Question

i) The following information is extracted from the financial statements of XERO Limited: Cash $677,423 Accounts Payable $1,721,669 Accounts Receivable $1,845,113 Notes Payable $2,113,345 Inventories $1,312,478 Total Current Assets $3,835,014 Total Current Liabilities $3,835,014 Net Sales $9,912,332 Cost $5,947,399

(a) Briefly explain what you understand by the term ‘operating cycle’. ​(1 mark)
b) What is the operating cycle for XERO Limited? ​(1 marks
c) What can you say about XERO Limited’s accounts receivable and inventory management if it is known that the industry average operating cycle is 72 days? ​(1 mark)

(d) Briefly explain what you understand by the ‘cash conversion cycle’. ​(1 mark).

(e) What is the cash conversion cycle for XERO Limited? ​(1 mark)
(f) What can you say about XERO Limited’s cash conversion cycle if it is known that the industry average cash conversion cycle is 42 days?​(1 mark) Click or tap here to enter text.
ii) The current ratio and net working capital are good predictors of a firm's ability to meet its short-term obligations. Do you agree or disagree? Provide your rationale.

Answer 1

(a) Operating cycle tells about efficiency of a company. Operating cycle tells about the speed of selling inventory. Shorter operating cycle is more favorable. The length of operating cycle determines the amount of cash which is needed to be maintained. Less amount of cash needs to be maintained when a business has small operating cycle. Large amount of cash needs to be maintained when a business has large operating cycle. Credit policy of a business influences the operating cycle.

(b) Inventory period= 365/ inventory turnover

Inventory turnover= Cost of goods sold / Average inventory=$5,947,399 /$1,312,478=4.5314275744

Inventory period=365/4.5314275744=81 days

Accounts receivable period=365/receivables turnover=365/5.37220863979=68 days

Receivables turnover=credit sales/ accounts receivable=$9,912,332/$1,845,113=5.37220863979

Operating cycle=81 days+68 days=149 days

(c) XERO Limited's accounts receivable and inventory management is not good when the industry average operating cycle is 72 days. The operating cycle of XERO limited is 77 days more than the industry average.

(d) Cash conversion cycle tells about time taken by a business to convert its investments into cash flows from sales. It is time taken to convert resource inputs into cash. Cash conversion cycle tells about the time for which a business will be deprived of cash . Cash conversion cycle tells about the time period for which cash of the busines is blocked. It is the timespan between the disbursement and collection of cash by a business firm.

(e) Cash conversion cycle=days of inventory outstanding+days of sales outstanding+days payables outstanding=81 days+68 days-106 days=43 days

Days payable outstanding= Average accounts payable/COGS per day=$1,721,669/16,294=106 days

(f) The cash concersion cycle of XERO limited is close to the industry average of 42 days. There is only a difference of one day.

(ii) I agree with the statement.It is true that current ratio and net working capital are good predictors of a firm's ability to meet its short-term obligations. Current ratio= current assets/ current liabilities. Net working capital=Current assets- current liabilities. Increase in current ratio increases the probability of a firm's ability to meet its short-term obligations. Increase in net working capital increases the probability of a firm's ability to meet its short term obligations. Decrease in current ratio decreases the probability of a firm's ability to meet its short-term obligations. Decrease in net working capital decreases the probability of a firm's ability to meet its short term obligations.