P Inc. is revising its payables policy. It has annual sales of $50,735,000, an a

Question

P Inc. is revising its payables policy. It has annual sales of $50,735,000, 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? (Hint: compare old to new).   

Explanation / Answer

First of all let’s calculate old cash conersion cycle;

Formuls of Cash conversion cycle is as follow;

Cash conversion cycle = (DSO + DIO – DPO)

So we have to calculate each one by one;

DSO = Average Accounts Receivable * 365 / Credit Sales

= $10008000 * 365 / $50735000

DSO = 72 days

DIO = Average Inventory * 365 / Cost of goods sold

= $15012000 * 365 / $43124750

DIO = 127.06 days

DPO = 30 days (It is given in the question.)

Thus Cash conversion cycle = (72 days + 127.06 days – 30 days)

= 169.06 days (Approx.)

Now let’s calculate new cash conersion cycle;

Formuls of Cash conversion cycle is as follow;

Cash conversion cycle = (DSO + DIO – DPO)

So we have to calculate each one by one;

DSO = Average Accounts Receivable * 365 / Credit Sales

= $8062000 * 365 / $50735000

DSO = 58 days

DIO = Average Inventory * 365 / Cost of goods sold

= $13066000 * 365 / $43124750

DIO = 110.59 days

DPO = 40 days (It is given in the question.)

Thus Cash conversion cycle = (58 days + 110.59 days – 40 days)

= 128.59 days (Approx.)

So far we have calculated old and new Cash conversion cycle. Thus change in cash conversion cycle will be as follow;

Change in cash conversion cycle = (Old – New)

169.06 days – 128.59 days = 40.47 days (Approx)

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