Question

The steel company is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. Company’s sales last year (all on credit) were $150,000, and it earned a net profit of 6%, or $9,000. It turned over its inventory 7.5 times during the year, and its DSO was 36.5 days. Its annual cost of goods sold was $121,667. The firm had fixed assets totaling $35,000. Steel's payables deferral period is 40 days.

a) Calculate steel's cash conversion cycle.

b) Assuming steel Co. holds negligible amounts of cash and marketable securities, calculate its total assets turnover and ROA.

c) Suppose steel company's managers believe the annual inventory turnover can be raised to 9 times without affecting sales. What would steel's cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 9 for the year?

Answer 1

Question a). Solution :-

Cash Conversion cycle = Days inventory outstanding (DIO) + Days sales outstanding (DSO) - Days payables outstanding (DPO).

Days inventory outstanding (DIO) = 365 / Inventory Turnover ratio

= 365 / 7.50

= 48.67 Days (approx).

Days sales outstanding (DSO) = 36.5 Days (Given in question)

Days payables outstanding (DPO) = 40 Days (Given in question)

Accordingly, Cash conversion cycle (CCC) = 48.67 Days + 36.50 Days - 40 Days

= 45.17 Days (approx).

Conclusion :- Cash conversion cycle (CCC) of Steel company = 45.17 Days. (approx).

Question b). Solution :- Total assets = Fixed assets + Accounts receivables + Inventory.

Days sales outstanding (DSO) = 365 * Accounts receivable / Sales revenue.

36.50 = 365 * Accounts receivable / 150000

Accounts receivables = (36.50 * 150000) / 365 = $ 15000.

Inventory turnover ratio = Cost of goods sold / Inventory. (Please read note at the below.)

7.50 = 121667 / Inventory

Inventory = 121667 / 7.50

Inventory = $ 16222 (approx).

(Note :- Inventory turnover ratio is calculated generally on the basis of cost of goods sold. Since the cost of goods sold amounting to $ 121667 given in the question, accordingly, the same is taken in numerator portion in the formula of inventory turnover ratio. If in the question, The cost of goods sold would not have been provided then only the mathematical figure of annual sales on credit amounting to $ 150000 can be taken in numerator portion in the formula of inventory turnover ratio).

Accordingly. Total assets = 35000 + 15000 + 16222 = $ 66,222.

Total assets turnover = Sales / Total assets

= 150000 / 66,222

= 2.265 Times.

Return on assets (ROA) = Total assets turnover * Net profit margin

= 2.265 * 6.00 %

= 13.59 %

Conclusion :- Return on assets (ROA) = 13.59 % and Total assets turnover = 2.265 Times.

Question c). Solution :- If inventory turnover ratio be 9 times :-

Cash Conversion cycle = Days inventory outstanding (DIO) + Days sales outstanding (DSO) - Days payables outstanding (DPO).

Days inventory outstanding (DIO) = 365 / Inventory Turnover ratio

= 365 / 9.00

= 40.56 Days (approx).

Days sales outstanding (DSO) = 36.5 Days (Given in question)

Days payables outstanding (DPO) = 40 Days (Given in question)

Accordingly, Cash conversion cycle (CCC) = 40.56 Days + 36.50 Days - 40 Days

= 37.06 (approx).

Total assets = Fixed assets + Accounts receivables + Inventory.

Accounts receivables = (36.50 * 150000) / 365 = $ 15000. (as calculated in the above question b).

Inventory turnover ratio = Cost of goods sold / Inventory.

9.00 = 121667 / Inventory

Inventory = 121667 / 9.00

Inventory = $ 13519 (approx).

Accordingly. Total assets = 35000 + 15000 + 13519 = $ 63,519.

Total assets turnover = Sales / Total assets

= 150000 / 63519

= 2.36 Times.

Return on assets (ROA) = Total assets turnover * Net profit margin

= 2.36 * 6.00 %

= 14.16 %

Conclusion :- If inventory turnover ratio is 9 times then :-

Cash conversion cycle (CCC) = 37.06 Days, Return on assets (ROA) = 14.16 % and Total assets turnover = 2.36 Times.