Cash Conversion, Inventory and Receivables Management

Cash conversion cycle

The cash conversion cycle is an important ratio that gives information on the duration it takes a company to convert various inputs into cash flows. Thus, it reveals how long input is tied into the production procedure and the process of sale before cash is received after the sale (Graham, Smart & Meggison, 2010). This ratio gives information on the overall level of efficiency of the company. The formula for calculating the cash conversion cycle is presented below.

Cash conversion cycle = Average age of inventory + average collection period – average payment period

Average age of inventory = Inventory ÷ [cost of goods sold ÷ 365] = 842,020 ÷ [(0.57 * \$43,803,000) ÷ 365] = 12.31 days

Average collection period = Accounts receivables ÷ (Sales ÷ 365) = \$3,240,222 ÷ (43,803,000 ÷ 365) = 27 days

Average payment period = Accounts payable ÷ (sales ÷ 365) = \$1,826,070 ÷ [(0.57 * 43,803,000) ÷ 365] = 26.695 days = 12.31 + 27 – 26.695 = 12.615 days

Thus, from the formula presented and the workings presented above the cash conversion cycle is presented below.

The current cash conversion cycle of the company is 12.615 days. This implies that the company takes 12.615 days to convert the inputs into cash flow. It is a low ratio and it indicates that the company is well managed. The ratio is quite significant when evaluating the performance of the company over various periods and comparing the performance of various entities. However, it is important to use other ratios such as return on equity and assets together with cash conversion cycle when evaluating the efficiency of the management and the capability of an entity (Graham, Smart & Meggison, 2010).

Economic order quantity

The main goal of estimating the economic order quantity is to minimize the total inventory cost. Some of the inventory costs that companies usually incur are holding costs, costs of shortages, and costs of ordering the inventory (Graham, Smart & Meggison, 2010). The formula presented below will be used to calculate the economic order quantity o the company.

EOQ = √ (2 * D * K) / h

Where;

EOQ = Economic order quantity

D = Annual demand quantity

K = fixed cost per order

H = annual holding cost per unit / carrying / storage costs

EOQ = √ [(2 * 3,000 * 5,000) / 75] = 632 per order

The calculations show that it will be economical for the company to have 632 ingots of aluminum per order. Thus, any order that contains a quantity that is less or more than 632 will not be economical.

Reorder point

At the moment the company makes use of 8.22 ingots per day, that is, 3,000 ÷ 365. The weekly consumption of aluminum is 57.54 ingots (8.22 * 7 days). Thus, the reorder point should occur when the inventory level falls to 57.54 ingots with a one-week lead time. This will ensure that the company does not run out of raw materials for production. Besides, it will minimize the holding and storage cost of inventory.

Safety stock

A 3% safety stock requires that the company should have 90 ingots of aluminum for safety, that is, 3% * 3000. It is important to have safe stock. The stock ensures that the operations of the business continue smoothly if there are uncertainties in the supply and demand. An example of such uncertainty is stockouts. Thus, businesses need to plan for risks that may arise in the future (Graham, Smart & Meggison, 2010). To cater to the safety stock requirements, the company should hold about 147.53 ingots in stock, that is, 57.54 + 90.

Effect of relaxing the credit standards

Current position

The first step is to calculate the additional profit from sales. The value will be estimated using the formula presented below.

= Change in sales * contribution margin

= (.038 * \$43,803,000) * (\$1.5 – \$0.5126)

= \$1,643,541

The next step will be to calculate the cost of marginal investment in the accounts receivables. This will be calculated using the steps below.

Total Variable Costs of annual sales

= \$43,803,000 ÷ \$1.5 * \$0.5126

= \$14,968,945

Accounts receivable turnover

= 365 ÷ 27

= 13.52 times

AIARcurrent = Total Variable Costs of annual sales / accounts receivables turnover

=\$14,968,945÷ 13.52

= \$1,107,170

After calculating additional profit from the current position of the company, it will be important to calculate the additional profit arising from sales with the new proposal. A comparison will be made between these two values to obtain the cost of marginal investment in accounts receivable (Graham, Smart & Meggison, 2010). The additional profit from sales is calculated below.

