Question

In: Finance

You are provided with the following information about a business: a. The sales of the business...

You are provided with the following information about a business:

a. The sales of the business has increased over the past financial year;

b. The gross profit of the business has decreased;

c. The payment periods for both accounts receivable and accounts payable have increased; and

d. The amount values of inventory and cash have declined.

Asked: Briefly provide possible reasons for each of the above mentioned situations and indicate whether it should be regarded as signs of possible overtrading or not.

Solutions

Expert Solution

a.  The sales of the business has increased over the past financial year

Explanation:

Increase in sales is generally through 2 factors - a) increase in per unit price or b) rise in volume. Here it is seems mainly due to rise in sales volume due to increase in credit sales

b. The gross profit of the business has decreased;

This is generally result of increase in raw material prices (increase in COGS) or discount on the product of the company to increase the sales volume. Here it seems company is offering high discount on per unit price of existing products although price of raw material are stable. Offering discount ed to decline in gross profit / margin

c. The payment periods for both accounts receivable and accounts payable have increased

Explanation:

Increase in account receivable seems mainly due to rise in credit sales or increase in payment period given to customers. It seems that company has loosen its credit policy to increase the sales volume.

Increase in account payable is due to delay from company side to supplier as company has long receivable days to collect the payment from their customer. Also due to non-availability of enough cash, it is delaying payment to the suppliers.

d. The amount values of inventory and cash have declined.

Explanation:

As mentioned as above, due to loose credit policy and discounts, company's sales increased considerably and hence company is replenishing the existing inventory fast but new inventory is not being added as company has less cash due delay in collection from receivables.

Although existing inventory is oversold and account payable increased but company likely to have blocked large amount in the account receivable. Overall it seems net working capital of the company increased substantially which led to decline in cash on the balance sheet.

Here it is likely the case of over trading where company is trying to increase their sales as fast as possible by offering the discounts and loosing credit policies.


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