PLEASE SHOW WORK Johnson also knows that decisions about working capital cannot
ID: 2787071 • Letter: P
Question
PLEASE SHOW WORK
Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stock-outs and loss of sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Johnson has begun her investigation by collecting the ratios shown below. (The partial cash budget shown after the ratios is used later in this mini case.)
RR Industry
Current 1.75 2.25
Quick 0.92 1.16
Total liabilities/assets 58.76% 50.00%
Turnover of cash and securities 16.67 22.22
Days sales outstanding (365-day basis) 48.75 32.00
Inventory turnover 12.80 20.00
Fixed assets turnover 7.75 13.22
Total assets turnover 2.60 3.00
Profit margin on sales 2.07% 3.50%
Return on equity (ROE) 10.45% 21.00%
Payables deferral period 35.00 33.00
1. Johnson plans to use the preceding ratios as the starting point for discussions with RR’s operating team. She wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA. Based on the data, does RR seem to be following a relaxed, moderate, or restricted working capital policy?
2. How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current assets because it is inefficient? Does RR’s working capital policy seem appropriate?
3. Calculate the firm’s cash conversion cycle given annual sales are $900,000 and cost of goods represent 80% of sales. Assume a 365-day year.
Explanation / Answer
Ans 1. Change in Inventories:Lower Inventories will increase inventory turnover hence reduce no. of days of inventory in hand thus reducing the cash conversion cycle thus increasing profitability
Change in Receivables: Lower Account Receivables will increase receivables turnover hence reduce no. of Days of sales outstanding thus reducing the cash conversion cycle thus increasing profitability.
The RR seems to have highly relaxed working capital policy.
Cash Conversion cycle= (Days of sales outstanding + days of inventory in hand – Number of days of paybales).
Where Days of inventory = 365/Inventory Turnover
For RR it is = 48.75 + 28.51 – 35 = 42.26 Days
For Industry it is = 32+18.25-33 = 17.25 Days
For RR its cash conversion is very long compared to industry.
Ans 2. A lower inventory Turnover & Receivables turnover ratio signifies excess current assets and thus inefficient working capital policy. Too much relaxing working capital policy reflects gross inefficiencies in the system.
A relaxed but rational working capital policy should be near to the industry standards. A relaxed & rational working policy can have higher number of days of payables (days that a firm takes to pay to is suppliers) thus reducing the cash conversion cycle and also saving interest on working capital.
Ans3. Data is missing. Average receivables and Average inventory not mentioned to determine Days of sale outstanding and Inventory turnover respectively.
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