17-6 WORKING CAPITAL INVESTMENT
The Prestopino Corporation produces motorcycle batteries. Prestopino turns out 1,500 batteries a
day at a cost of $6 per battery for materials and labor. It takes the firm 22 days to convert raw
materials into a battery. Prestopino allows its customers 40 days in which to pay for the batteries,
and the firm generally pays its suppliers in 30 days.
a. What is the length of Prestopino’s cash conversion cycle?
Cash conversion cycle = Inventory conversion period + Average collection period + Payables
deferred period
Cash conversion cycle = 22 days + 40 days – 30 days
Cash conversion cycle = 32 days
Inventory conversion period 22 days
Average collection period 40 days
Payables deferred period (30) days
Cash conversion cycle 32 days
b. At a steady state in which Prestopino produces 1,500 batteries a day, what amount of working
capital must it finance?
Units $1,500
Multiply by: cost per unit $ 6
Total Cost $9,000
Multiply by: cash conversion cycle 32 days
Working capital financing $288,000
c. By what amount could Prestopino reduce its working capital financing needs if it was able to
stretch its payables deferrals period to 35 days?
If the payables deferral period to 35 days, its working capital financing would reduce by
$45,000.
Units $1,500
Multiply by: cost per unit $ 6
Total Cost $9,000
Multiply by: cash conversion cycle - decrease 27 days
Working capital financing $243,000
Working capital financing = $288,000 – 243,000 = 45,000
d. Prestopino’s management is trying to analyze the effect of a proposed new production process
on its working capital investment. The new production process would allow Prestopino to
decrease its inventory conversion period to 20 days and to increase its daily production to 1,800
batteries. However,the new process would cause the cost of materials and labor to increase to $7.
Assuming the change does not affect the average collection period (40 days) or the payable
deferral period (30days), what will be the length of its cash conversion cycle and its working
capital financing requirement if the new production process is implemented?
Inventory conversion period 20 days
Average collection period 40 days
Payables deferred period (30) days
Cash conversion cycle 30 days
Units $1,800
Multiply by: cost per unit $ 7
Total Cost $12,600
Multiply by: cash conversion cycle 30 days
Working capital financing $378,000
17-7 CASH CONVERSION CYCLE
Christie Corporation is trying to determine the effect of its inventory turnover ratio and days
sales outstanding (DSO) on its cash conversion cycle. Christie’s 2014 sales (all on credit) were
$150,000; its cost of goods sold is 80% of sales; and it earned a net profit of 6%, or $9,000. It
turned over its inventory 6 times during the year, and its DSO was 36.5 days. The firm had fixed
assets totaling $35,000. Christie's payables deferral period is 40 days.
a. Calculate Christie's cash conversion cycle.
ICP = 365 / Inventory turnover ratio
ICP = 365 / 6
ICP = 60.83 days
Inventory conversion period 60.83 days
Average collection period (DSO) 36.5 days
Payables deferred period (40 days)
Cash conversion cycle 57.33 days or 57 days
b. Assuming Christie holds negligible amounts of cash and marketable securities, calculate
its total assets turnover and ROA.
COGS = Sales $150,000 x 80% = $120,000
Inventory = COGS / Inventory conversion period
= $120,000 / 6 times
= $20,000
Accounts receivable = (Sales / 365) × Average collection period
= ($150C,000 / 365) × 36.50
= $ 15,000
Total assets = Inventory + Accounts receivable + Fixed assets
= $20,000 + $15,000 + $35,000
= $70,000
Total asset turnover = Sales / Total assets
= $150,000 / $70,000
= 2.14 times
ROA = Net profit / Total assets
= $9,000 / $70,000
= 12.86%
OR
ROA = Net profit margin × Total asset turnover
= 6% × 2.14
= 12.84%
c. Suppose Christie's managers believe that the inventory turnover can be raised to 9.0 times.
What would Christie’s cash conversion cycle, total assets turnover, and ROA have been if the
inventory turnover had been 9.0 for 2015?
New ICP = 365 / 9 times = 40.56 days
New CCC = 40.56 + 36.50 – 40.00 = 37.06 days
Total assets = Inventory + Accounts receivable + Fixed assets
= ($120,000 /9) + $15,000 + $35,000
= $13,333 + $15,000 + $35,000
= $63,333
Total asset turnover = $150,000 / $63,333 = 2.37 times
ROA = 6% × 2.37 times = 14.21%
