Unit 3 Planning

For
RECEIVABLE COLLECTION PERIOD (RCP)/ DAYS SALES
OUTSTANDING (DSO)/ AVERAGE COLLECTION PERIOD (ACP):

It represents the average length of time to convert the firm’s receivable into cash.
In other words, RCP refers the time lag between the sale of goods in credit and
Working Capital collection of cash. It is computed by using following equation :
Account receivable
×Day sin ayear
Annnual credit sales
WORKING CAPITAL CASH FLOW CYCLE RCP =

Cash conversion cycle represents the time between when the firm makes
Account receivable
payments and when it receives cash from the sale of finished goods. In other
words, it represents the time the firm has tied up in working capital. Working Or, Daily credit sales
capital cash flow cycle mainly includes following three components, which are; (Note: Less RCP is preferable)

Gross cash conversion cycle/ Operating cycle = ICP + RCP

INVENTORY CONVERSION PERIOD (ICP): - represents the average length
of time required to convert raw materials into finished goods and then sell those
goods (in credit). In other words, ICP can be defined as the time lag between the PAYABLE DEFERRAL PERIOD (PDP): - represents the average length of
purchase of materials and conversions of raw materials into finished goods and time between the purchase of raw materials and labour and the payment of cash
then sell them. Inventory conversion period is computed by using following for them. It is computed by using following equation;
equation : Account payable
PDP = Annual credit purchase × days in a year
Days in a year Or, A/P/Credit purchase per day
Or, A/P/ Cost of goods sold ×days in a year
Inventory turnover ratio (Note: High PDP is preferable)
(ICP)=
Where,
Cost of goods sold CASH CONVERSION CYCLE: After computing above three components,
cash conversion cycle can be calculate by using following equation
Inventory turnover ratio = Average inventory
Cash conversion cycle = ICP + RCP – PDP
(Note: Less ICP is preferable because less ICP refers high sales as well as
inventory turnover which are both beneficial for an organization)  or, CCC = Operating cycle -PDP
Significance of cash conversion cycle: As we know that, both excessive as well
as insufficient level of working capital is harmful for an organization, the
financial manager should more focused on determining optimum level of working
capital. Determination of cash conversion cycle helps the financial manager to
manage the optimum level of working capital to run day-to-day operations
COMPUTATION OF WORKING CAPITAL
smoothly.
1. FOR MANUFACTURING CONCERN ORGANIZATION:
Cash conversion cycle represents the time interval over which additional funds, (Firms that purchase materials convert into finished goods and sell it)
called working capital should be obtained in order to carry out the firm’s Production cost
operations. For example; cash conversion cycle of 40 days refers that the firm  Direct materials
 Direct labor
should manage manufacturing and other expenses for 40 days. Meaning that
 Overhead expenses
working capital for 40 days should be managed by the firm. Therefore, cash  Manufacturing overhead
conversion cycle plays vital role to determine the optimum level of working  Administration overhead
capital.  Selling and distribution overhead
Requirement of working capital financing = CCC × Daily working Statement of working capital requirement
Particulars Amount Amount
capital
A) Estimation of Current Assets
Finally, it can be conclude that the firm should try to reduce working capital 1) Inventory
financing. To reduce requirement of working capital financing, the firm should Raw materials ××××
shorten its cash conversion cycle both shortening ICP and RCP or lengthening Work-in-progress ××××
Finished goods: ×××× ××××
PDP considering firm’s creditworthiness

2) Debtors ××××

3) Cash balance (if any) ××××

4) If advance payment is to be made to

creditors ××××

(A) Total Current Assets ××××

B) Estimation of Current Liabilities
1) Creditors ××××
2) Outstanding expenses ××××
3) Others if any ××××
4) If payment is received in advanced ××××
××××
 (B) Total Current Liabilities ×××× Production units ×Overhead cost per unit
×××× × Average time
Days / Months/Weeks∈ a year
C) Net working capital (A-B) lag in payment of overhead
Add: Provision for contingencies ××××
Total working capital
POINTS TO BE REMEMBER
(i) Work-in-progress = Raw material + Wages + Manufacturing
The amount of different items is estimated in the following ways:
(i) Amount of Raw materials: expenses
Production units ×Cost per unit (ii) While determining WIP, the net profit should not be included
× Average holding period
Days / Months/Weeks∈ a year (iii) While determining the value of WIP, degree of completion should
inventory be regarded as basis. If the degree of completion or complete work
(ii) Work-in-progress percentage is not mentioned in the question, 100% cost of material,
wages and overhead should be considered as WIP.
Production units ×Cost of WIP per unit
× Average time span of (iv) The finished goods and debtors should be valued at cost unless
Days /Months /Weeks∈a year
WIP otherwise asked in the question.
(iii) Finished goods inventory (v) Creditor’s amount is calculated on the basis of purchasing price of
Production units × TCPU raw materials.
× Finished goods holding
Days/ Months/Weeks ∈a year
period

(iv) Debtors
Credit sales ×TCPU
× Average collection period
Days/ Months/Weeks ∈a year
(v) Creditors
Production units ×Cost of raw materials per unit
× Credit
Days/ Months /Weeks ∈a year
allowed by creditors

(vi) Direct wages

Production units × Direct labour cost per unit
× Average
Days / Months/Weeks∈a year
time lag in payment of wages

