Question

4. Cash conversion cycle

Cash management is a very important function of managers. Companies need to manage their operations in a way that they can sustain growth and yet not run out of cash.

Consider the case of the Red Hamster Manufacturing Inc.:

Red Hamster Manufacturing Inc. has forecasted sales of $28,000,000 for next year and expects its cost of goods sold (COGS) to remain at 80% of sales. Currently, the firm holds $3,100,000 in inventories, $2,300,000 in accounts receivable, and $2,600,000 in accounts payable.

Approximately how long does it take Red Hamster Manufacturing to convert its raw materials to its finished products and then to sell those goods? (Note: Use 365 days as the length of a year in all calculations, and round all values to two decimal places.)

50.51 days

55.56 days

35.36 days

47.98 days

On average, it takesError! Filename not specified.   from the time a sale is made until the time cash is collected from customers.

Red Hamster Manufacturing relies on customer credit when it buys raw materials from its suppliers. On average, it takesError! Filename not specified.   after the firm purchases materials before it sends cash to its suppliers. The length of Red Hamster Manufacturing’s cash conversion cycle (CCC) is Error! Filename not specified. . In general, firms prefer aError! Filename not specified. CCC.

What is the length of Red Hamster Manufacturing’s cash conversion cycle (CCC)?

47.65 days

32.40 days

38.12 days

43.84 days

In general, firms prefer aError! Filename not specified. CCC.

The management at Red Hamster Manufacturing wants to continue its internal discussions regarding its cash management. One of the finance team members presents the following case to her cohorts:

Case in Discussion

Lost Pigeon Aviation’s management plans to finance its operations with bank loans that will be repaid as soon as cash is available. The company’s management expects that it will take 60 days to manufacture and sell its products and 50 days to receive payment from its customers. Lost Pigeon Aviation’s CFO has told the rest of the management team that they should expect the length of the bank loans to be approximately 110 days.

Which of the following responses to the CFO’s statement is most accurate?

The CFO’s approximation of the length of the bank loans should be accurate, because it will take 110 days for the company to manufacture, sell, and collect cash for its goods. All these things must occur for the company to be able to repay its loans from the bank.

The CFO is not taking into account the amount of time the company has to pay its suppliers. Generally, there is a certain length of time between the purchase of materials and labor and the payment of cash for them. The CFO can reduce the estimated length of the bank loan by this amount of time.

Is it possible for a firm to have a negative CCC?

No

Yes

Answer 1

Answer a.

Annual Sales = $28,000,000

Cost of Goods Sold = 80% * $28,000,000
Cost of Goods Sold = $22,400,000

Days Inventory Outstanding = 365 * Inventory / Cost of Goods Sold
Days Inventory Outstanding = 365 * $3,100,000 / $22,400,000
Days Inventory Outstanding = 50.51 days

Answer b.

Days Sales Outstanding = 365 * Accounts Receivable / Annual Sales
Days Sales Outstanding = 365 * $2,300,000 / $28,000,000
Days Sales Outstanding = 29.98 days

On average, it takes 29.98 days from the time a sale is made until the time cash is collected from customers.

Answer c.

Days Payable Outstanding = 365 * Accounts Payable / Cost of Goods Sold
Days Payable Outstanding = 365 * $2,600,000 / $22,400,000
Days Payable Outstanding = 42.37 days

Red Hemster Manufacturing relies on customer credit when it buys raw materials from its suppliers. On average, it takes 42.37 days after the firm purchases materials before it sends cash to its suppliers.

Answer d.

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding
Cash Conversion Cycle = 50.51 + 29.98 - 42.37
Cash Conversion Cycle = 38.12 days

Answer e.

The CFO is not taking into account the amount of time the company has to pay its suppliers. Generally, there is a certain length of time between the purchase of materials and labor and the payment of cash for them. The CFO can reduce the estimated length of the bank loan by this amount of time.

Answer f.

Yes, CCC can be negative if days payable outstanding is higher than the sum of days sales outstanding and days inventory outstanding.