Question

TGA is a pharmaceutical company. The company has been having challenges in the management of its working capital and has decided to examine its performance. Its financial statement for year ending December 31, 2019 are as follows:

Statement of Financial Position as at December 31, 2019
Assets
Cash and marketable securities	142,000
Accounts receivables	1,138,000
Inventories	1,827,000
	3,107,000
Plant and Equipment	3,577,000
Total Assets	6,684,000
Liabilities & Equity
Accounts payables	1,166,000
Accrued expenses	1,029,000
	2,195,000
Long term debts and other liabilities	2,736,000
Common stock	105,000
Retained earnings	1,648,000
Total Liabilities & Equity	6,684,000

Income Statement for the year ended 31 December 2019
Net Sales	13,644,000
Cost of sales	9,890,000
Selling and administrative expenses	2,264,000
Other expenses	812,000
Total expenses	12,966,000
Earnings before tax	678,000
Taxes	268,000
Earnings after tax	410,000

Note:

1. 50% of annual sales are credit sales
2. Assume that average inventory, receivables and payables are the same as the ending values.
3. Industry Averages are: inventory conversion period 75 days; Average collection period 55 days; average payment period 60 days; current ratio 1.9 and quick ratio 1.5.

Required:

1. Determine the cash conversion cycle of TGA. (show all workings)              

2. Comment on the management of working capital by TGA relative to the average firm in the industry.                                                                                                

3. Evaluate the liquidity position of TGA relative to the average firm in the industry (consider the current ratio and quick ratio)                                                          

4. TGA Co plans to change working capital policy in order to improve its profitability. This policy change will not affect the current levels of credit sales, cost of sales or cash and marketable securities, however accrued expenses are expected to reduce by 80%. As a result of the policy change, the following working capital ratio values are expected:

Inventory days 50 days

Trade receivables days 55 days

Trade payables days 45 days

For the change in working capital policy, calculate the change in the cash operating cycle and the effect on the current ratio. Comment on your findings.                      

5. Discuss THREE techniques that TGA Co could use in managing trade receivables.

Answer 1

1).

Cash Conversion Cycle = DIO + DSO – DPO

Where:

• DIO stands for Days Inventory Outstanding
• DSO stands for Days Sales Outstanding
• DPO stands for Days Payable Outstanding

2).

Current Ratio of our firm is 1.42 whereas that of the industry is 1.9. This shows that the working capital management of TGA is not good compared with the industry standards. The industry standards are better as it has a higher current ratio. Current ratio shows the working capital management of the company as it compares current assets and current liabilities.

3).

As we can see here, the liquidity position of TGA is very bad compared with that of the industry standards. The major part of liquid assets included inventory. This means that the level of inventory maintained by the company is much higher than the required level. It also shows a bad inventory management by the company. The company must be taking a higher amount of the time to realise the inventory held with them. Hence, the quick assets value is very low compared to the total amount of current assets.

4).

With the given changes, updated

Cash Conversion cycle = Inventory days + Receivables days - Payables days

= 50 days + 55 days - 45 days = 60 days.

Operating Cycle = DSO + DIO = 55 days + 50 days = 105 days.

When accrued expenses are reduced by 80%:

Old amount of accrued expenses = $ 10,29,000
New amount of accrued expenses = $ 205,800

Updated current Ratio is

Here we can see, with the reduction in accrued expenses, the current ratio has increased and now it is greater than the industry average. This is a favourable situation and it indicates that the working capital policy is a great success.