Company Q has annual sales of $85 million of which 85% were on credit.
Q has a 20% gross margin on its sales and credit purchases are 90% of cost of sales. Q’s normal working capital investment is:
Inventory days: 100 days Receivable days: 70 days Payables days: 80 days
The industry averages for Q’s industry are: Inventory – 90 days; Receivables – 60 days; and Payables – 90 days.
(a) Calculate Q’s overall investment in working capital. (3 marks)
(b) What is the length of Q’s operating cycle? (2 marks)
(c) What is the length of Q’s cash conversion cycle? (2 marks)
(d) Explain the significance of the length of the cash conversion cycle. Why is working capital management important? (6 marks)
(e) If Q is financing its working capital investment through borrowings at 7% per annum, determine the annual interest savings if Q was able to improve its working capital management to match industry averages. (4 marks)
(f) Q is considering the introduction of a new credit policy including an early settlement discount for its customers. Under the proposed new policy, credit customers would get a 2% discount for settlement within 10 days. Customers not paying within 10 days would be required to pay within 60 days. Q believes that 25% of credit customers will take the discount and the rest will pay within 60 days. The cost of capital is 10%.
Determine if the proposed new policy is financially advantageous to Q by comparing the existing cost of carrying its receivables with the new cost including the cost of the early settlement discount. (8 marks)
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