16 – 1 William & Sons last year reported sales of $10 million and an inventory turnover ratio of

2. The company is now adopting a new inventory system. If the new system is able to reduce the
firm’s inventory level and increase the firm’s inventory turnover ratio to 5 while maintaining the
same level of sales, how much cash will be freed up?
Sales $10,000,000
Inventory Turnover ratio (old) 2
Inventory Turnover ratio (new) 5
Freed up Cash ?
So, let’s find out the freed up cash
We know level of inventory are calculated as follows
Inventory = SalesInventory turnover ratio
Calculating $ value of old inventory
Inventory Old = $10,000.0002
= $5,000,000
Calculating $ value of New inventory
Inventory New = $10,000,0005

m
er as
= $2,000,000
The freed up cash would be = Old Inventory – New Inventory

co
eH w
= $5,000,000 - $2,000,000
= $3,000,000

o.
rs e
16 – 2 Medwig Corporation has a DSO of 17 days. The company averages $3,500 in credit sales
ou urc
each day. What is the company’s average account receivable?
If we recall the formula to calculate DSO (Daily Sales Outstanding):
DSO =
o

So we have DSO of 17 days and also have average sales i.e.

aC s

$3,500
vi y re

Putting this in equation

17 =
So Accounts Receivables will be
Accounts Receivable = 17 X $3,500
ed d

= $59,500
ar stu

16 – 3 What is the nominal and effective cost of trade credit under the credit terms of 3/15, net
30?
Nominal cost of Trade formula is:
is

= discount percentage100- Discount Percentage x 365Days credit is Outstanding-Discount

Period
Th

So putting values in equation:

= 397 X 36530-15
= 0.03093 x 24.33
= 0.75263
sh

= 75.26%

Effective Cost of Trade Formula is:

Periodic rate = 0.03 / 0.97 = 0.3093

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 Periods/year = 365 / (30-15) = 24.33
EAR = (1 + periodic rate)N – 1
= (1.03093)24.33 – 1 = 109.84%
16 - 4 A large retailer obtains merchandise under the credit terms of 1/15, net 45, but routinely
takes 60 days to pay its bills. (Because retailer is an important customer, suppliers allow the firm
to stretch its credit terms.) What is the retailer’s effective cost of trade credit?
Effective Cost of Trade Formula is:
Periodic rate = 0.01 / 0.99 = 0.01010
Periods/year = 365 / (60-15) = 8.11
EAR = (1 + periodic rate)N – 1
= (1. .01010)8.11 – 1 = 8.49%

16 -5 A chain of appliance stores, APP Corporation, purchases inventory with a net price of
$500,000 each day. The company purchases the inventory under the credit terms of 2/15, net 40.
APP always takes the discount but takes the full 15 days to pay its bills. What is the average
accounts payable for APP?

m
er as
We can calculate Average Accounts Payable as follows:
= Credit Purchases Per day x Length of Collection

co
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Period
= $5,000,000 x 15 Days

o.
= $7,500,000
rs e
ou urc
o
aC s
vi y re
ed d
ar stu
is
Th
sh

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