Jon Jeffery is the new CFO of Sums Metal Casting, a UK-based company. Jon has decided to

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Jon Jeffery is the new CFO of Sums Metal Casting, a UK-based company. Jon has decided to familiarize himself with the financial status of the business’ operations and is, therefore, interested in different short-term finance-related activities to start with. Sums supplies custom metal parts to high-end yacht manufacturers. It has clients based in Italy, the United States, China, Japan, and Canada.

As the luxury yacht market has been growing fast due to an increasing number of ultra wealthy people around the world, Sums has also witnessed great success over the last decade. The company uses custom design software that allows its customers to work out the exact design of metal parts that will be used in high-end yachts. As customers get this software from Sums, they can seamlessly order parts, which Sums then produces in its UK-based factory. The finished units are then shipped to customers across the world as needed.

Jon has prepared details of the firm’s cash management practices. In order to assess the suitability of these practices, he wants to determine the current operating and cash conversion cycles. He has found that Sums purchases all its raw materials on open account or credit. It does not get any volume discount as the raw metal ingots it uses provides such discount only for quantities beyond a thousand metric tons, which is not feasible for Sums to order at once. It also do not get any early payment discount from its suppliers. The firm usually receives credit term of net 30.

An analysis of accounts payable of Sums suggests that its average payment period is 30 days. Jon researched industry data and found that the industry average is 40 days. He further investigated and found out that Sums’ close competitors also have 40 days of average payment days.

Jon then turned his focus on the sales cycle. Sums sells all its products on a net 60 basis. This is in line with the industry practice followed by specialist parts manufacturers.

Jon conducted an aging analysis of accounts receivable and calculated the average collection period for the firm to be 80 days. Some more research in industry practices revealed that this is also the standard credit term among the firm’s competitors.

However, a number of its competitors provide discount terms to reduce their receivable days. Jon predicts that if Sums starts offering credit terms of 3/10 net 60, the average collection period can be reduced by 50%.

As of now, Sums Metal Casting is spending £13,250,000 per year on operating cycle investments. Jon has estimated that this will be the minimum amount the firm will need in the coming year. Jon is not very convinced that the firm’s cash management practices are as robust as they should be. He knows that the firm pays 14%

annual interest for its resource investments. He is concerned about the financing costs resulting from inefficiencies in cash management.

For all calculations, assume a 365-day year and that the cost of operating cycle investment per pound of payables, inventory, and receivables is the same.

TO DO

a. Assume that Sums purchases, produces, and sells at a uniform rate throughout the year. What are Sums’s existing operating cycle, cash conversion cycle and resource investment requirement?

b. If Jon can change and improve Sums’s operations according to industry standards, what will be the firm’s operating cycle, cash conversion cycle, and resource investment requirement under these revised efficiency conditions?

c. In terms of resource investment requirements, what is the cost of Sums’s operational inefficiencies?

d. Answer the following 

(1) Assume that in addition to achieving the industry standard for payables and inventory, the firm can also reduce the average collection period by offering credit terms of 3/10 net 60. What additional savings in resource investment costs will result from the shortened cash conversion cycle? Assume that the level of sales remains constant.
(2) If the total sales of the firm are £20,000,000 and 45% of the customers are expected to take the discount, what will be the reduction in the firm’s annual revenue because of the discount?
(3) The variable cost of the firm is 80% of its revenue of £20,000,000. Determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment. Assume that sales remain constant.
(4) If the firm’s bad debts percentage declines from 3% to 2% of sales, what would its annual savings be? Again, assume that sales remain constant.
(5) Use your findings in the parts (2), (3), and (4) to explain if the offering of early payment discount can be justified financially.

e. What will your recommendation for Jon Jeffery be? Use the figures that you have calculated in parts a to d to justify your recommendations.

f. Advise Jon Jeffery about some alternative sources of short-term financing that Sums can tap into to finance its resource investment need calculated in part b. Include both secured as well as unsecured sources.

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Principles Of Managerial Finance

ISBN: 9781292400648

16th Global Edition

Authors: Chad Zutter, Scott Smart

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