At current the working capital cycle is
Receivables days $0.4m/$10m * 365 = 15 days
Inventory days $0.7m/$8m * 365 = 32 days (cost of sales = $10m - $2m)
Payables days $1.5m/$8m * 365 = (68 days)
Total (21 days)
Clearly Keswick is exceptionally resourceful in its use of working capital.
The planned arrangement would shorten payables days in relation to half of cost of sales to 15 days. The effect is to inferior the average to
(½ * 68 days) + (½ * 15 days) = 41.5 days
Overall this will rise cycle time to
[15 + 32 - 41.5 days] that is to 5.5 days
At present interest cover earnings prior to interest and tax divided by interest is $2m/$0.5m
= 4.0 times this appears safe.
The advanced payment will increase interest costs but will generate savings via the discount. The discount relate to half of cost of sales that is ½ × $8m × 5% = $0.2m. The EBIT will rise accordingly.
The net advanced payment of ($4m - $0.2m) = $3.8m will have to be financed for an extra (68 - 15) days generating interest costs of
[$3.8m × 12% × 53/365] = $66,214
The interest covers somewhat declines to
[$2.0m + $0.2m]/[$0.50m + $0.066m] = 3.89 times
Profit after tax, ROE and EPS
The "before" and "after" income statements seems thus
The proposal seems beneficial to Keswick in terms of the effect on profitability measures that is EPS, EBIT, PAT, and ROE. But it does have a slightly harmful effect on its interest cover. It as well lengthens its working capital cycle and turns it into a net demander of working capital. This suggests an raise in its capital gearing.
Prior to the adjustment gearing at book values (overdraft/shareholder's funds) was
$3.0m/$2m = 150%
The overdraft will raise by
($3.8m × 53/365] = $0.55m
Ignoring the helpful effect on equity, gearing after the adjustment becomes
$3.55m/$2m = 178%
This appears rather dangerous considering the short-term nature of much of the debt and Keswick's low liquidity. May be Keswick must reconsider its policy regarding long-term borrowing although whether prospective lenders would oblige is probably doubtful.