(vii) Overhead ( other than depreciation and amortization)

 a) What is the length of the firm’s cash conversion cycle?
b) If Saliford’s annual sales are Rs.3960000 and all sales are on credit,
what is the average balance in account receivable?
c) How many times per year does Saliford turnover its inventory?
d) What would happen to Saliford’s cash conversion cycle? If, on
average inventories could be turned over 8 times a year?
Problem-4.
The Falimngo Corporation is trying to determine the effect of its inventory
turnover ratio and days sales outstanding (DSO) on its cash flow cycle.
Flamingo’s 2011 sales (all on credit) were Rs.180000, and it earned a net
profit of 5 percent, or Rs.9000. The cost of goods sold equals 85 percent of
sales. Inventory was turned over 8 times a year, and the DSO was 36 days.
The firm had fixed assets totaling Rs.40,000. Flamingo’s payables deferral
PRACTICAL PROBLEMS
period is 30 days.
Problem-1. a) Calculate Flamingo’s cash conversion cycle.
RTC is concerned about managing cash efficiently. On average inventories b) Assuming Flamingo holds negligible amounts of cash and
have an average age of days, and account receivable are collected in 90 days. marketable securities calculate its total assets turnover and ROA?
Account payable is paid 30 days after they arise. c) Suppose Flamingo’s managers believe that the inventory turnover
a. Calculate the firm’s operating cycle. can be raised to 10 times. What would Flamingo’s cash conversion
b. Calculate the firm’s cash conversion cycle. cycle, total assets turnover, and ROA have been if the inventory turns
over had been 10 for 2011?
Problem-2.
ABC Corporation turned over its inventory 4 times during the year, and its Problem-5.
DSO was 30 days. The Corporation’s payable deferred period is 40 days. Verbrugge Corporation is a leading US producer of automobile batteries.
a. Calculate the length of cash conversion cycle. Verbrugge turns out 1500 batteries a day at a cost of Rs.6 per battery for
b. If the inventory turnover can be raised to 6 time, what would be the materials and labor. It takes the firm 22 days to convert raw materials into a
cash conversion cycle? battery. Verbrugge allows its customers 40 days in which to pay for the
batteries, and the firm generally pays its suppliers in 30 days.
Problem-3. a) What is the length of Verbrugge’s cash conversion cycle?
The Saliford Corporation has an inventory conversion period of 60 days, a b) If Verbrugge always produces and sells, 1500 batteries a day, what
receivables conversion period of 36 days, and a payables deferral period of 24 amount of working capital must it finance?
days.
 c) By what amount could Verbrugge reduce its working capital financing Accounts payable 1600 2,400
needs if it was able to stretch its payables deferral period to 35 days? Account payable 2,700 4,800
d) Verbrugge’s management is trying to analyze the effect of a proposed Required:
new production process on the working capital investment. The new a. How long does it take to collect its receivable?
production process would allow Verbrugge to decrease its inventory b. How long does inventory stay around before it is sold?
conversion period to 20 days and to increase its daily production to c. How long does it take to pay its bills?
1800 batteries. However, the new process would cause the cost of d. Compute the length of cash conversion cycle.
materials and labor to increase to Rs.7. Assuming the change does not
affect the receivables conversion period (40 days) or the payables Problem-8.
deferral period (30 days), what will be the length of the cash conversion
The Mercantile Computer Inc. is attempting to analyze its efficiency in working
cycle and the working capital financing requirement if the new
capital management. The firm has sales of Rs.360,000 this year of which 80
production process is implemented?
percent are in credit. The investment in receivables for the firm is worth
Rs.50,000. The cost of goods sold which includes the material and labor costs are
Problem-6. amounted to 60 percent of sales (assume all purchases are in credit). The firm has
Sunrise corporation is concerned about managing cash efficiently. On average
Rs.60,000 investment in inventories and an average accounts payable of rs.30,000.
inventories have an average age of 75 day, and accounts receivable are collected in
Assume 360 days a year.
40 day. Account payable is paid approximately after 35 days they arise. The firm
a. What are the firm’s days sales outstanding, inventory conversion period
spends Rs 50 million operating cycle investments each year, at a constant rate.
and payable deferral period?
Assuming 360 days year.
b. What is the length of cash conversion cycle?
a. Calculate the firm’s operating cycle.
c. What amount of working capital must it finance?
b. Calculate the firm’s cash conversion cycle.
d. What is the working capital turnover of the firm?
c. Calculate the amount of negotiated financing required to support the
firm’s cash conversion cycle. Answer
d. Discuss how management might be able to reduce the cash conversion 1. a. 130 b 100
cycle. 2. a. 80 b. 50
3. a. 72 days b. Rs.396000 c. 6 times d.57 days
Problem-7. You are given the following information: 4. a. 51 days b. 2.33 times and 11.67% c.42 days, 2.46 times, 12.28%
5. a. 32 days b.Rs.288000 and 11.25 times c. 45000 d.30 days, Rs.378,000, 12

Sales for the year just ended were Rs.50,000 and cost of goods sold was 60 percent times
6. a.111 days b. 80 days c.Rs.11,111,111
of sales.
7. a.14.40 days b.72 days c.45 days d.41.4 days
Item Beginning (Rs.) Ending 8. a.62.5 days, 100 days and 50 days b.112.5 days c.Rs.67,500 d.3.2 times
Inventory 5,000 7,000