Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

annual sales, variable costs and accounts receivable turnover. We then repeat this process for the level of

sales expected to result from a change in credit standards. Equations 18.4, 18.5 and 18.6 present the steps

required. Note that we use variable costs in calculating investment in accounts receivable because this is the

company’s actual cash expense incurred (and tied up in receivables).

Eq. 18.4 Averageinvestmentin accountsreceivable(AIAR)

Totalvariablecostofannualsales

Turnoverofaccountsreceivable

=

Eq. 18.5 Total variable cost of annual sales (TVC) = Annual unit sales × Variable cost/unit

Eq. 18.6 Turnoverofaccountsreceivable(TOAR)

365

Averagecollectionperiod(ACP)

=

We can use these equations to compute the average investment in accounts receivable (AIAR) for the current,
AIARcurrent, and proposed, AIARproposed, credit standards. First, we compute the total variable cost (TVC) of annual
sales under the current credit standards, TVCcurrent, and the proposed plan, TVCproposed, using Equation 18.5:

TVCcurrent = 120,000 units × $12/units = $1,440,000

TVCproposed = 126,000 units × $12/units = $1,512,000
Next, we note that the 30-day average collection period under the current plan, ACPcurrent, is expected
to rise to 45 days under the proposed plan, ACPproposed. This allows us to use Equation 18.6 to compute the
turnover of accounts receivable (TOAR) under the current, TOARcurrent, and proposed, TOARproposed, credit terms:

TOAR

365

ACP

365

30 days

current 12.2t

current

=== ii mes/year

TOAR

365

ACP

365

proposed proposed 45

==

days

=8.1times/year

These turnover measures suggest that, if YMC relaxes its credit standards, then the turnover of its accounts
receivable will slow down from 12.2 times per year to 8.1 times per year. Clearly, this slowing is attributable to
the generally slower paying additional credit customers generated by the relaxed credit standards. We now
have all the inputs required to use Equation 18.4 to compute the AIARcurrent and AIARproposed:

AIAR

TVC

TOAR

$1 440000

12. 2

$118 033

AIAR

TVC

TOAR

$1512, 000

8.1

$186 667

current

current

current

proposed

proposed

proposed

===

===

,,

,

,

,

With these measures, we can now determine the cost of the marginal investment in accounts receivable. This
amount is the marginal investment in accounts receivable required to support the proposed change in credit
policy multiplied by the required return on investment, r. This important calculation recognises the company’s
opportunity cost – the cost of forgoing earning opportunities as a result of tying up additional money in
accounts receivable.

Eq. 18.7 Cost of marginal investment
in accounts receivable = Marginal investment × Required return
= (AIARproposed – AIARcurrent) × r
= ($186,667 – $118,033) × 0.12
= $68,634 × 0.12 = $8,236

This value of $8,236 is a cost of adopting the relaxed credit standards; it represents the opportunity cost
of investing an additional $68,634 in accounts receivable rather than investing these funds in another earning
asset.

average investment in

accounts receivable (AIAR)

An estimate of the actual

amount of cash (variable cost)

tied up in accounts receivable

at any time during the year

total variable cost of

annual sales (TVC)

Calculated by multiplying

the annual sales in units by

the total variable cost per

unit and used to estimate

the average investment in

accounts receivable under a

stated policy

turnover of accounts

receivable (TOAR)

Three-hundred-sixty-five

divided by the average

collection period (ACP). Used

to calculate the average

investment in accounts

receivable (AIAR) when

evaluating accounts receivable

policies

cost of marginal

investment in accounts

receivable

The marginal investment in

accounts receivable required to

support a proposed change in

credit policy multiplied by the

required return on investment

example