Cash conversion cycle American Products is concerned about managing cash efficiently. On the average, inventories have an age of 90 days, and accounts receivable are collected in 60 days. Accounts payable are paid approximately 30 days after they arise. The firm has annual sales of about $30 million. Assume there is no difference in the investment per dollar of sales in inventory, receivables, and payables; and a 365-day year.
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
a.90+60=150
b.150-30=120
c. 30million/365 x 120=9.9million
d.decrease inventory age or accounts receivable, or increase accounts payable
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a. To calculate the firm's operating cycle, we need to add the average age of inventories to the average collection period for accounts receivable.
Operating cycle = Average age of inventories + Average collection period for accounts receivable
Operating cycle = 90 days + 60 days
Operating cycle = 150 days
b. To calculate the firm's cash conversion cycle, we need to deduct the average payment period for accounts payable from the operating cycle.
Cash conversion cycle = Operating cycle - Average payment period for accounts payable
Cash conversion cycle = 150 days - 30 days
Cash conversion cycle = 120 days
c. The amount of resources needed to support the firm's cash conversion cycle can be calculated by multiplying the firm's daily sales by the cash conversion cycle.
Resources needed = Daily sales x Cash conversion cycle
Resources needed = ($30 million / 365) x 120 days
Resources needed = $821,918
d. To reduce the cash conversion cycle, management can employ several strategies. For example:
1. Negotiating better payment terms with suppliers to extend the average payment period for accounts payable.
2. Implementing efficient inventory management techniques to reduce the average age of inventories.
3. Offering customers incentives to encourage early payment of accounts receivable.
4. Streamlining internal processes to speed up the collection of accounts receivable.
5. Building strong relationships with customers to encourage prompt payment.
By implementing these strategies, management can reduce the cash conversion cycle, which will help improve cash flow and overall cash efficiency.
a. The firm's operating cycle can be calculated by summing the average age of inventories and the average collection period for accounts receivable.
Operating cycle = Inventory age + Accounts receivable collection period
Operating cycle = 90 days + 60 days
Operating cycle = 150 days
b. The firm's cash conversion cycle is calculated by subtracting the average payment period for accounts payable from the operating cycle.
Cash conversion cycle = Operating cycle - Accounts payable payment period
Cash conversion cycle = 150 days - 30 days
Cash conversion cycle = 120 days
c. The amount of resources needed to support the firm's cash conversion cycle can be calculated by multiplying the cash conversion cycle by the average daily sales.
Resources needed = Cash conversion cycle * Average daily sales
Resources needed = 120 days * (Annual sales / 365 days)
Resources needed = 120 days * ($30,000,000 / 365 days)
Resources needed ≈ $9,863,014.49
d. Management can reduce the cash conversion cycle by taking steps to decrease the time it takes to collect accounts receivable and pay accounts payable, as well as by managing inventories more efficiently. Some possible strategies include:
- Offering discounts to customers for early payment, which can encourage quicker payment and reduce the accounts receivable collection period.
- Negotiating longer payment terms with suppliers to increase the accounts payable payment period.
- Implementing just-in-time inventory management techniques to reduce inventory levels and decrease the inventory age.
- Streamlining and automating the order-to-cash and procure-to-pay processes to remove inefficiencies and delays.
- Improving forecasting and demand planning to reduce stockouts and avoid excess inventory.
By implementing these strategies, the firm can shorten its cash conversion cycle, optimize cash flow, and improve overall cash efficiency.
a. To calculate the firm's operating cycle, we need to sum the average age of inventory and the average collection period for accounts receivable.
Inventory age = 90 days
Accounts receivable collection period = 60 days
Operating cycle = Inventory age + Accounts receivable collection period
Operating cycle = 90 days + 60 days
Operating cycle = 150 days
b. The cash conversion cycle represents the time it takes for a company to convert its investments in inventory and accounts receivable into cash flow from sales, while also considering the payment period for accounts payable.
Cash conversion cycle = Operating cycle - Accounts payable payment period
Accounts payable payment period = 30 days
Cash conversion cycle = 150 days - 30 days
Cash conversion cycle = 120 days
c. To calculate the amount of resources needed to support the firm's cash conversion cycle, we need to determine the average investment in inventory and accounts receivable.
Average investment in inventory = (Cost of goods sold / 365) * Inventory age
Cost of goods sold = Annual sales = $30 million
Average investment in inventory = ($30,000,000 / 365) * 90
Average investment in inventory = $2,465,753.42
Average investment in accounts receivable = (Annual sales / 365) * Accounts receivable collection period
Average investment in accounts receivable = ($30,000,000 / 365) * 60
Average investment in accounts receivable = $4,109,589.04
Total resources needed = Average investment in inventory + Average investment in accounts receivable
Total resources needed = $2,465,753.42 + $4,109,589.04
Total resources needed = $6,575,342.46
d. Management can reduce the cash conversion cycle by taking various measures:
1. Improve inventory management: Reducing the age of inventory by implementing just-in-time (JIT) inventory systems or optimizing order quantities can help minimize the investment in inventory.
2. Accelerate accounts receivable collection: Implementing stricter credit policies, offering discounts for early payment, or using automated payment systems can help speed up the collection of accounts receivable.
3. Negotiate better terms with suppliers: Extending the payment period with suppliers or negotiating favorable payment terms can help to delay cash outflows and improve cash flow.
4. Streamline internal processes: Improving internal systems and processes can reduce the time between sales and cash collection, thereby shortening the overall cash conversion cycle.
Overall, by reducing inventory levels, collecting receivables faster, and optimizing payment terms with suppliers, management can effectively reduce the cash conversion cycle, resulting in improved cash flow and more efficient cash management.