Part (d) In order to assist Tshepo with the working capital analysis – (ii) comment on the outcomes of the analysis. Round all workings and final answers to the nearest whole number. Use year-end (and not average) balances in the calculation of any supporting amounts or ratios. Use 365 days per year when calculating relevant ratios.
answer
Shorter Version of the Dumbed-Down Version
The company's finances are in trouble because it's running out of cash. This is happening because:
Customers are paying their bills too slowly.
The company is paying its own suppliers too quickly.
Profit margins are shrinking, making it harder to cover costs.
These issues have led to the company's bank account going from positive to a negative overdraft.
Dumbed-Down Version
An auditor is looking at a company's money situation, especially how it handles its daily operations. The company, RainbowT, is in trouble because it's running out of cash.
Here's why:
Customers aren't paying quickly. RainbowT tried to get more sales by letting customers buy things on credit, but now those customers are taking a long time to pay them back. This means RainbowT's cash is stuck in customer debts.
Inventory is piling up. Even though sales are down, the amount of stuff in the warehouse hasn't gone down. This means money is also stuck in unsold products.
They're paying bills too fast. While customers are taking their time to pay, RainbowT is paying its own suppliers faster than before. This is like a person with no money who gives away what little they have.
Profit is shrinking. The profit made on each item sold has dropped. This makes it harder for the company to cover its everyday costs.
The bank account is empty. All these problems have caused the bank balance to go from a positive amount to an empty account with an overdraft (a negative balance).
In short, the company is struggling with its cash flow because it's giving out money faster than it's bringing it in.
Explanation of the Solution
Part (d) of the solution provides a detailed analysis of a company's working capital position, focusing on the period affected by lockdowns. Working capital is the difference between current assets (what a company owns that can be turned into cash within a year) and current liabilities (what it owes within a year). The analysis highlights significant issues in three key areas: debtors (accounts receivable), inventory, and creditors (accounts payable).
1. Deterioration of Debtors' Management and Liquidity:
The most critical issue identified is the company's deteriorating liquidity, primarily due to poor debtor management.
Increased Credit Sales: Despite a drop in total sales, credit sales increased. This suggests the company offered more lenient credit terms to customers to boost sales, a risky strategy that resulted in cash flow problems.
Worsening Cash Conversion Cycle: Customers are taking much longer to pay their debts, as indicated by the drastic increase in debtors' days in FY2020. This ties up the company's cash and makes it difficult to pay its own bills. The solution suggests investigating whether this is due to increased sales volume or customers struggling financially.
Ineffective Discounts: The company's offer of discounts for early payment is not working, as customers are not using them. This further indicates that customers may be facing their own financial difficulties.
Inadequate Credit Controls: The analysis points out a need for stricter credit screening procedures and better debt collection processes.
2. Inventory and Gross Profit Issues:
Inventory Levels: Inventory days remained constant, which, given the decline in sales, points to a build-up of stock. This could be due to reduced customer spending.
Declining Gross Profit: The gross profit margin dropped significantly. While this is common during economic downturns (as prices are reduced to move products), the new, lower margin may be insufficient to cover the company's operating costs, which is a major concern.
3. Creditor and Overall Financial Strain:
Accelerated Creditor Payments: The company is paying its suppliers faster, as accounts payable days have decreased. This, combined with the slow collection from debtors, puts further strain on cash flow.
Deteriorating Ratios: The current and quick ratios, which measure a company's ability to meet short-term debts, have worsened. This, along with the bank balance turning from positive to a negative overdraft, is a clear sign of a liquidity crisis.
In conclusion, the solution indicates that the company, RainbowT, is facing serious financial challenges. The core problem is the significant mismatch between its slow cash inflows (from debtors) and its accelerating cash outflows (to creditors), a situation likely made worse by a relaxed credit policy in a difficult economic environment.
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