Question

You have been tasked to evaluate the financial health and working capital policy of Yoyo Co.
The extracts of the balance sheet as at 31 December 2019 and income statement for the year ended are as follows:
Balance sheet
$'000
Income Statement
$'000
Current assets
Sales
20,000
Inventory
2,500
Cost of Sales
15,000
Accounts receivables
4,250
Cash
4,000
Current liabilities
Accounts payables
2,750
Short-term bank loan
2,500
Companies which are similar to Yoyo Co have the following average metrics for 2019:
Inventory days
57 days
Accounts receivable days
55 days
Accounts payables days
60 days
Current ratio
2.4x
Quick ratio
1.7x
Management is currently reviewing their credit policies in order to attract more customers and improve its operating cycle. The sales manager proposes that for customers who order goods exceeding $100,000, Yoyo Co can extend credit terms of 2/10, net 60.
Assume 360 days in a year.
(a) Compute the working capital cycle (i.e. cash cycle) of Yoyo Co as at 31 December 2019.

(b) Interpret Yoyo Co’s cash cycle based on your computations.

(c) Analyse the performance metrics of Yoyo Co as compared to its competitors based on the cash cycle and liquidity ratios.

(d) Discuss the circumstances when the cash cycle of a company is positive and when the cash cycle is negative.

(e) Calculate the implied interest rate when Yoyo Co’s customers do not take up the discount offered to them.

Answer 1

A) Working capital Cycle = Receivable days + Inventory Days - Payable Days

Receivable Days = Ending Receivables/Sales * 360 = (4250/20000)*360 = 76.5

Inventory Days = Ending Inventory / Cost of Sales * 360 = (2500/15000)*360 = 60

Payable Days = Ending Payables/Cost of Sales * 360 = (2750/15000)*360 = 66

Working Capital Cycle = 76.5+60 -66 = 70.5

b) So the company takes 70.5 days to turn its initial cash investment (making the goods) in inventory back into cash

c)

Metrics	Yoyo	Competitors	Comments/Analysis
Inventory Days	60	57	Inventory days are almost at the same level as competitors. However, longer inventory days suggest more time is taken to churn (sell/move) the inventory. Hence, Yoyo should try to improve this.
Receivable Days	76.5	55	Yoyo's average time to get payments from its debtors is very high compared to its creditors. It should look at ways to reduce these receivable days
Payable Days	66	60	Yoyo is better off here as it is getting a better (longer) payment period from its creditors
Current Ratio	(Current Assets/Current Liabilities) = 2.05x	2.4x	The current ratio ideally should be 2:1. However, the greater the better. Hence competitor fares better here too
Quick Ratio	(Current Assets - Inventory)/Current Liabilities = 1.6x	1.7x	Ideally should be 1:1. Hence, Yoyo is well above the requirement but below its competitors.

D) The cash cycle is made of three components :

1. Debtors (Receivables) 2. Inventory 3. Payables

The following are the circumstances when the Cash Cycle will be positive/negative :

Positive :

a. Normal businesses usually have a positive cash cycle. Because they sell goods on credit which causes Receivable days to be +ve and add to that the inventory days.

b. Cases where business have to make a cash payment to their creditors

Negative:

a.Businesses that do cash sales mostly but have a decent credit period (higher than inventory days) from their creditors

b. When a company needs very little time to sell its inventory and its credit period is higher than receivable days

E) 2/10 net 60 mean, Yoyo is willing to offer a 2% additional trade/cash discount to its creditors if they make a payment within 10 days of the invoice rather than a 60 day credit period.

So if a debtor owes $150000

If he makes the payment in 10 days

Amount to be paid = 98% of 150000 = $147000

But if he makes payment at 60 days

Total Payment = $150000

Hence, additional amount paid for paying after (60-10) 50 days = $3000

This is the interest cost. If we annualize this :

(360/50)*3000 = 21600

Hence, effective interest = 21600/147000 = 14.69%