Question

Google improved its operations from a net loss in 2015 to a net profit in 2016. While happy about these developments, they are concerned with trying to understand how long the firm takes to complete its cash conversion cycle in 2016. Use the following financial statements to make your calculations. Balance sheet items should reflect the averages of the 2015 and 2016 accounts.

Google products

PRODUCTS COMPANY
INCOME STATEMENT		2015	2016
Net sales		$900,000	$1,500,000
Cost of goods sold		540,000	900,000
Gross profit		360,000	600,000
Marketing		90,000	150,000
General and administrative		250,000	250,000
Depreciation		40,000	40,000
EBIT		–20,000	160,000
Interest		45,000	60,000
Earnings before taxes		–65,000	100,000
Income taxes		0	25,000
Net income (loss)		–$65,000	$ 75,000
BALANCE SHEET	2015			2016
Cash	$ 55,000			$ 20,000
Accounts receivable	200,000			280,000
Inventories	400,000			500,000
Total current assets	655,000			800,000
Gross fixed assets	450,000			540,000
Accumulated depreciation	–100,000			–140,000
Net fixed assets	350,000			400,000
Total assets	$1,005,000			$1,200,000
Accounts payable	$ 135,000			$160,000
Accruals	50,000			70,000
Bank loan	90,000			100,000
Total current liabilities	275,000			330,000
Long-term debt	300,000			400,000
Common stock (0.05 par)	150,000			150,000
Additional paid-in-capital	200,000			200,000
Retained earnings	80,000			120,000
Total liabilities and equity	$1,005,000			$1,200,000

1a.   Calculate the inventory-to-sale conversion period for 2016. What does this number represent?

1b.   Calculate the sale-to-cash conversion period for 2016. What does this number represent?

1c. Calculate the purchase-to-payment conversion period for 2016. What does this number represent?

1d. Determine the length of the Product’s cash conversion cycle for 2016.

Answer 1

Answer 1a)

Average Inventory of 2015 and 2016 = (2015 Inventory + 2016 Inventory) / 2

Average Inventory of 2015 and 2016 = (400,000+500,000) /2 = 450,000

Cost of Goods Sold per day = Cost of goods sold of 2016 / 365

Cost of Goods Sold per day = 900,000 / 365

Cost of Goods Sold per day = 2465.753

Inventory to sale conversion period of 2016 = (Average Inventory of 2015 and 2016) / (Cost of Goods Sold per day)

Inventory to sale conversion period of 2016 = 450,000 / 2465.753

Inventory to sale conversion period of 2016 = 182.5 days

This ratio tells us that on average it takes the company 182.5 days to convert the inventory into sales. It measures the length of time period on average between the acquisition of product and sale of product.

Answer 1b)

Average Accounts Receivable of 2015 and 2016 = (Accounts Rec 2015 + Accounts Rec. 2016) /2

Average Accounts Receivable of 2015 and 2016 = (200,000+280,000) / 2

Average Accounts Receivable of 2015 and 2016 = 240,000

Average Daily Credit Sales of 2016 = Net Sales of 2016 / 365

Average Daily Credit Sales of 2016 = 1,500,000 / 365

Average Daily Credit Sales of 2016 = $4109.589

Sale-to-cash conversion period for 2016 = Average Accounts Receivable / Average Daily Credit Sales

Sale-to-cash conversion period for 2016 = 240,000 / 4109.589 = 58.4 days

This ratio tells us on average the number of days that it requires a firm to collect cash payment after credit sales have been made. Lower the sale to cash conversion period, higher is the efficiency of the firm to deal with receivables.

Answer 1c)

Average Accounts Payable of 2015 and 2016 = (Accounts Payable 2015 + Accounts Payable 2016) /2

Average Accounts Payable of 2015 and 2016 = (135,000+160,000) / 2

Average Accounts Payable of 2015 and 2016 = 147,500

Cost of Goods Sold per day = Cost of goods sold of 2016 / 365

Cost of Goods Sold per day = 900,000 / 365

Cost of Goods Sold per day = 2465.753

Purchase-to-payment conversion period for 2016 = Average Accounts Payable / Avergae Cost of Goods sold per day

Purchase-to-payment conversion period for 2016 = 147,500 / 2465.753

Purchase-to-payment conversion period for 2016 = 59.82 days

This ratio tells potrays the average time needed (in days) for a firm in order to pay its invoices and payables to its trade creditors. Trade creditors include suppliers,vendors, or financiers.

A company with a higher purchase to payment conversion period takes longer to pay its payables and invoices which indicates that it can retain available funds for a longer duration of time. This allows the company an opportunity to use those funds in an optimum way to maximize the benefits. However, it may also indicate an inability to pay dues on time.

Answer 1d)

Length of the Product’s cash conversion cycle for 2016 = Inventory-to-sale conversion period for 2016 + Sale-to-cash conversion period for 2016 - purchase-to-payment conversion period

Length of the Product’s cash conversion cycle for 2016 = 182.5 + 58.4 - 59.82

Length of the Product’s cash conversion cycle for 2016 = 181.08 days

Length of Cash conversion cycle indicates the time required (in days) for a firm to convert its investments made in inventory and into cash from its sales. It is also known as the Net Operating Cycle .

In other words, length of cash conversion cycle attempts to measure how long cash is occupied up in the production and sales process before it can get converted into cash.