Question

American Products is concerned about managing cash efficiently. On average, inventories have an age of 80 days, and accounts receivables are collected in 40 days. Accounts payable are paid on average 30 days after they arise. The firm has annual credit sales of $30 million, cost of goods sold total $20 million, and purchases are $15 million.

1. What is operating cycle? Calculate the firm's operating cycle and explain what it means.

2. What is cash cycle? Calculate the firm's cash cycle and explain what it means.

3. Calculate the amount of cash needed to support the firm's cash cycle.

4. Discuss how management might be able to reduce the cash cycle. What is the benefit to have a short cash cycle?

Answer 1

1. Firms operating cycle = Average collection period + Average days of inventory = 80 + 40 = 120

Operating cycle is the time requried for the business to receive , sell and collect from the sale of inventory.

2. Cash cycle = Operating cycle - Accounts payable period = 120 - 30 = 110 days

It is the time required for the business to convert the investment in inventory to cash.

3. Cash needed = Cash outlay * Cash cycle /365 = 30,000,000* 110/365 = 9041095.89

4. The management can reduce the cash cycle by increasing the accounts payable period or by reducing the average inventory or receivables period.The benefit of having a short cash cyle ensures liquidity for the company and enhance profitability.