Question

Williams & Sons last year reported sales of $22 million, cost of goods sold (COGS) of $18 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 3 while maintaining the same level of sales and COGS, how much cash will be freed up? Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

Sales = $22,000,000
Cost of Goods Sold = $18,000,000

If Inventory Turnover Ratio is 2:

Inventory Turnover Ratio = Cost of Goods Sold / Average Accounts Receivable
2 = $18,000,000 / Average Accounts Receivable
Average Accounts Receivable = $9,000,000

If Inventory Turnover Ratio is 3:

Inventory Turnover Ratio = Cost of Goods Sold / Average Accounts Receivable
3 = $18,000,000 / Average Accounts Receivable
Average Accounts Receivable = $6,000,000

Cash Freed Up = $9,000,000 - $6,000,000
Cash Freed Up = $3,000,000

So, if inventory turnover ratio is increased to 3 times, then $3,000,000 cash will be freed.