Balance Sheet: Cash $ 20 A/R 1,000
Inventories 2,000
Total current assets $ 3,020
Net fixed assets 2,980
Total assets $ 6,000
Income Statement:
Sales $10,000
Cost of goods sold 9,000
EBIT $ 1,000
Interest (10%) 600
EBT $ 400 Taxes (40%) 160
Net Income $ 240
1. The industry average DSO is 18 (360-day basis). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. How much cash can the company free up from reducing receivables?
The industry inventory turnover ratio is 15. Collins plans to reduce the inventory level to equal the industry average. How much cash can the company free up from reducing inventories? Assume that the sales level & cost of goods sold will remain constant.

1. Cash amount the company can be freed up from reducing receivables = $500

2. Cash amount the company can be freed up from reducing inventories = $1,400

Explanation:

1. The industry average DSO is 18 (360-day basis). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. How much cash can the company free up from reducing receivables?

The desired receivables (A/R) can be calculated using the Days sales outstanding (DSO) formula as follows:

DSO = (Desired A/R / Sales) * 360 ………………………… (1)

DSO = industry average DSO = 18

Desired A/R = ?

Sales = Sales in the income statement = $10,000

Substituting the relevant values into equation (1) and solve for Desired A/R, we have:

18 = (Desired A/R / 10,000) * 360

18 / 360 = Desired A/R / 10,000

0.05 = Desired A/R / 10,000

Desired A/R = 0.05 * 10,000 = $500

Therefore, we have:

Cash amount the company can be freed up from reducing receivables = A/R in the balance sheet – Desired A/R = $1,000 - $500 = $500

2. The industry inventory turnover ratio is 15. Collins plans to reduce the inventory level to equal the industry average. How much cash can the company free up from reducing inventories? Assume that the sales level & cost of goods sold will remain constant.

The desired Inventories can be calculated using the inventory turnover ratio formula as follows:

inventory turnover ratio = Cost of goods sold / Desired inventories …… (2)

Where:

inventory turnover ratio = Industry inventory turnover ratio = 15

Cost of goods sold = Cost of goods sold in the income statement = 9,000

Desired inventories = ?

Substituting the relevant values into equation (2) and solve for Desired inventories, we have:

15 = 9,000 / Desired inventories

Desired inventories = 9,000 / 15 = $600

Therefore, we have:

Cash amount the company can be freed up from reducing inventories = Inventories in balance sheet - Desired inventories = $2,000 - $600 = $1,400

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