Ridgeway Distribution: Cash Conversion Cycle and Trade Credit
Ridgeway Distribution has annual sales of $24 million and cost of goods sold equal to 75% of sales. Inventory is $3.6 million, accounts receivable $4.2 million, and accounts payable $2.7 million. All sales and purchases are on credit. A major supplier offers terms of 2/10, net 60 on $10 million of annual purchases. Ridgeway's bank line costs 9.5% and has $3 million of unused capacity. The credit manager reports that days sales outstanding have risen from 48 to 64 days, and bad debts are 1.5% of sales. She proposes tightening credit to a 35-day policy, which she expects would cut sales by 5% but reduce bad debts to 0.8% of the lower sales. The contribution margin is 25%. The CFO is skeptical because sales growth is a strategic priority, but she is also under pressure to release cash. She asks for a quantitative assessment and a recommendation that separates the trade-credit decision from the credit-policy decision.
1. Compute Ridgeway's cash conversion cycle and interpret what it says about the firm's financing need.
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DSO = $4.2/$24 × 365 = 63.9 days. DIO = $3.6/(0.75 × $24) × 365 = $3.6/$18 × 365 = 73.0 days. DPO = $2.7/$18 × 365 = 54.8 days. CCC = 63.9 + 73.0 − 54.8 = 82.1 days. The operating cycle is 136.9 days; suppliers finance 54.8 days, leaving 82.1 days to finance. At $24M sales, daily revenue = $65,753; 82.1 days of financing need ≈ $5.40M, though this is an approximation because costs, not sales, drive inventory and payables. The DSO rise from 48 to 64 days is the main deterioration: it alone adds about 16 days of financing, or roughly $1.05M at the current sales rate. The CCC separates the problem into inventory, receivables, and payables levers rather than treating working capital as one undifferentiated cash drain.
2. Evaluate the 2/10, net 60 offer. Compute the cost of forgoing the discount and the annual dollar benefit of borrowing to take it. Does the $3 million line constrain the decision?
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Cost of forgoing the discount = (2/98) × [365/(60 − 10)] = 0.020408 × 7.3 = 14.9% annualized. The bank line costs 9.5%, so borrowing to pay within 10 days is cheaper than giving up the discount. On $10M of eligible purchases, the discount is 2% × $10M = $200,000. To take it, Ridgeway pays 98% × $10M = $9.8M on day 10 instead of $10M on day 60. The annual dollar-days of financing are $9.8M × 50/365, and interest at 9.5% is about $127,500. Net benefit = $200,000 − $127,500 = $72,500 per year, before taxes. The $3M unused line is not automatically a constraint because the average incremental balance is about $1.34M, not $9.8M at once. However, peak timing and seasonal purchases could strain the line, so the firm should monitor the peak draw rather than the annual total.
3. Evaluate the credit manager's proposal to tighten credit to 35 days. Should Ridgeway do it? Distinguish the trade-credit decision from the credit-policy decision.
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Lost contribution = 5% × $24M × 25% = $300,000. New sales = $22.8M. AR at 35 days = $22.8M × 35/365 = $2.186M; cash freed = $4.2M − $2.186M = $2.014M; annual savings at 9.5% = $191,000. Bad-debt savings = 1.5% × $24M − 0.8% × $22.8M = $360,000 − $182,400 = $177,600. Total benefit = $368,600 vs $300,000 cost; net +$68,600. Recommendation: tighten, but pilot or phase in because the sales loss may exceed 5% and the contribution margin is only 25%. The trade-credit decision is clearly yes: the 14.9% implicit cost exceeds the 9.5% bank cost. The credit-policy decision is marginally yes and should be monitored with leading indicators such as DSO, bad-debt write-offs, and lost-sales reports.