Nathan Daniel is a producer and retailer of designer accessories for young professionals set up by two partners, Nathan Phillips and Daniel Collins. Daniel and Nathan have been best friends since they found themselves abandoned by loving parents in their dormitory on the first day of university. Both graduated from Majesty University with a major in accounting and minor in economics. Both found articling positions in a coop program during their fourth year at Majesty University. After graduation, Daniel went to work for his father’s accounting firm, whereas Nathan procured full-time employment with the firm where he had articled. After three additional years of studying, they both managed to pass their national certification exams and became full-fledged, card-carrying, certified accountants. Two more years of accounting work, and the two friends decided to strike out on their own. However, Daniel and Nathan had had enough of spreadsheet and year-end deadlines and roof-top stress levels every quarter, and decided that they were better off striking out on their own in a completely different direction and in something that they are both enthusiastic about: the demand for accessories in the new metrosexual culture for young professionals, particularly those for young professional men. They opened up a store in Calgary selling bags, packs, briefcases, wallets, and other accessories. They designed some of their own merchandise and sold it under the designer label named Bones. Thanks to a great cover story in Macleans, the Bones brand became an instant success and orders started flooding in.
That was five years ago. Today, in addition to their store in Calgary, the company also ships merchandise to other retailers, not only in Alberta, but in BC and Ontario as well. Over the years, 70% of their annual sales of $3,500,000 have shifted to credit sales to other retailers, with 50% in Alberta, 30% in BC, the rest in Ontario. With the increase in credit sales, the management of cash cycle and float has become an important issue, as most of the credit customers make payments with cheques. The cheques are mailed via Canada Post. Cheques from Alberta usually arrive within one business day of posting, whereas cheques from BC take two days, and those from Ontario take an average of four days to arrive at their Calgary office. When each cheque arrives at the office, Naomi Mitchell, the office manager (who is also Nathan’s girlfriend), takes the cheques out of their envelopes, records them on the books, and puts them aside to be deposited at the end of business day at the company’s bank, Bank of Mount Royal. It usually takes about three days for the bank to process and clear the cheques, and deposit the money in the company’s account.
In terms of its accounts payable, the company mails its cheques out to its suppliers, all of whom are located in Alberta, as Nathan and Daniel had decided when they first started the company that they would source all their materials from local producers and artisans. Their costs of goods sold amount to approximately 75% of total sales revenue. On average, it takes about one day for their suppliers to take their cheques to their banks for deposit, and it takes another three days for their banks to process and clear the cheques.
In the last operating year, the company had started the year with payables of $130,000 and ended it with $110,000. Beginning receivables were $175,000 and ending receivables amounted to $145,000; beginning inventory was $80,000 and ending inventory was $120,000; and beginning cash reserves were $20,000 and ending cash reserves were $15,000. To expand their production and retail facilities, Nathan and Daniel had borrowed $550,000 from the bank two years ago at an interest rate of 15%. In addition to paying the interest on this loan, they are also repaying 10% on the original principal off each year (i.e., it would take another eight years to pay off this loan). At their most recent year-end, the company owns $650,000 in net fixed assets, and Daniel and Nathan owns $200,000 in equity in the company. The company uses a line of credit (up to a maximum of $200,000) with its bank whenever there is a shortfall in its cash-on-hand. The interest on this line of credit is 2% per month.
The manager of the Bank of Mount Royal just phoned Daniel and offered them same-day deposit for their cheques (i.e., to reduce their availability float to one business day, because let’s face it, no bank can really clear a cheque immediately unless they replace human tellers with robot tellers). The fee for this service will be $3,000 per year.
Nathan and Daniel must decide whether this is a good deal or not. At the end of the business week, the two partners grabbed a couple of pizzas and went to Nathan’s place to hash out their decision. They came up with the following list of questions.
1. What are the company’s inventory period, receivables period, and payables period? (Round all periods to nearest integer.)
2. What are the company’s operating and cash cycles?
3. How do the company’s operating and cash cycles compare to the industry average of 30 and 20 days, respectively?
4. If the company’s customers’ average cash cycle and operating cycle are 30 and 40 days, respectively, what can we say about the company’s credit management policy of net 30?
5. What is the company’s average daily collection float? Their average daily disbursement float? (Note #1: Use average mail float to calculate collection delay. Note #2: Use average daily cost of goods sold to calculate average daily disbursement float, and use average daily credit sales to calculate average daily collection float.)
6. What is their net float?
7. What is the effective annual interest rate on the company’s line of credit? What is the company’s annual short-term interest expense based on this effective annual rate?
8. What will be the net float if they take up the Bank of Mount Royal’s offer for same-day deposit of their cheques?
9. What amount of additional cash will be made available if they take up the Bank of Mount Royal’s offer for same-day deposit of their cheques? (Assume that on average, sales will remain at $3,500,000 each year.)
10. How much does the company have to borrow from its bank to cover net float if they take up the same-day deposit offer?
11. Should the partners accept the same-day deposit offer from its bank?