In: Finance
Parramore Corp has $10 million of sales, $1 million of inventories, $3 million of receivables, and $1 million of payables. Its cost of goods sold is 70% of sales, and it finances working capital with bank loans at an 6% rate. Assume 365 days in year for your calculations. Do not round intermediate steps.
a. Cash Conversion Cycle
The cash conversion cycle is a cash flow metric that measures the time taken for a company to convert its investment in inventory and other resource inputs into cash. Thus, it measures how long the company is able to convert its purchases to inventory and sales and then to collections of sales /payment of purchases.
Sales | 10,000,000 | Given in question |
Inventories | 1,000,000 | Given in question |
Receivables | 3,000,000 | Given in question |
Payables | 1,000,000 | Given in question |
Cost of goods sold (% of sales) | 70% | Given in question |
Cost of goods sold | 7,000,000 | (Sales * 70%) |
Bank Loan rate | 6% | Given in question |
Days Sales Outstanding | 109.50 | (Receivables/Sales*365) |
Days Inventory Outstanding | 52.14 | (Inventories/Cost of goods sold*365) |
Days Payable Outstanding | 52.14 | (Payables/Cost of goods sold*365) |
Cash Conversion cycle | 109.50 | Days Sales Outstanding+Days Inventory Outstanding-Days Payable Outstanding |
Cash Conversion cycle is 109.50 days
b. 8% reduction in Inventories & Receivables & 8% increase in Payables :
Inventories lowered by | 8% | |
Revised Inventories | 920,000 | (Old Inventory (1,000,000)*(100%-8%) |
Receivables lowered by | 8% | |
Revised Receivables | 2,760,000 | (Old receivables (3,000,000)*(100%-8%) |
Payables increased by | 8% | |
Revised Payables | 1,080,000 | (Old payables (1,000,000)*(100%+8%) |
Sales | 10,000,000 | Given in question (no change) |
Cost of goods sold (% of sales) | 70% | Given in question (no change) |
Cost of goods sold | 7,000,000 | (Sales * 70%) (no change) |
Days Sales Outstanding | 100.74 | (Revised Receivables/Sales*365) |
Days Inventory Outstanding | 47.97 | (Revised Inventories/Cost of goods sold*365) |
Days Payable Outstanding | 56.31 | ( Revised Payables/Cost of goods sold*365) |
Cash Conversion cycle | 92.40 | Days Sales Outstanding+Days Inventory Outstanding-Days Payable Outstanding |
Revised Cash Conversion Cycle is 92.40 days
c. Cash freed-up
Inventories lowered by | 8% | |
Revised Inventories | 920,000 | (Old Inventory (1,000,000)*(100%-8%) |
Receivables lowered by | 8% | |
Revised Receivables | 2,760,000 | (Old receivables (3,000,000)*(100%-8%) |
Payables increased by | 8% | |
Revised Payables | 1,080,000 | (Old payables (1,000,000)*(100%+8%) |
Cash freed-up from inventories | 80,000 | Old inventories - Revised inventories |
Cash freed-up from receivables | 240,000 | Old receivables - Revised receivables |
Cash freed-up from payaables | 80,000 | Revised payables - Old Payables |
Total Cash freed-up | 400,000 |
Total Cash freed-up is $400,000.
Note:
When there is a reduction in receivables, it means collections from customers has inreased and hence a cash-inflow.
When there is a reduction in inventories, it means more inventories have been sold and hence a cash-inflow.
When there is an increase in payables, it means payments to suppliers have been delayed and hence a cash-inflow.
d. Change in pre-tax profits
When there is a free-up of cash, company will repay its working capital loan to that extent and there will be saving of interest.
Thus, change in pre-tax profits due to saving in interest = Cash-freed-up * Bank loan interest rate =
$400,000*6% = $24,000
Change in pre-tax profits = $24,000