Question

American Products is concerned about managing cash efficiently. On average, inventories have an age of 80 days, and accounts receivables are collected in 40 days. Accounts payable are paid on average 30 days after they arise. The firm has annual credit sales of $30 million, cost of goods sold total $20 million, and purchases are $15 million.

1. What is operating cycle? Calculate the firm’s operating cycle and explain what it means.
2. What is cash cycle? Calculate the firm’s cash cycle and explain what it means
3. Calculate the amount of cash needed to support the firm’s cash cycle
4. Discuss how management might be able to reduce the cash cycle. What is the benefit to have a short cash cycle?

Answer 1

Operating Cycle = Inventory period + Accounts Receivables Period

Op. Cycle = 80+40 = 120 days

It implies it takes 120 days to receive inventory sell and realise in cash by sale of inventory

Cash Cycle = Days of Inv O/S + Days of Acc. Rec. O/S - Days of Acc. Payables O/S

Cash Cycle = 80+40-30 = 120-30 = 90 days

Cash to support cash cycle

Inventory = $ 30,000,000 * 80/365 = 6575342

+Acc Rec= $ 30,000,000 * 40/365 = 3287671

-Acc Pay = $ 15,000,000 * 30/365 = 1232877

Cash needed = 8630135

The management can reduce the cash cycle by reducing the average colletion period or by increasing the accounts payable period by doing this the company is able to retain more cash with the company there by reqire less cash to support the business which inturn reduce the working capital costs.