Question

Cash conversion cycle Consider the case of Teal Monkey Manufacturers: Teal Monkey Manufacturers is a mature firm that has a stable flow of business. The following data was taken from its financial statements last year: Annual sales Cost of goods sold Inventory Accounts receivable Accounts payable $9,500,000 $6,460,000 $3,100,000 $1,800,000 $2,600,000 Teal Monkey's CFO is interested in determining the length of time funds are tied up in working capital. Use the information in the preceding table to complete the following table. (Note: Use 365 days as the length of a year in all calculations, and round all values to two decimal places.) Value Inventory Conversion Period Average collection period Payables Deferral Period Cash conversion cycle Both the inventory conversion period and payables deferral period use the average daily COGS in their denominators, whereas the average collection period uses average daily sales in its denominator. Why do these measures use different inputs? Inventory and accounts payable are carried at cost on the balance sheet, whereas accounts receivable are recorded at the price at which goods are sold. • Current assets should be divided by sales, but current liabilities should be divided by the COGS The management at Teal Monkey Manufacturers wants to continue its internal discussions related to its cash management. One of the finance team members presents the following case about Red Hamster Manufacturing to his cohorts: Case in Discussion Red Hamster Manufacturing's management plans to finance its operations with bank loans that will be repaid as soon as cash is available. The company's management expects that it will take 60 days to manufacture and sell its products and 50 days to receive payment from its customers. Red Hamster's CFO has told the rest of the management team that they should expect the length of the bank loans to be approximately 110 days. Which of the following responses to the CFO's statement is most accurate? The CFO is not taking into account the amount of time the company has to pay its suppliers. Generally, there is a certain length of time between the purchase of materials and labor and the payment of cash for them. The CFO can reduce the estimated length of the bank loan by this amount of time. The CFO's approximation of the length of the bank loans should be accurate, because it will take 110 days for the company to manufacture, sell, and collect cash for its goods. All these things must occur for the company to be able to repay its loans from the bank

Answer 1

Inventory conversion period =175.16

Average collection period =69.16

Payable deferral period = 146.90

Cash conversion cycle= 1.08

Step-by-step explanation:

Inventory conversion period = (inventory / cost of goods sold) * 365 = (3,100,000/6,460,000) * 365 = 175.16

Average collection period = (receivables / annual sales) * 365 = (1,800,000/9,500,000) * 365 = 69.16

Parables deferral period = (Payables / cost of goods sold) * 365 = (2,600,000/6,460,000) * 365 = 146.90

Cash conversion cycle is given by:

Cash conversion cycle = DIO + DSO - DPO

where :

DIO = Days inventory outstanding

DIO = (Average inventory / cost of goods sold) * 365 = (3,100,000/365)*(365/6,460,000) = 0.48

DSO = Days sales outstanding

DSO = (Average accounts receivable / Total credit sales) * 365

= (1,800,000/365) * (365/1,800,000) = 1

DPO = Days payable outstanding

DPO = (Average accounts payable / cost of goods sold) * 365

= (2,600,000/365) * (365/6,460,000) = 0.40

Therefore :

Cash conversion cycle = 0.48 + 1 - 0.40

= 1.08

"Both the inventory conversion period and payables deferral period use the average daily COGS in their denominators, whereas the average collection period uses average daily sales in its denominator. Why do these measures use different inputs?" The reason is because inventory and accounts payable are carried at cost on the balance sheet, whereas accounts receivable are recorded at the price at which goods are sold.

The response to the CFO's statement which is most accurate is the CFO's approximation of the length of the bank loans should be accurate, because it will take 110 days for the company to manufacture, sell, and collect cash for its goods.