Empty Shelves and the Cash Conversion Cycle

Cash conversion cycle represents the time it takes (in days) to convert resource inputs into cash flows (Source: Investopedia). By “resource inputs”, we mean assets.

Let’s say you buy towels from a supplier and sell them in retail stores. Towels that are purchased into inventory are considered assets. Inventory is something you’ll use to make money in your business- you sell the towels for a profit. So, towels are assets.

The tricky part is planning your cash flow. You need enough cash to buy the towels into inventory. Next, you need cash to build and operate the stores. You’ll incur costs for payroll, advertising, etc. In other words, you need cash to operate until someone buys your towels.

The number of days from the time you buy the towels (cash out) until you sell the towels and collect the cash (cash in) is the cash conversion cycle.

What if a court decision prevented from stocking your shelves with your product?

I’ve provided a link to the article JC Penney Could Wind Up With Empty Shelves (3/4/13)

Source: http://hosted.ap.org/dynamic/stories/M/MACYS_PENNEY_TRIAL?SITE=AP&SECTION=HOME&TEMPLATE=DEFAULT&CTIME=2013-03-04-15-12-46

A New York State Supreme Court Judge told JC Penney that the firm “took a risk” by buying towels and other product from a company founded by Martha Stewart. Macy’s Inc. is claiming that they have an exclusive agreement to sell Martha Stewart merchandise. It’s not the legal issue I want to focus on. Instead, consider the cash and accounting impact.

Penney already bought the inventory

The big issue is that Penney already bought the inventory. Now, they may be prevented from selling it. In fact, the inventory was targeted to be sold in May- about 60 days from the date of the article. This brings up a whole bunch of problems. Here are a few:

1.     Assuming Penney is not allowed to sell the Martha Stewart inventory, they need to replace it with something else.

2.     Penney needs cash to buy the replacement inventory. Trouble is, they already used cash to buy the Martha Stewart inventory.

Cash to buy new inventory

One way to generate cash is to sell the Martha Stewart inventory to someone else. Unfortunately, the buyer may be the very company (Macy’s) that is in litigation with Penney! Since Macy’s has an exclusive agreement, who else would Penney sell to? Penney would certainly take a loss of the sale of inventory.

If this scenario plays out, Penney would end up with less cash to use for purchasing replacement inventory. The company might have to raise funds to have sufficient cash for new inventory purchases.

Changing other costs- new product offering

If Penney is replacing the inventory, all of the marketing/ advertising/ store displays will change. It’s likely that the firm would write off the prior spending on marketing Martha Stewart as a loss. Penney would have to decide if and how much to market the new inventory. Would the company invest heavily in marketing and advertising to get the word out? After all, the original product was going on the shelf in 60 days. They don’t have much time to get the word out.

Cash conversion cycle: Before and after the change

Originally, Penney invested in marketing and advertising to sell the Martha Stewart line. They bought inventory. The plan was to stock the store shelves and start selling product in May. So, cash collections would start in May. Those cash inflows would cover the cash outflows for purchasing inventory, marketing, etc.

If Penney loses in court, the cash flow is dramatically different. The firm may take a loss on selling the Martha Stewart inventory. Penney will be to use cash to buy replacement inventory. The company will also consider an investment in a new marketing campaign to sell a different product. Will consumers (who were expecting Martha Stewart) buy the replacement product? How will the new product’s sale compare with the original plan? These questions have a huge impact on the expected cash inflows.

Your comments are welcome! Visit my website for online classes on the toughest accounting topics.

Thanks!

Ken Boyd

St. Louis Test Preparation

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