Consider the case of Green Melon Electronics Company Green Melon Electronics Com
ID: 1171539 • Letter: C
Question
Consider the case of Green Melon Electronics Company Green Melon Electronics Company is a mature firm that has a stable flow of business. The following data was taken from its financial statements last year: $10,500,000 Annual sales Cost of goods sold$7,140,000 Inventory Accounts receivable $2,100,000 Accounts payable $2,600,000 $3,100,000 Green Melon's CFO is interested in determining the length of time funds are tied up in working capital. Use the information in the preceding table to complete the following table. (Note: Use 365 days as the length of a year in all calculations, and round all values to two decimal places.) Value Inventory Conversion Period Average collection period Payables Deferral Period Cash conversion cycle Both the inventory conversion period and payables deferral period use the average daily COGS in their denominators whereas the average collection period uses average daily sales in its denominator. Why do these measures use different inputs? Inventory and accounts payable are carried at cost on the balance sheet, whereas accounts receivable are recorded at the price at which goods are sold O Current assets should be divided by sales, but current liabilities should be divided by the COGS The management at Green Melon Electronics Company wants to continue its internal discussions related to its cash management. One of the finance team members presents the following case to his cohorts Which of the following responses to the CFOs statement is most accurate? Case in Discussion The CFO's approximation of the length of the bank loans should be accurate, because it will take 75 days for the company to manufacture, sell, and collect cash for its goods. All these things must occur for the company to be able to repay its loans from the bank Extensive Enterprise's management plans to finance its operations with bank loans that will be repaid as soon as cash is available The company's management expects that it will take 40 days to manufacture and sell its products and 35 days to receive payment from its customers. Extensive's CFO has told the rest of the management team that they should expect the length of the bank loans to be approximately 75 days. The CFO is not taking into account the amount of time the company has to pay its suppliers. Generally, there is a certain length of time between the purchase of materials and labor and the payment of cash for them. The CFO can reduce the estimated length of the bank loan by this amount of timeExplanation / Answer
Inventory Conversion Period = Days Inventory Outstanding = DIO = (365 x Inventory / COGS) = (365 x 3100000 / 7140000) = 158.47 days
Average Collection Period = Days Sales Outstanding = DSO = (365 x Accounts Receivable / Annual Sales) = (365 x 2100000) / 10500000) = 73 days
Payables Deferral Period = Days Payable Outstanding = DPO = (COGS x Accounts Payable / COGS) = (365 x 2600000 / 7140000) = 132.91 days
Cash Conversion Cycle = DIO + DSO - DPO = 158.47 + 73 - 132.91 = 98.56 days
DIO and DPO uses COGS whereas DSO uses Annual Sales because Accounts Receivable is recorded at the selling price whereas Inventory and Accounts Payable are recorded at cost. Hence, the correct option is (a).
As accounts payable are considered as a source of cash by a firm, the time it takes to convert raw material to inventory to sales to sale proceeds collection can be reduced by the delay in paying the firm's suppliers (DIO + DSO), thereby creating accounts receivable. Hence, the firm requires cash financing for a period of time less than (DIO + DSO). The amount of reduction being DPO. Hence, the correct option is (b).