Elements of Working Capital

The intent of this assignment is to help you identify the relationships between elements of working capital such as accounts receivable and inventory. When sales increase, current assets and current liabilities will grow as well. An investment in inventory is needed to grow sales and there are costs associated with investing in inventory. If credit sales are allowed to grow, accounts receivable will increase as well. To evaluate whether an increase in sales will result in a positive impact to net income, you need to compare the costs associated with growing the sales and compare them to the increase in sales. If the costs exceed the sales, there will be a decrease in net income and a negative impact. If the sales exceed the costs, additional net income will be derived.

Instructions

This comprehensive problem requires you to evaluate such a decision. Use the information from the following scenario to complete the required computations below.

Fly Away Corporation makes pumps for the aviation industry. The company pays accounts payable on the 15th day after purchase. The average collection period is 40 days and the average age of inventory is 50 days. They are considering a promotional campaign that will increase their credit sales by $500,000. All of the credit sales will be collectible. The company will require investments in accounts receivable and inventory. The turnover for accounts receivable is 4x and inventory is 8x. The accounts receivable collection costs are 4% of sales and production and selling costs are 75% of sales. The cost to carry inventory will be 8% of inventory. The tax rate is 35%.

Required:

1. Compute the cash conversion cycle for Fly Away Corporation.
2. Compute the investments in accounts receivable and inventory based on the turnover ratios (sales divided by turnover ratios).
3. Compute the accounts receivable collection costs and selling and production costs.
4. Compute the costs of carrying inventory (additional inventory from step 2 x carrying cost).
5. What is the income after taxes related to this promotional campaign (additional credit sales less costs computed in 2, 3 and 4)?
6. Should they proceed with the promotional campaign? (Does it generate positive net income?)