MRP Finance Internship Unit 02

Unit 02 · Practice solutions

Practice solutions

Diagnosing a Business with Ratios · Ghana · GH₵

Worked answers to the optional practice questions. The required question is turned in to the TAs, and its answer is not published here.

Practice solutions

2.1

  1. Inventory. It is growing more than twice as fast as revenue while receivables and payables both track sales closely, so this is not a general growth effect. Benign explanation: a deliberate stock build ahead of a known demand increase or to protect against import delays. Worrying explanation: goods are not selling and obsolete or slow-moving stock is accumulating on the balance sheet at full carrying value.
  2. Overhead is being spread over a larger revenue base, which is normal operating leverage and generally good news — the fixed portion of overhead does not double when revenue doubles. The bad-news reading is that the firm has cut spending that will show up later: reduced maintenance, marketing, or staff development that lowers cost today and revenue in two years.
  3. The raw amount confounds size with efficiency — a large firm will hold more inventory than a small one for reasons that say nothing about how well either is run. It also ignores the pace at which each firm sells. Compare inventory as a percentage of total assets, or better, as days of inventory outstanding against cost of goods sold, which is comparable across firms of any size.

2.2

  1. Firm A: 6% × 1.5 × 2.0 = 18.0%. Firm B: 3% × 3.0 × 2.0 = 18.0%. A earns a wide margin on slow-moving assets — likely a branded or specialist product where the value is in the price premium. B earns very little per sale but turns its assets twice as fast — likely a distributor, wholesaler, or volume retailer where the value is in throughput.
  2. Year 1 leverage = 14% / (5.0% × 1.8) = 1.56. Year 2 leverage = 19% / (4.2% × 1.6) = 2.83. Both operating drivers deteriorated and the entire improvement in ROE — and more — came from nearly doubling leverage. A lender should conclude that the firm's returns are being manufactured by borrowing, that the underlying business is weakening, and that the capacity to absorb a bad year has fallen sharply.
  3. At Year 1 turnover of 2.667, assets would be 80.00 / 2.667 = GH₵30.0M, against actual assets of GH₵34.0M — GH₵4.0M lower. That is roughly a quarter of Adom's GH₵16.5M of total debt, meaning a meaningful share of the borrowing exists only to fund assets the company would not have needed at its former efficiency. (Note for instructors: this understates the effect, because Year 1 turnover was itself already above peer levels only on a much smaller asset base; video 2.4 does the sharper version using days.)

2.3

  1. Gross profit 28.0 − 19.6 = GH₵8.4M, 30.0%. Operating income 8.4 − 4.2 − 1.1 = GH₵3.1M, 11.07%. Pretax 3.1 − 0.9 = GH₵2.2M; tax GH₵0.55M; net income GH₵1.65M, 5.89%. Gross-to-operating gap 18.93pp; operating-to-net gap 5.18pp.
  2. Overhead must have fallen by four percentage points of sales, since operating margin is unchanged while gross margin fell four points. Benign: the firm reclassified costs — for example, moving delivery expense from overhead into cost of goods sold — which lowers gross margin and overhead by the same amount with no economic change. Worrying: the firm is genuinely losing pricing power or facing higher input costs and is offsetting it by cutting overhead, which is not repeatable indefinitely.
  3. Implied rate = 1.20 / 9.40 = 12.8%. At 16.8% on opening debt of GH₵9.40M, interest would be GH₵1.58M. Pretax = 4.00 − 1.58 = GH₵2.42M; tax GH₵0.61M; net income GH₵1.82M, down from GH₵2.10M — a fall of 13.5% from a four-point rate move, with the business itself unchanged.

2.4

  1. With a 40% gross margin, cost of goods sold is 60% of revenue. The correct figure is 34 / 0.60 = 56.7 days. The error understates inventory days by 22.7 days, or about 40% — because revenue is a larger denominator than cost of goods sold, using it always makes inventory look as though it turns faster than it does. The size of the error grows with the gross margin.
  2. At 38 days: 60 × 38/365 = GH₵6.25M. At 52 days: 60 × 52/365 = GH₵8.55M. Additional cash tied up = GH₵2.30M.
  3. The supermarket sells for cash at the till, so it is owed almost nothing; it turns stock in under a month and pays suppliers in 45 days, so its suppliers fund the entire cycle. The contractor bills on completion and waits over three months to be paid, holds materials for two months, and cannot stretch its own suppliers far enough to compensate. The contractor needs the overdraft — its cycle is roughly 105 days positive, while the supermarket's is about 14 days negative and generates cash as it grows.

2.5

  1. CCC = 44 + 51 − 38 = 57 days. A cedi leaves the firm when it pays its supplier and does not return until 57 days later, and the firm must fund that cedi from its own capital or borrowings throughout.
  2. Payables are money the firm has received value for but not yet paid, so they fund part of the cycle and reduce what the firm must finance itself — the minus sign reflects financing provided rather than consumed. A firm might choose not to stretch them because it would forgo early-payment discounts that are worth more than the financing, because suppliers may raise prices or reduce reliability in response, or because in a market where supply is scarce a reputation for prompt payment is itself a commercial asset.
  3. Daily cost base = 68.00 / 365 = GH₵0.186M per day. Closing half the 50.8-day gap is 25.4 days × 0.186 = GH₵4.73M. Halving the GH₵10.41M figure from the video gives GH₵5.21M. The two differ because the day-count method applies a single cost-based daily rate to all three components, whereas the video's method values receivables at revenue (GH₵80M base) and inventory and payables at cost (GH₵68M base). The video's figure is the more accurate one; the day-count shortcut is a reasonable field estimate.

2.6

  1. TIE = 3.6 / 1.1 = 3.27× — operating income covers interest just over three times, so profit could fall about 69% before interest became unaffordable. Current ratio = (0.4 + 5.2 + 4.4) / 6.8 = 1.47 — short-term assets cover short-term obligations with modest room. Quick ratio = (0.4 + 5.2) / 6.8 = 0.82 — excluding inventory the firm cannot cover its current liabilities, so it depends on selling stock to meet near-term obligations.
  2. First, if the 2.0 firm's current assets are mostly aged receivables and slow-moving inventory that will not convert to cash at carrying value, while the 1.2 firm holds mainly cash and receivables from strong payers. Second, if the 2.0 ratio arose because the firm cannot sell its stock — a rising current ratio driven by inventory build is a symptom of failure, not strength.
  3. First, TIE covers interest only and says nothing about principal; the firm may comfortably afford interest and still be unable to fund a scheduled capital repayment. Second, TIE is built from operating income, an accrual figure that may include large amounts of revenue not yet collected in cash — the profit exists and the money has not arrived.
  4. Model answer: "The operating problem is in buying or pricing: gross margin has fallen eight percentage points from 32% to 24%, while overhead has been held flat at 14% of sales, so the deterioration is entirely above the overhead line. Inventory is the second problem — days held have risen from 55 to 95 while collections and payables are unchanged, lengthening the cash conversion cycle by 40 days with no offsetting supplier credit. The two are likely connected: stock that is not moving is often stock that must eventually be discounted, which is one explanation for the falling gross margin. Leverage has not changed — debt is steady at 30% of assets — so this is not a financing problem in origin. But interest cover has more than halved, from 6.0 to 2.8, purely because operating income has fallen, which means the same debt is now materially less safe. The firm should first review pricing and inventory ageing to identify what is not selling and why, and second open a conversation with its lender now, while cover is still comfortably above one, rather than after another year of the same trend."