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Chapter 15: Problem 1

Williams \& Sons last year reported sales of \(\$ 10\) million and an inventory turnover ratio of \(2 .\) The company is now adopting a new inventory system. If the new system is able to reduce the firm's inventory level and increase the firm's inventory turnover ratio to 5 while maintaining the same level of sales, how much cash will be freed up?

Short Answer

Expert verified
The firm will free up $3 million in cash.

Step by step solution

01

Understand the Inventory Turnover Ratio

The inventory turnover ratio is calculated as the cost of goods sold (COGS) divided by the average inventory. It tells us how many times the company's inventory is sold and replaced over a period.
02

Calculate the Original Inventory Amount

The initial inventory turnover ratio is given as 2. With sales of \(10 million, we assume COGS is also \)10 million (as not specified otherwise). Using the formula for inventory turnover: \[ \text{Inventory} = \frac{\text{COGS}}{\text{Inventory Turnover Ratio}} = \frac{10,000,000}{2} = 5,000,000 \] Thus, the original inventory amount is $5 million.
03

Calculate the New Inventory Amount

With the adoption of the new system, the inventory turnover ratio increases to 5, while sales (and thus COGS) remain at \(10 million. Calculate the new inventory amount using the formula: \[ \text{New Inventory} = \frac{10,000,000}{5} = 2,000,000 \] Thus, the new inventory amount is \)2 million.
04

Determine the Reduction in Inventory

To find out how much inventory is reduced, subtract the new inventory from the original inventory: \[ \text{Freed Up Cash} = \text{Original Inventory} - \text{New Inventory} = 5,000,000 - 2,000,000 = 3,000,000 \] Thus, $3 million in cash is freed up by the new system.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Inventory Turnover Ratio
The inventory turnover ratio is an essential metric in Financial Management. It measures how efficiently a company manages its inventory. The ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory during a period. This ratio tells you how many times a company's inventory is sold and restocked within a particular time frame.

The formula for inventory turnover ratio is as follows:
  • Inventory Turnover Ratio = \( \frac{\text{COGS}}{\text{Average Inventory}} \)
A higher turnover ratio indicates efficient inventory management because the company sells its inventory quickly. Conversely, a lower ratio might suggest overstock or obsolescence.

In this exercise, the initial inventory turnover ratio was 2, meaning the company sold and restocked its inventory twice during the year.
Cost of Goods Sold
Cost of Goods Sold (COGS) is a crucial concept when calculating profitability and efficiency metrics like the Inventory Turnover Ratio. COGS refers to the direct costs attributable to the production of the goods sold in a company. This figure includes the cost of the materials and labor directly used to create the product. Excluded are indirect expenses, such as distribution, and sales force costs.

Accurately calculating COGS is vital for businesses as it affects both the inventory turnover calculation and the overall gross profit.

In this scenario, we're assuming the COGS equaled the sales of $10 million, as it's not specified otherwise. This assumption is crucial when determining the beginning and ending inventory values in the exercise.
Cash Flow Management
Cash flow management is a vital practice for businesses, ensuring they have enough liquidity to meet their short-term obligations. Effective inventory management is crucial for optimizing cash flow. By enhancing their inventory turnover ratio, companies can free up cash that would otherwise be tied up in unsold inventory.

Managing inventory levels effectively allows businesses to reduce storage and carrying costs, leading to better cash flow. In this exercise, improving the inventory turnover ratio from 2 to 5 allowed Williams & Sons to free up $3 million. This freed capital can be reinvested into the business, used to pay off debt, or allocate funds towards new growth opportunities.

Effective cash flow management requires businesses to maintain a balance between keeping enough inventory to satisfy demand and not having excess that ties up cash.

