You are a financial advisor to Mr. C Ndhlovu who is considering investing in any
ID: 2812717 • Letter: Y
Question
You are a financial advisor to Mr. C Ndhlovu who is considering investing in any one of the
following three companies in the same cement industry. He considers them to be equal in all
regards except for the differences described below. Mr. Ndhlovu has asked you to help him
understand the effects of the different working capital strategies adopted by each company. He
has provided you with the following information:
(Figures in K ’million)
In each case, Mr. Ndhlovu expects earnings before interest and tax to be 10% of sales. Under normal
trading conditions, he would expect annual sales to be twice the present level of current assets.
You may ignore taxation.
Required:
(a) Advise Mr. Ndhlovu which company will provide the best return on equity.
(b) Discuss what other matters, including risk, which Mr. Ndhlovu should consider when comparing
the working capital strategies.
Cement PLC Dangote
Cement Ltd Great Wall
Cement Ltd Non-current assets 100 100 100 Current assets 250 325 400 350 425 500 Equity 150 200 250 Long Term Loan 10% Interest rate 50 100 150 Current liabilities 150 125 100 350 425 500
Explanation / Answer
a… Larfage Dangote Great Wall Annual sales expected 500 650 800 EBIT at 10%*sales 50 65 80 less: interest 5 10 15 EBT 45 55 65 Equity 150 200 250 ROE 30% 27.5% 26% Larfage provides the best return on equity b..A good working capital is to balance the current assets vis-a-vis current liabilities so that a company can meet its immediate/short-term obligations and also maintain its day-to-day operating expenses. In this regard,two major components of working capital are current assets and current liabilities. Current assets comprise cash, accounts recievables , inventory & prepaid expenses. Current liabilities include trade payables , accrued expenses & current portions of with-in-a-year falling -due payables. There needs to a balance in maintaining just right & adequate net working capital (Excess of current assets over current liabilities), neither too low or a tight working capital as to lose out on good business opportunities , nor too high a net working capital investment as to lose out on interest income of investible funds or alternate profitable opportunities. So there exists these risks of losing more profitable opportunities , when there is unnecessary working capital or losing of customers in the current business if there is shortage of working capital. Thus, the company needs to strike a balance , by experience,comparing with previous years & observing the industry peers & patterns.
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