Question

Merton Analytics is considering changes in its working capital policies to improve its cash flow cycle. Merton’s sales last year were $4,250,000 (all on credit), and its net profit margin was 7%. Its inventory turnover was 7.5 times during the year, and its DSO was 41 days. Its annual cost of goods sold was $2,200,000. The firm had fixed assets totaling $585,000. Merton’s payables deferral period is 42 days.

a.         Calculate Merton’s cash conversion cycle.

b.         Assuming Merton holds negligible amounts of cash and marketable securities,

calculate its total assets turnover and ROA.

c.         Suppose Merton’s managers believe the annual inventory turnover can be raised to 9.5 times without affecting sales. What would Merton’s cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 9.5 for the year?

Answer 1

a). ICP = 365 / Inventory Turnover Ratio = 365 / 7.5 = 48.67 days

CCC = DSO + ICP - PDP = 41 + 48.67 - 42 = 47.67 days

b). Inventory = Sales / Inventory Turnover Ratio = $4,250,000 / 7.5 = $566,666.67

DSO = 365 / [Sales / Accounts Receivable]

41 = 365 / [$4,250,000 / Accounts Receivable]

$4,250,000 / Accounts Receivable = 365 / 41

Accounts Receivable = $4,250,000 / 8.90 = $477,397.26

Total Assets = Fixed Assets + Accounts Receivable + Inventory + Cash

= $585,000 + $477,397.26 + $566,666.67 = $1,629,063.93

Total Assets Turnover = Sales / Total Assets = $4,250,000 / $1,629,063.93 = 2.61 times

ROA = Net Profit Margin * Total Assets Turnover = 7% * 2.61 = 18.26%

c). ICP = 365 / Inventory Turnover Ratio = 365 / 9.5 = 38.42 days

CCC = DSO + ICP - PDP = 41 + 38.42 - 42 = 37.42 days

b). Inventory = Sales / Inventory Turnover Ratio = $4,250,000 / 9.5 = $447,368.42

Total Assets = Fixed Assets + Accounts Receivable + Inventory + Cash

= $585,000 + $477,397.26 + $447,368.42 = $1,509,765.68

Total Assets Turnover = Sales / Total Assets = $4,250,000 / $1,509,765.68 = 2.82 times

ROA = Net Profit Margin * Total Assets Turnover = 7% * 2.82 = 19.71%