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Most popular questions from this chapter

Dorothy Koehl recently leased space in the Southside Mall and opened a new business, Koehl's Doll Shop. Business has been good, but Koehl has frequently run out of cash. This has necessitated late payment on certain orders, which, in turn, is beginning to cause a problem with suppliers. Koehl plans to borrow from the bank to have cash ready as needed, but first she needs a forecast of just how much she must borrow. Accordingly, she has asked you to prepare a cash budget for the critical period around Christmas, when needs will be especially high. Sales are made on a cash basis only. Koehl's purchases must be paid for during the following month. Koehl pays herself a salary of \(\$ 4,800\) per month, and the rent is \(\$ 2,000\) per month. In addition, she must make a tax payment of \(\$ 12,000\) in December. The current cash on hand (on December 1 ) is \(\$ 400\), but Koehl has agreed to maintain an average bank balance of \(\$ 6,000-\) this is her target cash balance. (Disregard till cash, which is insignificant because Koehl keeps only a small amount on hand in order to lessen the chances of robbery.) " The estimated sales and purchases for December, January, and February are shown below. Purchases during November amounted to \(\$ 140,000\). $$\begin{array}{lcr} & \text { SALES } & \text { PURCHASES } \\ \hline & & \\ \text { December } & \$ 160,000 & \$ 40,000 \\ \text { January } & 40,000 & 40,000 \\ \text { February } & 60,000 & 40,000 \end{array}$$ a. Prepare a cash budget for December, January, and February. b. Now, suppose Koehl were to start selling on a credit basis on December 1 , giving customers 30 days to pay. All customers accept these terms, and all other facts in the problem are unchanged. What would the company's loan requirements be at the end of December in this case? (Hint: The calculations required to answer this question are minimal.)

The Thompson Corporation projects an increase in sales from \(\$ 1.5\) million to \(\$ 2\) million, but it needs an additional \(\$ 300,000\) of current assets to support this expansion. Thompson can finance the expansion by no longer taking discounts, thus increasing accounts payable. Thompson purchases under terms of \(2 / 10,\) net \(30,\) but it can delay payment for an additional 35 days \(-\) paying in 65 days and thus becoming 35 days past due without a penalty because of its suppliers' current excess capacity problems. What is the effective, or equivalent, annual cost of the trade credit?

Suncoast Boats Inc. estimates that because of the seasonal nature of its business, it will require an additional \(\$ 2\) million of cash for the month of July. Suncoast Boats has the following 4 options available for raising the needed funds (1) Establish a 1-year line of credit for \(\$ 2\) million with a commercial bank. The commitment fee will be 0.5 percent per year on the unused portion, and the interest charge on the used funds will be 11 percent per annum. Assume that the funds are needed only in July, and that there are 30 days in July and 365 days in the year. (2) Forgo the trade discount of \(2 / 10\), net \(40,\) on \(\$ 2\) million of purchases during July. (3) Issue \(\$ 2\) million of 30 -day commercial paper at a 9.5 percent per annum interest rate. The total transactions fee, including the cost of a backup credit line, on using commercial paper is 0.5 percent of the amount of the issue. (4) Issue \(\$ 2\) million of 60 -day commercial paper at a 9 percent per annum interest rate, plus a transactions fee of 0.5 percent. since the funds are required for only 30 days, the excess funds ( \(\$ 2\) million) can be invested in 9.4 percent per annum marketable securities for the month of August. The total transactions cost of purchasing and selling the marketable securities is 0.4 percent of the amount of the issue. a. What is the dollar cost of each financing arrangement? b. Is the source with the lowest expected cost necessarily the one to select? Why or why not?

