Question

When the Copper Corporation buys inventory, it must often rely on short-term bank financing to pay for the goods. Bank financing is usually in the form of a short-term self-liquidating loan, where the amount outstanding increases when goods are paid for and decreases when cash is received from sales. Copper’s bank charges interest at prime (7%) plus 1%.

Consider the following example.

November 1 Buy inventory for $10,000. December 1 Pay supplier / borrow $10,000. January 30 Sell goods for $20,000 . March 15 Collect receivables, $20,000, and repay loan, $10,000 •

Copper buys and receives $10,000 worth of inventory on November 1. • The supplier’s invoice is due on December 1.

• Copper expects to sell the goods about January 30, say for $20,000. • Copper expects to receive the cash about March 15.

• Accordingly, Copper would borrow $10,000 on December 1 in order to pay the supplier. It would repay the loan on March 15, when the cash becomes available. Required:

2 a. What is the inventory holding period?

b. What is the receivables collection period

c. What is the operating cycle?

d. What is the payables payment period?

e. What is the cash conversion cycle?

f. Calculate Copper’ interest expense in this situation.

g. Explain 3 ways in which Cooper can reduce its interest charges with better management of its operating cycle.

Answer 1

a. Copper purchased inventory on November 1 while the sales was made on January 30. Therefore, the inventory holding period will be from November 1 to January 30 i.e., 30+31+30 = 91 days or 3 months

b. Copper sells the goods on January 30 and collect the receivables on March 15. Thus, receivables collection period will be from January 30 to March 15 i.e., 28+15 = 43 days or 1.5 month

c. The outlay for procurement of goods was made on December 1 and cash was received on March 15. Thus, operating cycle will be from December 1 to March 15 i.e., 31+31+28+15 = 105 days or 3.5 months

d. Cooper bought inventory on November 1 and made payment on December 1. Thus payables payment period will be 30 days or 1 month

e. Cash conversion cycle will be from December 1 to March 15 i.e 3.5 months or 105 days.

f. Interest will be charged from December 1 to March 15. Thus interest expense will be $10,000 X 8% X 3.5/12 = $233.33

g. Copper can reduce its interest charges in thje following three ways

- Reduce receivables collection period

- Increase payables payment period

- Reduce inventory holding period