Question

American Products is concerned about managing cash efficiently. On average, inventories have an age of 80 days, and accounts receivable are collected in 40 days. Accounts payable are paid approximately 30 days after they arise. The firm has annual sales of about $30 million. Goods sold total $20 million, and purchases are $15 million.

a. Calculate the firm’s operating cycle.
b. Calculate the firm’s cash conversion cycle.
c. Calculate the amount of resources needed to support the firm’s cash conversion cycle.
d. Discuss how management might be able to reduce the cash conversion cycle.

Answer 1

a. The firm's operating cycle is 120 days. b. The firm's cash conversion cycle is 90 days. c. The amount of resources needed to support the firm's cash conversion cycle is $4.93 million. d. Management can reduce the cash conversion cycle by improving inventory management, accounts receivable management, and negotiating payment terms with suppliers.

Step-by-step explanation:

a. The operating cycle of a firm is the average time it takes for a company to convert its inventory into cash. In this case, the average age of inventory is given as 80 days and the average collection period for accounts receivable is 40 days. Adding these two together gives us the operating cycle: 80 + 40 = 120 days.

b. The cash conversion cycle is a measure of the time it takes for a company to convert its investments in inventory and accounts receivable into cash. To calculate it, we subtract the average payment period for accounts payable from the operating cycle. In this case, the average payment period for accounts payable is 30 days. So the cash conversion cycle would be 120 - 30 = 90 days.

c. The amount of resources needed to support the cash conversion cycle can be calculated by multiplying the average daily cost of goods sold by the cash conversion cycle. Here, the cost of goods sold is $20 million and the cash conversion cycle is 90 days. So the resources needed would be: $20 million * (90/365) = $4.93 million.

d. Management can reduce the cash conversion cycle by adopting strategies such as improving inventory management to reduce the average age of inventory, implementing efficient accounts receivable management to collect payments more quickly, and negotiating longer payment terms with suppliers to increase the average payment period for accounts payable.