Additional profit from sales = change in sales * contribution margins

= (.038 * \$43,803,000) * (\$1.5 – \$0.5126)

= \$1,643,541

Cost of marginal investment in accounts receivable:

Total Variable Costs of annual sales

= (\$43,803,000 * 1.038) ÷ \$1.5 * \$0.5126

= \$15,537,765

Accounts receivable turnover

= 365 ÷ (27 + 3)

= 12.17 times

AIARproposed = Total Variable Costs of annual sales / accounts receivables turnover

= \$15,537,765÷ 12.17

= \$1,276,727

Cost of marginal investment in accounts receivable:

= Additional investment * required return

Additional investment = (AIARproposed – AIARcurrent)

The required rate of return is 13%;

= (\$1,276,727 – \$1,107,170) * 13%

= \$22,042

The next step will be to calculate the cost of marginal bad debt expenses. The calculations are presented below.

Proposed bad debt expense = (Proposed sales * percentage of bad debts proposed)

= \$43,803,000 * 1.038 * 0.005

= \$227,338

Current bad debt expense = 0

= \$227,338 – \$0

= \$227,338

The final step is to calculate the net profit arising from the credit decision. This will be calculated using the formula presented below.

= Additional profit from sales arising from the new proposal – cost of marginal investment in accounts receivable – marginal bad debt expense

= \$1,643,541 – \$22,042 – \$227,338

= \$1,394,161

The resulting amount shows that the company will generate a profit amounting to \$1,394,161 if the credit terms are relaxed. This implies that the company stands to gain if the proposals are implemented. Therefore, Bracelet Blanks Inc. should reduce its credit standards.

The effect of reducing cash discounts

The first step, in this case, is to calculate the margin profit that arises from increased sales. The calculations are presented below.

= \$43,803,000 ÷ \$1.5

= 29,202,000 units x 0.01

= 292,020 new units

= 292,020 new units x (\$1.5 – 0.5126) = \$288,341

Thus, the margin profit is \$288,341. The next step is to calculate the cost of marginal investment in accounts receivables. The calculations are presented below.

Total variable costs of annual sales

= \$43,803,000 ÷ \$1.5 * \$0.5126

= \$14,968,945

Accounts receivable turnover

= 365÷27

= 13.52 times

AIARcurrent = \$14,968,945 ÷ 13.52

= \$1,107,170

Total variable costs of new annual sales

= ((\$43,803,000 x 1.01) ÷ \$1.5) * \$0.5126

= \$15,118,635

Accounts receivable turnover

= 365 ÷ (27 – 5)

= 16.59

AIARproposed = \$15,118,635 ÷ 16.59

= \$911,310

The final step in calculating the marginal investment in accounts receivables is summarized below.

Reduction in accounts receivable investment

= AIARcurrent – AIARproposed

= \$1,107,170 – \$911,310

= \$195,860

The cost savings from reduced investment amounts to \$195,860. The next step is to calculate the cost savings that arise from reduced investment. In this case, the opportunity cost of funds invested in accounts receivables is 10%. Thus, the calculations of cost savings are presented below.

= \$195,860 x 0.10

= \$19,586

The next step is to calculate the cost of a cash discount. The calculations are presented below.

= (0.02 x \$43,803,000 x 1.01 x 0.63)

= \$557,437

The final step is to calculate the arising net profit or net cost that arises from changing the cash discounts.

= \$288,341 + \$19,586 – \$557,437

= (\$249,510)

In this case, changing the cash discount results in a net cost amounting to \$249,510. This implies that the company will not gain by changing the credit terms. Therefore, Bracelet Blanks Inc. should not change the credit terms. The discussion and analysis above indicate that it is important for a business to evaluate the impact of various proposals that affect the credit terms before implementing them. This will give information on whether such proposals are profitable or not (Graham, Smart & Meggison, 2010).

References

Graham, J., Smart, S., & Meggison, W. (2010). Corporate finance: linking theory to what companies do. USA: Cengage Learning.

Cite this paper

Select style

Reference

Reference

Work Cited

References

BusinessEssay. (2022) 'Cash Conversion, Inventory and Receivables Management'. 23 November.

References

BusinessEssay. 2022. "Cash Conversion, Inventory and Receivables Management." November 23, 2022. https://business-essay.com/cash-conversion-inventory-and-receivables-management/.

1. BusinessEssay. "Cash Conversion, Inventory and Receivables Management." November 23, 2022. https://business-essay.com/cash-conversion-inventory-and-receivables-management/.

Bibliography