A B C D E F

1 Tool Kit Chapter 16

2 Supply Chains and Working Capital Management
3
4 16-3 The Cash Conversion Cycle
5
6 The cash conversion cycle starts with the receipt of raw materials and ends with the collection of cash from
7 sales.
8
9 Target Inputs:
10 Target inventory conversion period, ICP (days) = 50
11 Target average collection period, ACP (days) = 60
12 Target payables deferral period, PDP (days) = 40
13
14 Target Cash Conversion Cycle:
15
16 Target Cash Inventory
Average
17 Conversion Cycle = conversion +
collection period
−
18 (CCC) period
19 = 50 + 60 −
20 = 70
21
22 Selected Items from GBM's Financial Statements (Millions of Dollars)
23
24 Annual sales $150
25 Cost of goods sold $122
26 Inventories $17
27 Accounts receivable $51
28 Accounts payable $13
29
30 Days/year 365
31
32
33 Figure 16-3
34 GBM's Target and Actual Cash Conversion Cycles (Dollars in Millions)
35 Panel A. Target CCC: Based on Plans
36 Target Cash Planned Credit Terms
Inventory
37 Conversion Cycle = Conversion + Offered to −
38 (CCC) Customers (ACP)
Period (ICP)
39 = 50 + 60 −
40 Target CCC = 70
41 Panel B. Actual CCC: Based on Financial Statements
42
43 Sales $150.0
44 COGS $122.0
45 Inventories $17.0
46 Receivables $51.0
47 Payables $13.0
48 Days/year 365
49 Inventory ÷ Receivables ÷
Actual CCC = + −
50 (COGS/365) (Sales/365)
51 = $17 ÷
+ $51 ÷
−
($122/365) ($150/365)
 A B C÷
$17 D E÷
$51 F
= + −
52 ($122/365) ($150/365)
53 = 50.9 + 124.1 −
54 Actual CCC = 136.1
55 Panel C. Actual versus Target Components
56 ICP ACP
57 Actual − Target = 50.9 − 50.0 124.1 − 60.0
58 = 0.9 64.1
59 % Difference = 1.7% 106.8%
60 Evaluation = Ok Bad
61 Numbers in the figure are shown as rounded values for clarity in reporting. However unrounded values are
62 used for all calculations.
63
64
65 Improvement in the cash conversion cylce can lead to substantial reductions in interest expenses due to
66 working capital loans and to substantial increases in free cash flow.
67
68 Figure 16-4
69 Benefits from Reducing the Cash Conversion Cycle (Dollars in Millions)
70
71 New Targets for Conversion Periods Old (Actual) New Target
72 Inventory conversion period (ICP, days) 50.9 35.0
73 Average collection period (ACP, days) 124.1 40.0
74 Payable deferral period (PDP, days) 38.9 50.0
75 Cash Conversion Cycle (CCC, days) 136.1 25.0
76 Reduction in Cash Conversion Cycle: 111.1
77
78 Impact of Reduction in CCC Old (Actual) New Target
79 Annual sales: No change $150.00 $150.00
80 Costs of goods sold (COGS): No change $122.00 $122.00
81 Inventory: New level is ICP(COGS/365) $17.00 $11.70
82 Receivables: New level is ACP(Sales/365) $51.00 $16.44
83 Payables: New level is PDP(COGS/365) $13.00 $16.71
84 Net operating working capital:
85 NOWC = Inventory + Receivables – Payables $55.00 $11.42
86 Interest rate on NOWC loans (10%) 10%
87 Interest expense due to NOWC: 10%(NOWC) $5.50 $1.14
88
89 Improvement in Selected Results
90 Reduction in NOWC: $43.6
91 Increase in free cash flow: $43.6
92 Reduction in interest expense: $4.36
93 Numbers in the figure are shown as rounded values for clarity in reporting. However unrounded
94 values are used for all calculations.
95
96
97
98 Comparing the Days of Working Capital Measure with the Cash Conversion Cycle
99 In the chapter's opening vignette, we discussed "Days of working capital." DWC is essentially the same as the
100 CCC except that the CCC uses the COGS when calculating both the ICP and the PDP whereas DWC uses sales for all
101 calculations. Here's the DWC calculation for GBM:
102 Actual data
103 Days of Working Capital (DWC): NOWC/(Sales/365) 133.8
 A B C D E F
104 CCC: NOWC component ÷ Sales or COGS ÷ 365 136.1
105
106 The CCC is larger than the DWC because Sales > COGS, and Sales is always used in the denominator for the DWC,
107 lowering the result if inventories exceed payables. We regard the CCC as being a more meaningful because it is
better reflects actual cash values.
 G
1 11/23/2018
Capital Management
2
3
4
5
6 of cash from
ends with the collection
7
8
9
10
11
12
13
14
15
16 Payables
17 deferral
18 period
19 40
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36 Credit Terms
Offered by
37 Suppliers
38 (PDP)
39 40
40
41
42
43
44
45
46
47
48
49 Payables ÷
50 (COGS/365)
51 $13 ÷
($122/365)
 G÷
$13
52 ($122/365)
53 38.9
54
55
56 PDP
57 38.9 − 40.0
58 −1.1
59 −2.8%
60 Ok
rting. However unrounded61 values are
62
63
64
65 due to
uctions in interest expenses
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
the Cash Conversion Cycle
al." DWC is essentially99
the same as the
nd the PDP whereas DWC 100uses sales for all
101
102
103
 G
104
105
106 for the DWC,
ays used in the denominator
107 because it is
as being a more meaningful
Scenario Summary
Current Values: Base Case Big Discount Short Net Period Long Net Period
Changing Cells:
$G$348 Base Case Base Case Big Discount Short Net Period Long Net Period
$G$349 20% 20% 70% 50% 5%
$G$351 10% 10% 10% 10% 90%
$G$352 100% 100% 100% 100% 100%
$G$353 60% 60% 60% 60% 60%
$G$354 $30 $30 $30 $30 $30
$G$355 $150 $150 $150 $150 $150
$G$356 $10 $10 $10 $10 $10
$G$357 2% 2% 4% 2% 1%
$G$358 10 10 10 10 10
$G$359 60 60 30 30 90
$G$360 0% 0% 0% 0% 15%
$G$361 0% 0% 10% -10% 20%
Result Cells:
$H$396 −$26.2 −$26.2 $0.8 −$21.7 −$103.2
$I$396 −$52.8 −$52.8 $25.9 −$30.8 −$224.4
$J$396 −$234.8 −$234.8 −$103.5 −$199.3 −$550.7
$K$396 −$86.2 −$86.2 −$21.7 −$118.0 −$491.9
$L$396 $17.8 $17.8 $40.1 −$61.7 −$276.1
$M$396 $27.0 $27.0 $29.4 −$80.0 −$198.2
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
 Terrible Economy

