D F H Only] [Repaired] B 4 21-3 The Cash Conversion Cycle E 5 G 6 The cash conversion cycle starts with the receipt of raw materials and ends with the collection of cash from sales. 7 8 Great Basin Medical Equipment (GEM) buys medical devices from manufacturers in China and sells them in the United States, Canada and Mexico. On average, 10 it is 40 days from the time GBM purchases merchandise ($10 million a month) until the time GBM sells to its customers. GBM's suppliers require payment 11 within 30 days, but GBM gives its customers 60 days to pay for their purchases 12 13 14 Target Inputs: 15 Target inventory conversion period, ICP (days) = 16 Target average collection period, ACP (days) = 17 Target payables deferral period, PDP (days) = 18 19 Target Cash Conversion Cycle: 20 21 Target Cash Inventory 22 Conversion Cycle Average collection Payables deferral conversion period period 23 (CCC) period 24 25 26 27 Selected Items from GBM's Financial Statements (Millions of Dollars) 28 29 Annual sales $200 30 Cost of goods sold $155 31 Inventories $28 32 $60 Accounts receivable 33 $23 Accounts payable 34 35 Days/year 365 36 37 A B C D E F G Figure 21-3 GBM's Target and Actual Cash Conversion Cycles (Dollars in Millions) Panel A. Target CCC: Based on Plans Target Cash Planned Conversion Cycle Inventory (CCC) Conversion Credit Terms Offered to Customers (ACP) Credit Terms offered by Suppliers (PDP) Target CCC Panel B. Actual CCC: Based on Financial Statements Sales COGS Inventories Receivables Payables Days/year 365 Actual CCC = Inventory = (COGS/365) Receivables (Sales/365) Payables = (COGS/365) 5 = 3 Actual CCC Panel C. Actual versus Target Components ICP ACP PDP Actual - Target = % Difference Evaluation deduecforcarito in reporting. However unrounded values are used for all calculations Suppose GBM can improve its business processes so that it reduces the inventory conversion period to 30 days and the average collection period to 50 days. In addition, suppose GEM can negotiate an extension in the suppliers payment terms to 35 days. The "New Target" column of Figure 21-4 shows the elects of these changes. Figure 21-4 Benefits from Reducing the Cash Conversion Cycle (Dollars in Millions) 3 New Targets for Conversion Periods Inventory conversion period (ICP, days) 3 Average collection period (ACP, days) Payable deferral period (PDP, days) Cash Conversion Cycle (CCC, days) 5 Reduction in Cash Conversion Cycle: old (Actual) New Target 7 3 Impact of Reduction in CCC old (Actual) New Target Annual sales: No change Costs of goods sold (COGS): No change Inventory: New level is ICP(COGS/365) 2 Receivables: New level is ACP(Sales/365) 3. Payables: New level is PDP(COGS/365) # Net operating working capital: 5 NOWC= Inventory + Receivables-Payables Interest rate on NOWC loans (10%) 10% 7 Interest expense due to NOWC: 10%(NOWC) 3 3 Improvement in Selected Results 0 Reduction in NOWC: 1 Increase in free cash flow: 2 Reduction in interest expense: muno are shown as rounded values for clarity in reporting. However unrounded values are used for all