Question

Van Den Borsh Corp. has annual sales of $68,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year

Answer 1

Answer:

The Cash Conversion Cycle is the number of days it takes management of a company to convert its inventory into cash on hand after its business transactions.  It is a useful metric for measuring the effectiveness of management, especially for companies with inventory of goods for sale.

CCC combines the days of inventory outstanding, accounts receivable outstanding, less accounts payable outstanding to obtain a value based on days.

Therefore, the net change in the Cash Conversion Cycle (CCC) in this scenario is the difference between the previous CCC and the new one based on the new proposals.

a) Days Inventory Outstanding or DIO = Average Inventory divided by Cost of Goods Sold (COGS)per day.  Cost of Goods Sold is 85% of sales.

DIO = $15,012,000 / $58,424,750 x 365 days = 94 days

b) Days Sales Outstand or DSO  = Average Accounts Receivable divided by Revenue per day.

DSO = $10,008,000 /$68,735,000 x 365 days = 53 days

c) Days Payable Outstanding or DPO = Average Accounts Payable divided by COGS

DPO = 30 days, as given in the question

d) CCC = DIO + DSO - DPO

CCC = 94 + 53 - 30 = 117 days

Based on the new proposals, the CCC is calculated as follows:

a) DIO = $15,012,000 - $1,946,000 / $58,424,750 x 365 days = 82 days

b) DSO = $10,008,000 - $1,946,000 /$68,735,000 x 365 days = 43 days

c) DPO = 40 days as given.

New CCC = 82+43-40 = 85 days.

Therefore, the net change in the cash conversion cycle is 117 - 85 days, i.e. = 32 days.

Explanation:

The CCC has decreased by 32 days in the new scenario.  This is an improvement worth pursuing by management.

CCC as a measure of management effectiveness is best obtained for many years in order to compare internally.

Another way it serves as a good measure is to compare the company's CCC with its competitors'.