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Chapter 15: Problem 6

McDowell Industries sells on terms of \(3 / 10\), net \(30 .\) Total sales for the year are \(\$ 912,500\). Forty percent of the customers pay on the 10th day and take discounts; the other 60 percent pay, on average, 40 days after their purchases. a. What is the days sales outstanding? b. What is the average amount of receivables? c. What would happen to average receivables if McDowell toughened up on its collection policy with the result that all nondiscount customers paid on the 30th day?

Short Answer

Expert verified
a. DSO is 28 days. b. Average receivables are approximately \$70,019. c. Average receivables decrease to \$55,015.

Step by step solution

01

Understanding the Problem

McDowell Industries sells goods with payment terms allowing a 3% discount if paid within 10 days, otherwise full payment is due in 30 days. We are given the total sales and different payment behaviors of customers. We need to calculate the days sales outstanding (DSO), average receivables, and the impact on receivables if payment behavior changes.
02

Calculate Days Sales Outstanding (DSO)

DSO measures the average number of days it takes to collect payment. It's calculated using the formula: \[\text{DSO} = \frac{\sum(\text{receivables} \times \text{days})}{\text{total sales}}\]- 40% of customers pay on the 10th day, therefore contributing 10 days.- 60% of customers pay, on average, 40 days after purchase.Thus, DSO is:\[\text{DSO} = (0.4 \times 10) + (0.6 \times 40) = 4 + 24 = 28 \text{ days}\]
03

Calculate Average Receivables

Average receivables represent the amount owed to the company at any point in time. It's calculated by multiplying the daily sales by the DSO. Daily sales is found by dividing total sales by 365:\[\text{Daily Sales} = \frac{\\(912,500}{365} \approx \\)2,500.68\]Then compute average receivables:\[\text{Average Receivables} = \text{Daily Sales} \times \text{DSO}\]\[\text{Average Receivables} \approx \\(2,500.68 \times 28 \approx \\)70,019.04\]
04

Impact of Policy Change on Average Receivables

If all nondiscount customers pay on the 30th day, the new DSO would change to :\[\text{New DSO} = (0.4 \times 10) + (0.6 \times 30) = 4 + 18 = 22 \text{ days}\]Calculate the new average receivables:\[\text{New Average Receivables} = \text{Daily Sales} \times \text{New DSO}\]\[\text{New Average Receivables} \approx \\(2,500.68 \times 22 \approx \\)55,014.96\]This reflects a decrease in receivables due to improved collection policy.

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Key Concepts

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

Days Sales Outstanding (DSO)
Days Sales Outstanding (DSO) is an important metric that helps a company understand how quickly it collects on its credit sales. Essentially, it represents the average number of days a company takes to receive payment after a sale has been made. A lower DSO value signifies quicker payment collection, while a higher DSO indicates a delay in payment, potentially indicating cash flow issues.
For McDowell Industries, we observed a DSO of 28 days under the given terms. This figure was calculated based on customer payment behavior, with 40% paying early, taking advantage of a discount, and 60% paying later than the standard terms allowed. To calculate the DSO, you adjust each group of customers by the average days it takes them to pay, and then find a weighted average:
  • 40% of customers pay after 10 days: Contribution to DSO = 0.4 * 10 = 4 days.
  • 60% of customers pay, on average, 40 days later: Contribution to DSO = 0.6 * 40 = 24 days.
The total DSO is then obtained by adding these contributions together, giving McDowell Industries a DSO of 28 days.
A high DSO like this could suggest that the company might need to revise their collection procedures or explore issues in customer credit management.
Average Receivables
Average Receivables is a key financial metric that reflects the typical amount of outstanding credit sales at any given time. It gives a snapshot of how much money is owed to the company from its customers. Knowing this amount helps businesses manage their cash flow efficiently.
To find the Average Receivables, you first figure out the Daily Sales, which is calculated by dividing the Total Sales by the number of days in a year (365 days):
  • Daily Sales = 912,500 / 365 = approximately 2,500.68.
With this information, you multiply the Daily Sales by the DSO (that we calculated earlier) to get:
  • Average Receivables = Daily Sales * DSO = 2,500.68 * 28 鈮� 70,019.04.
Thus, McDowell Industries typically has about $70,019.04 tied up in receivables at any given time. Managing this amount effectively ensures liquidity while maintaining good customer relationships.
Collection Policy
Collection Policy refers to the rules and procedures that a company implements to collect outstanding accounts receivable. It's crucial because it affects a company's cash flow, customer satisfaction, and the overall financial health.
For McDowell Industries, the current policy and customer behavior lead to a DSO of 28 days. However, if the company tightens its policy, encouraging customers to pay within 30 days instead of 40, the DSO would drop to 22 days.
This adjustment assumes that all of the 60% of customers taking longer would reduce their payment time, effectively lowering the DSO: - New DSO = (0.4 * 10) + (0.6 * 30) = 22 days. The result is a reduction in Average Receivables, as seen in the calculations:
  • New Average Receivables 鈮� 2,500.68 * 22 鈮� 55,014.96.
Such a policy change would reduce the receivables by around $15,004.08, reflecting better cash flow. Improvements in collection policies such as reminding clients via emails or phone calls, offering incentives for early payments, and clear contract terms, can significantly impact a company's cash position.

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Most popular questions from this chapter

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?

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 D. J. Masson Corporation needs to raise \(\$ 500,000\) for 1 year to supply working capital to a new store. Masson buys from its suppliers on terms of \(3 / 10,\) net \(90,\) and it currently pays on the 10 th day and takes discounts, but it could forgo discounts, pay on the 90 th day, and get the needed \(\$ 500,000\) in the form of costly trade credit. What is the effective annual interest rate of the costly trade credit?

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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.
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