Pretty Lady Cosmetic Products: Average Production
Ch15 1pretty Lady Cosmetic Products Has An Average Production Process
Ch15 1pretty Lady Cosmetic Products has an average production process time of forty days. Finished goods are kept on hand for an average of fifteen days before they are sold. Accounts receivable are outstanding an average of thirty-five days, and the firm receives forty days of credit on its purchases from suppliers.
a. Estimate the average length of the firm’s short-term operating cycle. How often would the cycle turn over in a year?
b. Assume net sales of $1,200,000 and cost of goods sold of $900,000. Determine the average investment in accounts receivable, inventories, and accounts payable. What would be the net financing need considering only these three accounts?
Paper For Above instruction
The short-term operating cycle of a company, also known as the cash conversion cycle, measures how quickly a company can convert its inventory and other resources into cash flows from sales. It comprises three primary components: the inventory period, the receivables period, and the payables period. Calculating this cycle provides valuable insights into the company's liquidity management and operational efficiency.
Part A: Estimating the Operating Cycle and Turnover Frequency
To estimate the firm's average operating cycle, we sum the inventory and receivables periods since the payables period reduces the total cycle duration. From the given data:
- Average inventory holding period: 15 days
- Average receivable collection period: 35 days
- Average production process time: 40 days
Initially, the total cycle duration can be calculated as the sum of production time, inventory holding period, and receivables period:
Operating cycle = Production process time + Inventory period + Receivables period
= 40 days + 15 days + 35 days
= 90 days
However, this calculation assumes the inventory maturation and receivables collection are sequential and do not overlap. Alternatively, in some financial analyses, the production process is included within the inventory period, emphasizing the time from raw materials to finished goods ready for sale. If the production process is part of the inventory period, then the operating cycle simplifies to:
Operating cycle = Inventory period + Receivables period
= 15 days + 35 days
= 50 days
Given the context, the production process is a separate phase, so the total operating cycle is approximately 90 days.
To find how often the cycle turns over during a year, divide the number of days in a year (365) by the cycle length:
Cycle turnover per year = 365 / Operating cycle
= 365 / 90
≈ 4.06 times per year
Thus, the company’s short-term operating cycle completes roughly 4 times annually.
Part B: Calculating the Investment in Accounts Receivable, Inventory, and Accounts Payable, and Net Financing Need
Using the given sales and cost data:
- Net sales = $1,200,000
- Cost of goods sold (COGS) = $900,000
First, determine the receivables, inventory, and payables balances based on their respective periods:
1. Accounts Receivable:
Average receivables = (Receivables period / 365) * Net sales
= (35 / 365) * $1,200,000
≈ 0.0959 * $1,200,000
≈ $115,068
2. Inventory:
Average inventory = (Inventory period / 365) * COGS
= (15 / 365) * $900,000
≈ 0.0411 * $900,000
≈ $36,986
3. Accounts Payable:
Average payables = (Payables period / 365) * COGS
= (40 / 365) * $900,000
≈ 0.1096 * $900,000
≈ $98,630
To determine the net short-term investment (or net working capital requirement), subtract current liabilities (accounts payable) from current assets (accounts receivable + inventory):
Net financing need = Accounts receivable + Inventory – Accounts payable
= $115,068 + $36,986 – $98,630
= $51,424
This net figure indicates the amount of external funding required to finance the company's short-term operating assets.
Summary of findings:
- The company's short-term operating cycle is approximately 90 days, with an estimated cycle turnover of about four times per year.
- The average investment in accounts receivable is roughly $115,068.
- Inventory investment averages approximately $36,986.
- Accounts payable represents around $98,630.
- The net financing need, considering these accounts, is approximately $51,424.
Implications
Optimizing these components can improve liquidity and reduce the external financing requirement. For instance, decreasing receivable collection periods or inventory holding times can directly impact the net working capital needs. The balance between extending credit to customers and managing receivables efficiently is crucial for maintaining liquidity without losing sales. Likewise, negotiating better credit terms with suppliers can decrease the financing burden.
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