Terrible Economy
20%
10%
100%
60%
$30
$150
$10
2%
10
60
0%
0%

−$26.2
−$52.8
−$234.8
−$86.2
$17.8
$27.0
SECTION 16-3
SOLUTIONS TO SELF TEST

A company has $20 million in inventory, $5 million in receivables, and $4 million in payables. Its annual
sales revenue is $80 million and its cost of goods sold is $60 million. What is its CCC?

Inventory $20
Receivables $5
Payables $4
Sales $80
COGS $60

Inventory conversion period = 121.67

Average collection period = 22.81

Payables deferral period = 24.33

Cash conversion cycle = 120.15

SECTION 16-4
SOLUTIONS TO SELF TEST

A company has $20 million in cost of goods sold and an inventory turnover ratio of 2.0. If it can reduce its
inventory and improve its inventory turnover ratio to 2.5 with no loss in units sold and no change in cost of
goods sold, by how much will FCF increase?

Inputs (Dollars in Millions)

Cost of goods sold (COGS) $20
Old inventory turnover ratio 2.0
New inventory turnover ratio 2.5

Intermediate Calculations
Old inventory = COGS / (Old Inv. Turnover) = $10.00

New inventory = COGS / (New Inv. Turnover) = $8.00

Final Result
Increase in available free cash flow $2.00
SECTION 16-5
SOLUTIONS TO SELF TEST

A company has annual sales of $730 million. If its DSO is 35, what is its average accounts receivables balance?

Annual sales $730

DSO 35.0

Daily sales $2.00

Accounts receivables = DSO × Daily Sales $70.00

SECTION 16-6
SOLUTIONS TO SELF TEST

A company has credit terms of 2/12 net 28. What is the nominal annual cost of trade credit? The effective
annual cost?

Discount percentage 2%
Dicount period 12
Regular credit period 28

Nominal annual cost of credit = Cost per period × Number of periods per year
0.0204 × 22.8125

Nominal annual cost of credit = 46.6%

Effective annual cost of credit = [ (1 + Cost per period) ^ (Number of periods per year) ] – 1
1.0204 ^ 22.8125 – 1
1.5855 – 1

Effective annual cost of credit = 58.5%

SECTION 16-12
SOLUTIONS TO SELF TEST

Simple interest loan

If a firm borrowed $500,000 at a rate of 10% simple interest with monthly interest
payments and a 365-day year, what would be the required interest payment for a 30-day
month?

Nominal rate 10%

Amount borrowed $500,000.00
Days/year 365

Rate/day = nominal rate / 365 = (fraction, not %) 0.000273972603

Interest / month = Amount borrowed × rate/day × 30 = $4,109.59

If interest must be paid monthly, what would be the effective annual rate?

If interest had to be paid daily, the effective rate would be found as follows:
Effective rate = (1 + nom rate/365)^365 – 1.0 = 0.10515578162 or 10.52%

However, interest must be paid monthly, so the effective rate is lower, found as follows:
Effective rate = (1 + nom rate/12)^12 – 1.0 = 0.10471306744 or 10.47%

It would be easy to go wrong on this problem for two reasons. First, you must recognize that the
monthly interest payment will vary depending on how many days are in the month, and second,
you must differentiate from daily interest compounding and monthly compounding.

Add-on Loan
If this loan had been made on a 10% add-on basis, payable in 12 end-of-month
installments, what would be the monthly payments?

Find the total interest: 0.1 × $500,000 = $50,000.00

Find the total amount of the loan: $500,000 + $50,000 = $550,000
Find the monthly payments: $550,000/12 = $45,833.33

What is the annual percentage rate?

Use the RATE function to find the rate that causes the PV of the monthly payment stream to equal
the amount borrowed. This is the nominal rate.

APR = Rate = 17.97%

What is the effective annual rate?

EFF using algebraic formula = 0.1953 = 19.53%

EFF using Excel function = 0.1953 = 19.53%