Question

4. Cash conversion cycle

Consider the case of Cranked Coffee Company:

Cranked Coffee Company is a mature firm that has a stable flow of business. The following data was taken from its financial statements last year:

Annual sales	$10,200,000
Cost of goods sold	$6,630,000
Inventory	$3,200,000
Accounts receivable	$2,200,000
Accounts payable	$2,400,000

Cranked Coffee’s CFO is interested in determining the length of time funds are tied up in working capital. Use the information in the preceding table to complete the following table. (Note: Use 365 days as the length of a year in all calculations, and round all values to two decimal places.)

	Value
Inventory conversion period	46.93; 41.71; 176.71; or 39.11
Average collection period	27.25; 78.73; 24.38; or 22.94
Payables deferral period	32.50; 41.07; 33.24; or 132.13
Cash conversion cycle	39.62; 122.77; 37.54; 45.88

B: Both the inventory conversion period and payables deferral period use the average daily COGS in their denominators, whereas the average collection period uses average daily sales in its denominator. Why do these measures use different inputs?

Inventory and accounts payable are carried at cost on the balance sheet, whereas accounts receivable are recorded at the price at which goods are sold.

Current assets should be divided by sales, but current liabilities should be divided by the COGS.

C. Is there generally a positive or negative relationship between net working capital and the cash conversion cycle? (In other words, if a firm has a high level of net working capital, is it likely to have a high or low cash conversion cycle?)

There is a positive relationship between net working capital and the cash conversion cycle.

There is a negative relationship between net working capital and the cash conversion cycle.

D. What are the four key factors in a firm’s credit policy?

Credit terms, discounts, credit standards, and collection policy

Credit period, discounts, credit standards, and collection policy

E. If the credit terms as published by a firm were 2/15, net 60, this means the firm will:

allow a 2% discount if payment is received within 15 days of the purchase, and if the discount is not taken the full amount is due in 60 days.

allow a 15% discount if payment is received within 2 days of the purchase, and if the discount is not taken the full amount is due in 60 days.

F. The management at Cranked Coffee Company wants to continue its internal discussions related to its cash management. One of the finance team members presents the following case to his cohorts:

Case in Discussion

Cranked Coffee Company’s management plans to finance its operations with bank loans that will be repaid as soon as cash is available. The company’s management expects that it will take 40 days to manufacture and sell its products and 35 days to receive payment from its customers. Cranked Coffee’s CFO has told the rest of the management team that they should expect the length of the bank loans to be approximately 75 days.

Which of the following responses to the CFO’s statement is most accurate?

The CFO is not taking into account the amount of time the company has to pay its suppliers. Generally, there is a certain length of time between the purchase of materials and labor and the payment of cash for them. The CFO can reduce the estimated length of the bank loan by this amount of time.

The CFO’s approximation of the length of the bank loans should be accurate, because it will take 75 days for the company to manufacture, sell, and collect cash for its goods. All these things must occur for the company to be able to repay its loans from the bank.

Setting and implementing a credit policy is important for three main reasons:

It has a minor effect on sales, it influences the amount of funds tied up in receivables, and it affects bad debt losses.

It has a major effect on sales, it influences the amount of funds tied up in receivables, and it affects bad debt losses.

Answer 1

A]

Inventory conversion period = 365 * inventory / COGS

Inventory conversion period = 365 * $3,200,000 / $6,630,000 = 176.17 days

Average collection period = 365 * accounts receivable / sales

Average collection period = 365 * $2,200,000 / $10,200,000 = 78.73 days

Payables deferral period = 365 * accounts payable / COGS

Payables deferral period = 365 * $2,400,000 / $6,630,000 = 132.13 days

Cash conversion cycle = Inventory conversion period + Average collection period - Payables deferral period

Cash conversion cycle = 176.17 + 78.73 - 132.13 = 122.77 days

B]

The correct option is -

Inventory and accounts payable are carried at cost on the balance sheet, whereas accounts receivable are recorded at the price at which goods are sold.

Hence, the appropriate denominator for inventory conversion period and payables deferral period is COGS, whereas for average collection period, the appropriate denominator is sales

C]

There is a positive relationship between net working capital and the cash conversion cycle.

Net working capital = current assets - current liabilities.

Cash conversion cycle is the time taken for raw materials / purchases to be actually converted into cash.

If net working capital is high, it means that current assets are high and current liabilities are low. This is results in a longer cash conversion cycle.

D]

The correct option is :

Credit period, discounts, credit standards, and collection policy