A decline in the profitability of the business would leave the business with less cash reserves and thus an increase in borrowings. Exhibit 1 shows that at a gross profit margin of 30%, the business would not have any borrowing over the period and would have a reserve of marketable securities of $21,836. Exhibit 2 shows that if the gross margin were to decline from 30% to 27.5% the business would exhaust its reserves in marketable securities in November and would have to borrow $47, 117 in November order to meet its closing cash balance target of $120,000. By the end of the fourth quarter, the business would have cumulative borrowings of $106,012. This analysis shows that the business should be concerned about decline in their profitability. Therefore, the business should not cut its gross profit margin unless such a reduction in gross margin would lead to a significant increase in sales that would generate sufficient cash flows to offset the effects of reduced profitability.
Increasing the inventory levels from the current 25% of the next month to either 30% or 40% of the next month’s sales would require an increase in working capital that would lead to higher financing costs (Müller, 2011). A business should consider three inventory costs in determining the optimum inventory policy these include holding cost, ordering cost, and stock-out costs (Müller, 2011). Ordering costs are costs of placing an order and are inversely proportional to the level of inventory. Stock-out costs relates to the costs of holding too little inventory that includes the lost contribution, the cost of making and emergency order, and the loss of customer goodwill (Müller, 2011). Holding costs are directly proportional to the amount of inventory held by a firm.
Exhibit 3 shows that if the business increases the amount of inventory held to 30% of the next month sales, it would comfortable finance the increase without having to borrow. However, if the business increases the amount of inventory held, the business would have cumulative borrowings of $26,398 and would face higher financing costs. The business would have to weigh between the finance costs and the costs of stock-outs in order to determine the ideal amount of level of inventory.
Cash discount is an incentive a business offers to its customers to entice them to make prompt payments. Faster collection of receivables reduces the cash operating cycle and improves profitability by reducing financing costs or releasing cash that can be invested in marketable securities to increase investment income (Reider & Heyler, 2003). However, cash discounts have drawbacks as well and the benefit of giving a cash discount must be weighed against the cost of the cash discount (Reider & Heyler, 2003). Exhibit 4 shows that if the business scraps the cash discount, 45% of the customers would pay within one month and 50% would pay after two months. The effect would be a slowdown in cash collection that would force the business to sell marketable drawing it down from $200,000 to $18,056 over the period.
Exhibit 4 shows that increasing the cash discount from 2% to 3% would result in 60% of the customers paying within the discount period, 25% paying within one month, and 10% paying within two months. An acceleration of cash collection would reduce the cash operating cycle. A shorter cash operating cycle translates to lower financing costs, as the business will finance lesser days (Reider & Heyler, 2003). The benefits of lower financing costs must be weighed against the cost of offering the discount. Increasing the discount would slightly reduce the liquidity of the business forcing it to sell more of its marketable securities. In this case, the business should not increase the cash discount because it has a negative impact on the cash flow. The stock of marketable securities would decline slightly from $21,836 to $20,651 if the business increases the cash discount from 2% to 3%.
References
Müller, M. (2011). Essentials of inventory management. New York: AMACOM.
Reider, R. & Heyler, P. (2003). Managing cash flow. Hoboken, N.J.: Wiley.
Appendix
Exhibit 1
Exhibit 2
Exhibit 3
Exhibit 4
