Page 288 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 1. How much cash would be released with the concentration banking system?

2. How much money can be saved due to reduction in the collection period by 2 days?
Should the firm institute the concentration banking system?
3. How much cash would be freed by lock-box system?

4. Between concentration banking and lock-box system, which is better?
Solution:
1. Cash released by the concentration banking system = 40,00,000 × 2 days = 80,00,000

2. Savings = 8% × 80,00,000 = 640,000. The firm should institute the concentration banking
system. It costs only 75,000 while the savings expected are 640,000.
3. Cash released by the lock-box system = 40,00,000 × 4 days = 160,00,000

4. Savings in lock box system 8% × 160,00,000 = 12,80,000
5. Lock-box system is better. Its net savings 11,60,000
( 1280,000 – 120,000) are higher than that of concentration banking.

Example: Assume, a firm which purchases raw materials on credit is required by the
credit terms to make payments within 60 days. The firm’s experience has been that it takes on an
average, 35 days to pay its accounts payable and 70 days to collect its accounts receivable.
Moreover, 85 days elapse between the purchase of raw materials and the sale of finished goods,
that is to say, the average age of a firm’s inventory is 85 days. What is the firm’s cash cycle? Also
estimate the cash turnover.

Solution: The cash cycle of the firm can be calculated by finding the average number of days that
elapses between the cash outflows associated with paying accounts payable and the cash inflows
associated with collecting accounts receivable, i.e.,
1. Cash cycle =85 days +70 days – 35 days =120 days
2. Cash Turnover = the assumed number of days in a year divided by the cash cycle
=365/120=3.04

Example: The under mentioned facts are available:

1. Cash turnover rate 4.5
2. Annual cash outflow 175,000
3. Accounts payable can be stretched by 20 days
What would be the effect of stretching accounts payable on the minimum operating cash
requirement?
Assuming the firm can earn 8% on its investments, what would be the saving on cost?
Solution: Cash turnover 4.5 i.e., 360/4.5 i.e., 80 days and annual cash outflow 175,000 hence cash
requirement= 175000/4.5 = 38,889.
With accounts payable stretching by 20 days, cash cycle will be 80+20 days i.e., 100 days, cash
turnover 360/60 =6 times, hence cash requirement will change to 175,000/6 = 29,167.
Cash requirement will reduce by 38,889 – 29,167 =9,722 and savings in cost will be 8% on
9722 = 778.

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