable payment period is ideally calculated by the formula:


x 365 days
Trade accounts payable
Purchases

Question
It is rare to find purchases disclosed in published accounts and so cost of sales serves as an approximation. The payment period often helps to assess a company's liquidity; an increase is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.
Liquidity and working capital
Calculate liquidity and working capital ratios from the accounts of TEB Co, a business which provides service support (cleaning etc) to customers worldwide. Comment on the results of your calculations.

	20X7	20X6
	$m	$m
Sales revenue	2,176.2	2,344.8
Cost of sales	1,659.0	1,731.5
Gross profit	517.2	613.3
Current assets
Inventories	42.7	78.0
Receivables (Note 1)	378.9	431.4
Short-term deposits and cash	205.2	145.0
	626.8	654.4
Current liabilities
Loans and overdrafts	32.4	81.1
Tax on profits	67.8	76.7
Accruals	11.7	17.2
Payables (Note 2)	487.2	467.2
	599.1	642.2
Net current assets	27.7	12.2

Notes

1. 
   Trade receivables
   
2. 
   Trade payables
   

295.2
190.8


335.5
188.1

Answer

	20X7 20X6
Current ratio	62^=1.05 ^44=1.02 599.1 642.2
Quick ratio	“tl.0.97 SZM.0.90 599.1 642.2
Accounts receivable collection period	___ r 335.5 __ _ x 365 = 49.5 days x 365 = 52.2 days 2,344.8
Inventory turnover period	X 365 = 9.4 days -^68°- X 365 = 16.4 days 1,659.0 1,731.5
Accounts payable payment period	x 365 = 42.0 days -^1- x 365 = 39.7 days 1,659.0 1,731.5

TEB Co's current ratio is a little lower than average but its quick ratio is better than average and very little less than the current ratio. This suggests that inventory levels are strictly controlled, which is reinforced by the low inventory turnover period. It would seem that working capital is tightly managed, to avoid the poor liquidity which could be caused by a long receivables collection period and comparatively high payables.

The company in the exercise is a service company and hence it would be expected to have very low inventory and a very short inventory turnover period. The similarity of receivables collection period and payables payment period means that the company is passing on most of the delay in receiving payment to its suppliers.
Question

1. 
   Calculate the operating cycle for Moribund pic for 20X2 on the basis of the following information.
   

$
Inventory: raw materials 150,000
work in progress 60,000
finished goods 200,000
Purchases 500,000
Trade accounts receivable 230,000
Trade accounts payable 120,000
Sales 900,000
Cost of goods sold 750,000
Tutorial note. You will need to calculate inventory turnover periods (total year end inventory over cost of goods sold), receivables as daily sales, and payables in relation to purchases, all converted into days'.

2. 
   List the steps which might be taken in order to improve the operating cycle.
   

Inventory turnover period:
Answer

plus
. . ... „ .. . , Closing trade receivables x 365
Accounts receivable collection period: ²
Sales
less

. . .. . . , Closing trade payables x 365 Accounts payable payment period: — — Purchases
	20X2
Total closing inventory ($)	410,000
Cost of goods sold ($)	750,000
Inventory turnover period	199.5 days
Closing receivables ($)	230,000
Sales ($)	900,000
Receivables collection period	93.3 days
Closing payables ($)	120,000
Purchases ($)	500,000
Payables payment period	(87.6 days)
Length of operating cycle (199.5 + 93.3 - 87.6)	205.2 days

(b) The steps that could be taken to reduce the operating cycle include:

1. 
   Reducing the raw material inventory turnover period.
   
2. 
   Reducing the time taken to produce goods. However, the company must ensure that quality is not sacrificed as a result of speeding up the production process.
   
3. 
   Increasing the period of credit taken from suppliers. The credit period already seems very long - the company is allowed three months credit by its suppliers, and probably could not be increased. If the credit period is extended then the company may lose discounts for prompt payment.
   
4. 
   Reducing the finished goods inventory turnover period.
   
5. 
   Reducing the receivables collection period. The administrative costs of speeding up debt collection and the effect on sales of reducing the credit period allowed must be evaluated. However, the credit period does already seem very long by the standards of most industries. It may be that generous terms have been allowed to secure large contracts and little will be able to be done about this in the short term.
   

4. 
   
   FAST FORWARD
   i
   Shareholders' investment ratios
   

Ratios such as EPS and dividend per share help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of a company.
They are:

1. 
   Earnings per share
   
2. 
   Dividend per share
   
3. 
   Dividend cover
   
4. 
   P/E ratio
   
5. 
   Dividend yield
   

The value of an investment in ordinary shares in a company listed on a stock exchange is its market value, and so investment ratios must have regard not only to information in the company’s published accounts, but also to the current price, and the fourth and fifth ratios involve using the share price.

1. 
   Earnings per share
   

It is possible to calculate the return on each ordinary share in the year. This is the earnings per share (EPS). Earnings per share is the amount of net profit for the period that is attributable to each ordinary share which is outstanding during all or part of the period (see Chapter 18).

2. 
   Dividend per share and dividend cover
   

The dividend per share in cents is self-explanatory, and clearly an item of some interest to shareholders.

Formula to learn
., . . _k. . Earnings per share
Dividend cover is a ratio of: —
Dividend per (ordinary) share
It shows the proportion of profit for the year that is available for distribution to shareholders that has been paid (or proposed) and what proportion will be retained in the business to finance future growth. A dividend cover of two times would indicate that the company had paid 50% of its distributable profits as dividends, and retained 50% in the business to help to finance future operations. Retained profits are an important source of funds for most companies, and so the dividend cover can in some cases be quite high.
A significant change in the dividend cover from one year to the next would be worth looking at closely. For example, if a company's dividend cover were to fall sharply between one year and the next, it could be that its profits had fallen, but the directors wished to pay at least the same amount of dividends as in the previous year, so as to keep shareholder expectations satisfied.

3. 
   Price/earnings ratio