Ch_16_Tool_Kit

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1 of 6 7/5/2003 Chapter 16. Model for managing and financing current assets Chapter 16 deals with working capital management. Two useful tools for working capital management are (1) the cash conversion cycle and (2) the cash budget. This spreadsheet model shows how these tools are used to help manage current assets. THE CASH CONVERSION CYCLE The cash conversion cycle model focuses on the length of time between when the company must make payments and when it receives cash inflows. The cash conversion cycle is determined by three factors: (1) The inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods. The inventory conversion period is measured by dividing inventory by the average daily sales. (2) The receivables collection period, which is the length of time required to convert the firm's receivables into cash, or how long it takes to collect cash from a sale. The receivables collection period is measured by the days sales outstanding ratio (DSO), which is accounts receivable divided by average daily sales. (3) The payables deferral period, which is the average length of time between the purchase of materials and labor and payment for them. The payable deferral period is calculated by dividing average accounts payable by purchases per day (cost of goods sold divided by 360 or 365 days). The cash conversion cycle is determined by the following formula: Cash conversion cycle = + - Problem Calculate the cash conversion cycle for the Real Time Computer Company. Annual sales are \$10 million, and the annual cost of goods sold is \$8 million. The average levels of inventory, receivables, and accounts payable are \$2,000,000, \$666,667, and \$666,667, respectively. RTCC uses a 365-day accounting year. Sales \$10,000,000 COGS \$8,000,000 Inventories \$2,000,000 AR \$657,534 AP \$657,534 Days/year 365 Cash conversion cycle (CCC) = + - = Inventory/Sales per day + AR/Sales per day - AP/COGS per day = 73.00 + 24.00 - 30.00 = 67.00 Inventory conversion period Receivables collection period Payables deferral period Inventory conversion period Receivables collection period Payables deferral period A B C D E F G H I J K 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43

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2 of 6 It takes 73 days to make and then sell a computer, and another 24 days to collect cash after the sale, or a total of 97 days between spending money and collecting cash. However, the company can delay payment for parts and labor for 30 days. Therefore, the net days the firm must finance its labor and purchases is 97 - 30 = 67 days, which is the cash conversion cycle. Companies like to shorten their cash conversion cycles as much as possible without adversely impacting operations. As noted in the chapter, Amazon.com and Dell have been able to produce goods on demand, hence to reduce the inventory conversion period to close to zero.
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