Pretty Lady Cosmetic Products Has An Average Producti 766653

Pretty Lady Cosmetic Products Has An Average Production Process Time

Pretty Lady Cosmetic Products has an average production process time of 40 days. Finished goods are kept on hand for an average of 15 days before they are sold. Accounts receivable are outstanding an average of 35 days, and the firm receives 40 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?

Another scenario involves a supplier offering a 2 percent cash discount if payments are made within ten days, with the bill due at 60 days otherwise. Should the firm borrow from a bank at an 18 percent annual interest rate to take advantage of this discount? Explain your reasoning.

Paper For Above instruction

The financial management of a manufacturing firm such as Pretty Lady Cosmetic Products hinges significantly on understanding and managing working capital components and supplier terms effectively. In this analysis, we assess the firm's short-term operating cycle, evaluate investment needs, and analyze the desirability of discount-related borrowing decisions to optimize cash flow and profitability.

Estimating the Operating Cycle

The operating cycle of a firm represents the time span from the acquisition of raw materials to the collection of cash from sales. It encompasses the production process, inventory holding, sales, and receivables collection. Based on the data provided, the calculation involves summing the durations of inventory holding, plus the accounts receivable period, minus the accounts payable period, to identify the net timing of cash inflows and outflows.

Specifically, the production process time is 40 days, reflecting the manufacturing duration. Finished goods are held an additional 15 days post-production before sale, indicating an inventory holding period of 15 days. Therefore, the total inventory holding period is 55 days (40 + 15). The accounts receivable period is 35 days, representing the time taken to collect cash after sales.

On the other hand, the firm benefits from a credit period of 40 days from suppliers, meaning the cash outflow for purchases of raw materials can be deferred, effectively reducing short-term working capital needs. Consequently, the operating cycle length is calculated as the inventory period plus receivables minus payables: 55 + 35 - 40 = 50 days.

The firm's operating cycle is approximately 50 days. To determine how many times this cycle occurs within a year, divide 365 days by 50: 365 / 50 ≈ 7.3. Thus, the cycle turns over about 7 times annually, informing inventory turnover and receivables management strategies.

Assessing Investment in Accounts Receivable, Inventories, and Accounts Payable

Given net sales of $1,200,000 and cost of goods sold (COGS) of $900,000, we proceed to estimate the average investments in current assets and liabilities. First, calculate the receivables and inventory balances using the respective turnover ratios and days outstanding.

Average accounts receivable is derived as: (Accounts receivable turnover) = 365 / receivables collection period = 35 days. The formula for accounts receivable investment is:

Accounts receivable = (Net sales / 365) × receivables collection period = ($1,200,000 / 365) × 35 ≈ $114,794.

Similarly, inventory investment is calculated based on the inventory holding period. The inventory turnover ratio is COGS divided by average inventory, but we focus on the days inventory outstanding:

Inventory investment = (COGS / 365) × inventory holding period = ($900,000 / 365) × 15 ≈ $37,012.

Accounts payable is calculated as: (Accounts payable) = (Purchases / 365) × payable period. Assuming purchases are approximately equal to COGS (assuming zero opening and closing inventory for simplicity),:

Accounts payable = ($900,000 / 365) × 40 ≈ $98,630.

The net working capital investment considering these accounts is:

Required investment = Accounts receivable + Inventory - Accounts payable ≈ $114,794 + $37,012 - $98,630 ≈ $53,176.

Analysis of Discount Offer and Borrowing Decision

The supplier offers a 2 percent discount for payments within 10 days, otherwise the bill is due at 60 days. To decide whether borrowing at 18 percent annually makes sense, compare the effective cost of forgoing the discount with the interest cost of borrowing.

The cost of not taking the discount—paying at 60 days instead of 10—is calculated as:

Discount percentage / (1 - discount percentage) / (Number of days difference / 360) = (2% / (1 - 0.02)) / (50 / 360) ≈ (0.0204) / (0.1389) ≈ 0.147, or 14.7% annualized rate.

This rate (14.7%) exceeds the bank's 18% interest rate, indicating that borrowing to pay early and take advantage of the discount is not cost-effective, since the discount's implied cost (14.7%) is lower than the bank's interest rate (18%). Conversely, since paying early costs less in effective interest than borrowing directly, the firm should take the discount if they can borrow at less than 14.7% annual interest, which is unlikely given standard market rates.

Thus, the firm should not borrow at 18% to pay early and secure the discount. Instead, it should either pay later and benefit from the supplier's extended terms or secure financing at a rate lower than 14.7% to capitalize on the discount. Since the bank interest rate is higher, and the effective discount rate is lower, it is optimal to avoid borrowing solely to pay early, unless favorable financing terms can be negotiated.

Conclusion

Effective working capital management involves understanding the firm's operating cycle, optimizing receivables and payables, and evaluating supplier discounts carefully. The firm's approximate 50-day operating cycle occurs about 7 times annually, guiding inventory and receivables policies. Investment in current assets totals around $53,176, necessitating appropriate short-term financing options. Regarding supplier discounts, paying early at the expense of borrowing at 18% is generally unjustified since the discount rate calculated is lower than the bank interest rate, suggesting the firm should either accept longer payment terms or seek cheaper financing if they wish to take advantage of early discounts.

References

• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Ross, S. A., Westerfield, R., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
• Damodaran, A. (2015). Applied Corporate Finance. Wiley.
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson.
• Higgins, R. C. (2012). Analysis for Financial Management. McGraw-Hill Education.
• Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of Financial Management. Pearson Education.
• Ross, S. A., & Westerfield, R. W. (2013). Essentials of Corporate Finance. McGraw-Hill Education.
• Levine, R. (2005). Finance and Growth: Theory and Evidence. In P. Aghion & S. Durlauf (Eds.), Handbook of Economic Growth.
• Myers, S. C. (2001). Capital Structure. Journal of Economic Perspectives, 15(2), 81–102.
• Tirole, J. (2006). The Theory of Corporate Finance. Princeton University Press.