The text identifies three principal components that jointly comprise the cash conversion cycle. The cash conversion cycle is defined as the average length of time a dollar is tied up in current assets, and it is determined by the interaction between the inventory conversion period, receivables collection period, and the payables deferral period. Ideally, a company wants to minimize the cash conversion cycle as much as possible. In some circumstances, a firm has a comparative advantage in working capital management because of the nature of its business. This cyber-problem looks at two competing booksellers. Barnes and Noble Inc. is a hybrid between the traditional brick and mortar retailer and the Internet retailer. However, approximately 85 percent of its revenues are generated in the traditional retail setting, which will lead us to consider it a traditional retail firm. Amazon.com, on the other hand, represents the new wave of Internet retailing. The success of Amazon.com has spawned the flood of specialty retailing into the Internet marketplace. We will look at the cash conversion cycles of these companies and their implications. For this cyberproblem, you will be accessing information from the web sites for Barnes and Noble Inc. and Amazon.com at http://www.shareholder.com/bks and http://www.amazon.com, respectively. a. Go to Barnes and Noble's web site, and click on "Annuals." Now that you are in the annual report gallery, click on "1999 Annual Report. (HTML version)" to view the 1999 annual report. Click on "1999 Financial Review" and then click on "Consolidated statements of Operations." From the income statement, write down the annual sales and cost of goods sold for \(1999 .\) Assuming a 365 -day year, what are the average daily sales and purchases for Barnes and Noble Inc.? b. Go back one screen and click on "Consolidated Balance Sheets." Write down the 1999 balances shown for the firm's inventories, accounts receivable, and accounts payable. Using this information plus that from part a, calculate its inventory conversion period, receivables collection period, and payables deferral period. c. What is Barnes and Noble's cash conversion cycle? d. Now, access Amazon's web site. Scroll to the bottom of the page, and click on "About Amazon.com." Next, click on "Investor Relations," and then click on "Annual Reports \& Financial Documents." Click on 1999 Annual Report on Form \(10-\mathrm{K},\) and scroll down until you see Amazon's Consolidated Statement of Operations. Find the annual sales and cost of goods sold. Again, assuming a 365 day year, calculate the average daily sales and purchases for Amazon. e. Scroll up a page until you see Amazon's Consolidated Balance Sheets. Record 1999 balances for inventories, accounts receivable, and accounts payable. Use this information to calculate Amazon's inventory conversion period, receivables collection period, and payables deferral period. f. Calculate Amazon's cash conversion cycle. g. Compare the cash conversion cycles of Barnes and Noble and Amazon. What factors are responsible for these differences? Are these differences firm specific, or are they consequences of the nature of the businesses in which these firms operate? h. Interpret your results. Explain in words what the cash conversion cycles you calculated mean for these companies.

Helen Bowers, owner of Helen's Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the firm for parts of 2002 and 2003: May \(2002 \quad \$ 180,000\) June 180,000 July 360,000 August 540,000 September 720,000 October 360,000 November 360,000 December 90,000 January 2003 180,000 Collection estimates obtained from the credit and collection department are as follows: collections within the month of sale, 10 percent; collections the month following the sale, 75 percent; collections the second month following the sale, 15 percent. Payments for labor and raw materials are typically made during the month following the one in which these costs have been incurred. Total labor and raw materials costs are estimated for each month as follows: May 2002 \(\quad \$ 90,000\) June 90,000 July 126,000 August 882,000 September 306,000 October 234,000 November 162,000 December 90,000 General and administrative salaries will amount to approximately \(\$ 27,000\) a month; lease payments under long-term lease contracts will be \(\$ 9,000\) a month; depreciation charges will be \(\$ 36,000\) a month; miscellaneous expenses will be \(\$ 2,700\) a month; income tax payments of \(\$ 63,000\) will be due in both September and December; and a progress payment of \(\$ 180,000\) on a new design studio must be paid in October. Cash on hand on July 1 will amount to \(\$ 132,000\), and a minimum cash balance of \(\$ 90,000\) will be maintained throughout the cash budget period. a. Prepare a monthly cash budget for the last 6 months of 2002 . b. Prepare an estimate of the required financing (or excess funds) \(-\) that is, the amount of money Bowers will need to borrow (or will have available to invest) - for each month during that period. c. Assume that receipts from sales come in uniformly during the month (that is, cash receipts come in at the rate of \(1 / 30\) each day), but all outflows are paid on the 5 th of the month. Will this have an effect on the cash budget \(-\) in other words, would the cash budget you have prepared be valid under these assumptions? If not, what can be done to make a valid estimate of peak financing requirements? No calculations are required, although calculations can be used to illustrate the effects. d. Bowers produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the company's current ratio and debt ratio would vary during the year assuming all financial requirements were met by short- term bank loans. Could changes in these ratios affect the firm's ability to obtain bank credit?
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