Hi guys, I have trouble to understand the last paragraph of the explanation of this problem. Please help! (If the original balances of accounts receivable were less than the original inventory balances, it would be expected that working capital would decrease since the increase in accounts receivable would be less than the increases in payables related to the increased sales production.)
Question:
Marsh, Inc., is experiencing a sharp increase in credit sales activity and has, therefore, had a steady increase in production. Management has also adopted an aggressive working capital policy by decreasing the inventory conversion period and holding the receivables collection period and the payables deferral period constant. Original inventory levels were higher than accounts receivable. Therefore, the company's current level of net working capital:
Correct A.would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment.
B.would most likely be higher than under other business conditions so that there will be sufficient funds to replenish assets.
C.can be financed most economically through the sale of common stock.
D.would most likely be higher than under other business conditions as the company's profits are increasing.
You are correct, the answer is A.
Net working capital is current assets minus current liabilities. As sales increase, accounts receivable, a component of current assets, will increase providing the receivable collection period (average accounts receivable/average sales per day) remains constant. If credit sales increase by 10%, receivables would be expected to increase by 10%, thus increasing working capital.
If the inventory conversion period (average inventory/average sales per day) is decreased, this means that inventory would be held for a shorter amount of time; therefore, in this situation, production has increased in order to accommodate increase sales; however, since the inventory conversion period has decreased, this means that inventory would have decreased or increased slower than sales.
As sales and production increase, accounts payable and accrued production costs will increase providing the payables deferral period (average payables/average purchases per day) remains constant. If purchases and production increase by 10%, accounts payable and payables related to variable production costs would be expected to increase by 10% thus decreasing working capital. (This is assuming that unit variable costs of production remain unchanged).
If the original balances of accounts receivable were less than the original inventory balances, it would be expected that working capital would decrease since the increase in accounts receivable would be less than the increases in payables related to the increased sales production.
.