Xtreme Toys is a small manufacturing company in Southern California.

Management is concerned
because as their sales have grown, their cash flow has shrunk. Management doesn't understand
how this could happen and has approached your team to find a solution for this dilemma.

1) Part A:
Calculate the following:

a) Inventory conversion period

b) Payables deferral period

c) Receivables conversion period

d) Operating cycle

e) Cash conversion cycle (cash gap)

If the company's cost of funds is 8%, what is the annual cost of financing the cash gap?

2) Part B:

Explain to Xtreme Toys management how rising sales could cause a decrease in the company's
cash position and provide three specific recommendations to management on ways to reduce the
cash gap. Explain to management why monitoring and managing the cash conversion cycle is
important to the overall profitability of the company.

Ans.

There are few options to reduce the cash gap. You can cut back on inventory in your warehouse, but doing so may
lead to shortages and eliminate bulk discounts. You can delay paying suppliers at the risk of losing early-bird
discounts and receiving less favorable credit terms.

So speeding up collections is often the most effective and simplest way to lower the cash gap. Five ways to
encourage customers to pay invoices include:

1. Performing credit checks on prospective customers,

2. Flagging new customers to ensure initial invoices are paid on time,

3. Sending out past-due reminder letters or email messages and following up with phone calls,

4. Offering early-bird discounts to customers that pay within 10 or 20 days, and

5. Hiring dedicated, experienced collection personnel.

To increase your receivables period, you can provide incentives for customer prepayment or discounts for early
payment along with incentives for and the option to pay using a credit card; send out invoices as soon as a sale is
complete; use a lockbox account, in which customers mail payment checks directly to a P.O. box set up by your
bank (this is also an excellent internal control to prevent fraud); and institute stricter collection procedures.
For days in inventory, you could move toward a just-in-time inventory system (producing
inventory to fulfill orders rather than accumulating stock), negotiate a better price for your inventory and materials
without sacrificing quality, and concentrate purchasing efforts on fast-moving inventory.

For the payables period, the best approach is to negotiate longer payment terms
with your vendors.

Cash Conversion Cycle

A companys cash conversion cycle consists of the operational journey a transaction takes to
generate money for the business. It starts with the review and background check of a
potential customer, the evaluation of the clients financial standing and creditworthiness,
and the credit approval for a specific transaction or a series of deals. After a company ships
merchandise to the patron, accounting managers record the underlying receivable, also
known as a customer receivable or account receivable. The corporate cash conversion cycle
also goes through the receipt of customer funds as well the collection and recovery efforts --
when it comes to customers default, near insolvency or bankruptcy.
Relationship

While theyre distinct concepts, working capital and a cash conversion cycle interact in a
companys operating machine. The business needs cash to soldier on, build strategic
commercial alliances, make money and propose items that will elevate its competitive
stature over time. Cash is a permanent fixture in business management, but it often is more
critical in the short term because an organization must pay its bills and earn revenue to be
around in the future -- say, one, two, five or 10 years.
Significance

In the corporate context, working capital discussions help top leadership sow the seeds of
commercial success, running efficient activities by the day to put the business on solid
operational footing. For senior executives, talking about the cash conversion cycle is a
money saver, an initiative that helps them rein in waste, avert significant operating losses
and replenish corporate coffers -- all of which prevent the entity from having monetary
problems and drifting over a financial Niagara Falls.

3) Part C:

Assume your recommendations have now resulted in Xtreme Toys being able to reduce their cash
gap by 20 days. Calculate the amount of additional cash that Xtreme Toy will now have on hand
and the savings on the annual cost of financing the cash gap at 8%. What tax considerations need to
be factored into your analysis?
 Xtreme Toys
Balance Sheet
Assets Liabilities and Equity
$ $
Cash and Marketable Securities 880,000 Accounts Payable 750,000

Accounts Receivable 2,075,000 Other Current Liabilities 1,950,000

$
Inventories 2,100,000 Total Current Liabilities 2,700,000

Other Current Assets 300,000

$
Total Current Assets 5,355,000 Long Term Debt 1,700,000

Plant and Equipment 3,700,000 Common Stock 300,000

Other Assets 700,000 Retained Earnings 5,055,000

$
Total Stockholder's Equity 5,355,000
$ $
Total Assets 9,755,000 Total Liabilities + Equity 9,755,000

Income Statement
$
Net Sales 12,000,000 .

Cost of Sales 6,700,000

Selling, General and Admin
Expenses 2,450,000

Other Expenses 550,000

$
Total Expenses 9,700,000

Earnings before taxes 2,300,000

Taxes 825,000
$
Net Income after Taxes 1,475,000

Payables Deferral Period

Accounts Payable 750,000
Cost of Sales/360 18,611
= Payables Deferral Period (days) 40

Inventory Conversion Period

Average Inventory 2,100,000
Cost of Sales/360 18,611
= Inventory Conversion Period (days) 113

Receivables Conversion Period

Accounts Receivable 2,075,000
 Annual Sales/360 33,333
= Receivables Conversion Period
(days) 62

Operating Cycle = days taken in

selling + days taken in recovering
cash
Cash Conversion Cycle

$
Daily Cost of Sales 18,611
x Cash Conversion Cycle 135 135
= Financing Needs $ 2,512,485

Cost of Funds @ 8% 200,999

Reduce CCC by 20 days 115

$
Financing Needs 2,140,265
$
Cost of Funds @ 8% 171,221
$
Cash Savings 29,778

$
Additional Cash on Hand 909,778
(as a result of reduced financing
needs)