Question

Cranston Dispensers, Inc.

In the early 1990s, Cranston Dispensers, Inc. was quick to realize that concern for the environment would cause many consumer product manufacturers to move away from aerosol dispensers to mechanical alternatives that pose no threat to the ozone layer. In the following decades, most countries banned the most popular aerosol propellants, first chlorofluorocarbons and then hydrocholrofluorocarbons. As the leading manufacturer of specialized pump and spray containers for a variety of products in cosmetics, household cleaning supplies, and pharmaceutical industries, Cranston experienced a rapid increase in sales and profitability after it made this strategic move. At that time, the firm focused much of its attention on capturing market share and keeping up with demand.

For most of 20x4 and 20x5, however, Cranston’s share price was falling while shares of other companies in the industry were rising. At the end of fiscal 20x5, the company hired Susan McNulty as the new treasurer, with the expectation that she would diagnose Cranston’s problems and improve the company’s financial performance relative to that of its competitors. She decided to begin the task with a thorough review of the company’s working capital management practices.

While examining the company’s financial statements, she noted that Cranston had a higher percentage of current assets on its balance sheet than other companies in the packaging industry. The high level of current assets caused the company to carry more short-term debt and to have higher interest expense than its competitors. It was also causing the company to lag behind its competitors on some key financial measures, such as return on assets and return on equity.

In an effort to improve Cranston’s overall performance, Susan has decided to conduct a comprehensive review of working capital management policies, including those related to the cash conversion cycle, credit policy, and inventory management. Cranston’s financial statements for the three most recent years follow.    

($ in thousands)

Account	20x5	20x4	20x3
Sales	3,784	3,202	2,760
Cost of Goods Sold	2,568	2,172	1,856
Gross Profit	1,216	1,030	904
Selling & Administrative	550	478	406
Depreciation	247	230	200
Earnings Before Interest and Taxes	419	322	298
Interest Expense	20	25	14
Taxable Income	399	297	284
Taxes	120	89	85
Net Income	279	208	199

Cranston Dispensers

Balance Sheet

($ in thousands)

Account	20x5	20x4	20x3
Current Assets
Cash	341	276	236
Accounts Receivable	722	642	320
Inventory	595	512	388
Total Current Assets	1,658	1,430	944
Net Fixed Assets	1,822	1,691	1,572
Total Assets	3,480	3,121	2,516
Current Liabilities
Accounts Payable	332	288	204
Accrued Expenses	343	335	192
Short-term Notes	503	491	243
Total Current Liabilities	1,178	1,114	639
Long-term Debt	398	324	289
Other Long-term Liabilities	239	154	147
Total Liabilities	1,815	1,592	1,075
Owners’ Equity
Common Equity	1,665	1,529	1,441
Total Liabilities & Equity	3,480	3,121	2,516

5.   Cranston now bills its customers with terms of net 45. Although most customers pay on time, some routinely stretch the payment period to sixty or even ninety days. What steps can Cranston take to encourage clients to pay on time? What is the potential risk of implementing penalties for late payment?

6.   Suppose Cranston institutes a policy of granting a 1% discount for payment within fifteen days with the full amount due in 45 days. Half the customers take the discount, the other half take an average of sixty days to pay.

a.   What is the length of Cranston’s collection cycle under this new policy?

b.   In dollars, how much would the policy have cost Cranston in 20x5?

c.    If this policy had been in effect during 20x5, by how many days would Cranston have shortened the cash conversion cycle?

7.   An image-based lockbox system could accelerate Cranston’s cash collections by three days. Cranston can earn an annual rate of 6% on the cash freed by accelerated collections. Using sales for 20x5, determine the most that Cranston should pay per year for the lockbox system.

Answer 1

Part 5)

The following steps can be taken by Cranston to encourage clients to pay on time:

1) Offer early payment discounts to clients. For Instance, Cranston can offer a discount of 2% if payment is made within 10 days of sale and 1% discount if payment is made within 30 days.

2) Cranston can ask its sales representatives to develop a strong relationship with the customers and ask them to do a follow up with the customers for payment on time. Timely reminders (to customers) may also help in recovering payments as and when they become due.

3) Cranston can levy penalties in the form of interest on the amount due from customers after the expiry of the credit period. The rate of interest should be high enough to discourage customers from delaying payments. Another alternative would be to stop making sales to customers having poor repayment history.

4) Cranston can ask for advance payment or engage in cash sales only. This can, however, affect its sales volume to a large extent (in an adverse way).

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Impact of Penalties

While penalties may encourage customers to make payments on or before time, imposition of penalities can force customers to look for other suppliers/sellers with better credit terms. Also, it may not be possible for Cranston to impose penalties on big customers. Cranston should take into account the risk of losing some customers as a result of penalties. Attracting new customers may also become difficult with credit terms comprising of a penalty clause.

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Part 6)

a) The length of Cranston’s collection cycle under this new policy is calculated as below:

Length of Cranston’s Collection Cycle = Percentage of Customers taking Discount*Discount Period in Days + Percentage of Customers Not taking Discount*Total Period in days taken by Customers Not availing Discount = 50%*15 days + 50%*60 days = 37.50 days

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b)

The cost of the policy to Cranston in 2005 is determined as follows:

Discount on Sales (3,784*1%*1/2)	18.92 million
Less Tax Not Paid on Discount [18.92*120/399]	5.69 million
Cost of Policy	$13.23 million

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c)

We will have to calculate the average collection period under the previous policy as below:

Average Collection Period (Old Policy) = 365/Accounts Receivables Turnover Ratio = 365/[Sales/Average Accounts Receivable] = 365/[3,784/((722+642)/2)] = 65.78 or 66 days

Under, the new policy the average collection period is 37.5 days (as calculated in Part 6-a). The cash conversion cycle would be shortened by 28.28 (65.78 days - 37.5 days) or 28.5 days (66 days - 37.5 days).

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7)

The total amount that should be paid by Cranston for the lockbox system should be less than the return realized on the cash freed by accelerated collections. The value of return realized is determined as follows:

Return Realized on the Cash Freed by Accelerated Collections = 3,784*3/365*6% = $1.866 million per year

Cranston should pay any amount less than $1.866 million per year for the lockbox system as the return on cash freed would exceed the cost of lockbox system.