Question

Q1.Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual sales of $45,625,000, or $125,000 a day on a 365-day basis. The firm's cost of goods sold is 80% of sales. On average, the company has $7,500,000 in inventory, $5,750,000 in accounts receivable, and $2,750,000 in accounts payable. Its CFO has proposed new policies that would result in a 25% reduction in both average inventories and accounts receivable, and a 10% increase in average accounts payable. She also anticipates that these policies would reduce sales by 5%.  What effect would these policies have on the company's cash conversion cycle?  

Q2.Newsome Inc. buys on terms of 4/10, net 45. It does not take the discount, and it generally pays after 65 days. What is the effective (not nominal) annual percentage cost of its non-free trade credit, based on a 365-day year?  

Answer 1

Old cash conversion cycle (CCC) = DIO + DSO - DPO

Here,

DIO (Days inventory outstanding) = Average inventory / Cost of goods sold * 365 days

DSO (Days Sales Outstanding) = Average Accounts Recievables/Total Credit Sales*365 days

DPO (Days Payable Outstanding) = Average accounts payable / Cost of goods sold * 365 days

i) Now old cash conversion cycle,

DIO =($75,00,000/($4,56,25,000 * 80%)) * 365 days

DIO = 75 days

DSO = ($57,50,000/$4,56,25,000) * 365 days

DSO = 46 days

DPO= ($27,50,000/($4,56,25,000 * 80%))*365 days

DPO = 28 days

Old cash conversion cycle = 75 + 46 - 28 = 93 days

ii) New cash conversion cycle,

New sales = $4,56,25,000 * (1 - 0.05) = $4,33,43,750

New cost of goods sold = $4,33,43,750 * 80% = $3,46,75,000

New average accounts recievables = $57,50,000 * (1 - 0.25%) = $43,12,500

New average accounts payables = $27,50,000 * (1 + 0.10) = $30,25,000

New average inventory = $75,00,000 * (1 - 0.25) = $56,25,000

Now,

New cash conversion cycle = DIO + DSO - DPO

Here,

DIO = $56,25,000 / $3,46,75,000 * 365 days

DIO = 59 days

DSO = $43,12,500 / $4,33,43,750 * 365 days

DSO = 36 days

DPO = $30,25,000 / $3,46,75,000 * 365 days

DPO = 32 days

New cash conversion cycle = 59 + 36 - 32

New cash conversation cycle = 63 days

Cash conversion cycle reduced by 30 days(93 - 63 days) due to proposed new policy.