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Philippine Christian University College of Business and Technology CASE ANALYSIS IN FINANCIAL MANAGEMENT: Assessing Roche Publishing Companys

Cash Management Efficiency

CATA, CHERRY MAE DONAIRE, KAREN D. MONTEGRANDE, KELVIN Q. RELLIN, MARICRIS T.

MARCH 19, 2012

Lisa Pinto, vice president of finance at Roche Publishing Company, a rapidly growing publisher of college texts, is concerned about the firms high level of shortterm resource investment. She believes that the firm can improve the management of its cash and, as a result, reduce this investment. In this regard, she charged Arlene Bessenoff, the treasurer, with assessing the firms cash management efficiency. Arlene decided to begin her investigation by studying the firms operating and cash conversion cycles. Arlene found that Roches average payment period was 25 days, She consulted industry data, which showed that the average payment period for the industry was 40 days. Investigation of three similar publishing companies revealed that their average payment period was also 40 days. She estimated the annual cost of achieving a 40-day payment period to be $53,000. Next, Arlene studied the production cycle and inventory policies. The average age of inventory was 120 days. She determined that the industry standard as reported in a survey done by Publishing World, the trade association journal, was 85 days. She estimated the annual cost of achieving an 85 day average age of inventory to be $150,000.

Further analysis showed Arlene that the firms average collection period was 60 days. The industry average, derived from the trade association data and information on three similar publishing companies, was found to be 42 days-30% lower than Roches. Arlene estimated that if Roche initiated a 2% cash discount for payment within 10 days of the beginning of the credit period, the firms average collection period would drop from 60 days to the 42-day industry average. She also expected the following to occur as a result of the discount: Annual sales would increase from $13,750,000 to $15,000,000; bad debts would remain unchanged; and the 2% cash discount would be applied to 75% of the firms sales. The firms variable cost equal 80% of sales.

Roche Publishing Company is currently spending $12,000,000 per year on its operating-cycle investment, but it expects that initiating a cash discount will increase its operating-cycle investment to $13,100,000 per year. (Note: The operating cycle investment per dollar of inventory, receivables, and payables is assumed to be the same.) Arlenes concern was whether the firms cash management was as efficient as it could be. Arlene knew that the company paid 12% annual interest for its resource investment and therefore viewed this value as the firms required return. For this reason, she was concerned about the resource investment cost resulting from any inefficiencies in the management of Roches cash conversion cycle. (Note: Assume a 365-day year.)

Time Context: Present Viewpoint:

Top Management
Central Problem: Reduction of the resource investment cost resulting from the inefficient management of cash conversion cycle. Objectives: Must: To be able to minimize the cash conversion cycle and achieve the industry level of operational efficiency. Want: To be able to maximize the shareholders wealth in the company.

Areas of Consideration: Strength: Fast-growing publisher of college textbooks Weakness: Inefficient in managing its cash Opportunity: High demand of its key product. Threat: Tight competition
Alternative Courses of Action: 1. Slowing down payments of payables Advantages: Increases Cash investment of the company Maximize investment potentials

Disadvantages: Increases average payment period Decreases the credit standing of the company
2.Relax the companys credit standards Advantages: Increases Sales Volume Produce positive net profits from its implementation (EXHIBIT 1) Disadvantages: Increases investment in Accounts Receivable Increases Bad Debts Expense

3. Manage the inventory through Just-in-Time (JIT) System Advantages: Minimizes Inventory investment Defect rates are reduced, resulting in less waste and greater customer satisfaction
Disadvantages: Results to shutdown of production if the system fails No inventory safety stocks

Recommendation: The company must proceed with ACA 2 which is to relax its credit standards Plan of Action: Turn over inventory as quickly as possible Collect accounts receivable as quickly as possible Manage mail, processing and clearing time Pay accounts payable as slowly as possible

EXHIBIT 1 (Effects on the profits from the relaxation of the credit standards) Changes in sales volume: Total contribution margin of annual sales: Under present plan ($13,750,000x.20) Under proposed plan ($15,000,000x.20) Additional profit contribution from sales Investment in accounts receivable: Turnover of accounts receivable: Under present plan =6 Under proposed plan = 8.57 Average investment in accounts receivable: Under present plan =$1,833,333 Under proposed plan =$1,400,233 Cost of marginal investment in accounts receivable: Average investment under proposed plan $1,400,233 - Average investment under present plan $1,833,333 Marginal investment in accounts receivable ($ 433,100) X Required return on investment .12 Cost of marginal investment in Accounts Receivable Cost of marginal bad debts: Bad debts would remain unchanged as specified in the case. Net profits from implementation of new plan

$2,750,000 $3,000,000 $250,000

($ 51,972)

EXHIBIT 2
ROCHE PUBLISHING COMPANY Operating Cycle = Average Age of Inventory + Average Collection Period =120 days + 60 days =180 days Cash Conversion Cycle = Operating Cycle Average Payment Period =180 days 25 days =155 days

INDUSTRY Operating Cycle

= Average Age of Inventory + Average Collection Period =85 days + 42days =127 days

Cash Conversion Cycle = Operating Cycle Average Payment Period =127 days - 40days = 87 days

Cost of Inefficiency
Industry Resources needed * = = Less: ROCHE Companys Resources needed = = Excess X Required return on investment Cost of Inefficiency = (5,166,667) ($3,266,667) .12 = $2,900,000

* This is the annual cost that the firm should incur to achieve industry level of operational efficiency.

Conclusion:
Roche Publishing Company should incur the annual cost of $2,900,000 to correct its cash management inefficiencies and should also soften the credit standards to improve its cash conversion cycle to save a total of $509,028 per year, computed as follows.

(EXHIBIT 2) (EXHIBIT 1)