Bookshelf Online: Financial.. X 18-5. (Calculating the operating and cash conver

Question

Bookshelf Online: Financial.. X 18-5. (Calculating the operating and cash conversion cycles) (Related to Checkpoint 18.1 on page 585) The Caraway Seed Company has for many years cultivated and sold what are known as heritage plants and seeds. For example, it has sought out older varieties of tomato plants that are no longer grown by commercial vegetable farmers because they take too long to mature, do not ship well, or do not hold up for long on store shelves. The company has recently been considering ways to reduce its invest- ment in working capital in order to make itself more profitable. At present, it has an inventory conversion period of 90 days and offers credit terms of 30 days, which are taken full advantage of by the majority of its customers. The company purchases its inventory items on credit terms that allow it 45 days to pay, but it has always followed a policy of making cash payments for invoices as soon as they are received, so the accounts payable deferral period is typically only 5 days a. What are Caraway's operating and cash conversion cycles? b. If Caraway decides to take full advantage of its credit terms and delay payment until the last possible date, how will this impact its cash conversion cycle? c. What is your recommendation to the company with regard to its working capital management practices and why? Managing Current Liabilities

Explanation / Answer

Answer:

a. Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Purchase Outstanding

= 90 + 30 - 5

= 115 Days

b. Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Purchase Outstanding
=90 + 30 - 45

= 75 Days

Therefore by taking the full advantage of credit period available on purchase, the cash conversion cycle can be reduced by 40 days.

c. In order to manage the working capital in proper way, the Days Inventory Outstanding should be reduced by practicing just in time system etc. and the Days Sales Outstanding should also be reduced by giving lower credit period on sales and Days Purchase Outstanding should be increased so that there is more time to repay the debts due to purchases. This leades to more working capital being available instead of being tied up in the business thereby reduces the cost of capital.

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