Q2. What is a Cash Cycle? Explain. Calculate using the following information. (Assume 360 days in a year). (10 Marks)
|Costs Incurred during the year|
|Selling and Distribution Expenses||6,20,000|
40% of sales are on credit and 70% of purchases are on credit.
CASH CONVERSION CYCLE
Cash conversion cycle can be defined as a financial ratio which represents the length of the time that it takes a company to convert its resource inputs into output. The complete cycle comprises of all the activities that are included in a firm operating and conversion process.
THE CASH CONVERSION CYCLE
The goal of firms is to make a profit and to achieve this ultimate goal, firms execute various functions. Finance is one of the basic functions of firms and firms need financial instruments such as cash reserve and outsource to carry out their activities. Cash management within the finance function is an important issue that needs to be carefully considered, especially in the short- and medium-term financial planning stage. Presently, the high competition among firms forces companies to manage their cash in the most effective way. The conceptual studies on the subject are quite old and date back to Keynes. According to Keynes, firms demand cash for transaction, prudence and speculation. As a result of analysis, it has been determined that cash conversion cycle has an impact on return on assets (ROA) and return on equity (ROE). There is a statistically significant and negative relationship between cash conversion cycle (CCC) return on assets (ROA) and return on equity (ROE). In addition, there is a positive relationship between return on assets (ROA) and firm size while there is a negative and statistically significant relationship between debt ratio (DEBT) and return on assets (ROA).
CALCULATION OF CASH CONVERSION CYCLE
DIO = Inventory / Cost of Sales * 365
DSO = Accounts Receivable / Total Credit Sales * 365
Finally, the company computes DPO by the formula we mentioned above –
DPO = Accounts Payable / (Cost of Sales / 365)
Finally, the DIO and DSO need to be added, and then the DPO needs to be deducted from the sum.
The Cash conversion cycle is a measures of time duration a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. Cash conversion cycle is important for each manufacturing firm. Cash conversion cycle helps financial managers to specify the stock holding period. In addition, cash conversion cycle is a powerful tool for examining how well the working capital of a manufacturing firm is managed. In order for the company to survive, finance managers need to create a balance between current assets and current liabilities in terms of working management. Financial managers can also manage the cash conversion cycle well to reduce future shortage and bankruptcy risk.
Shorter period of cash conversion cycle, inventories turnover, receivable turnover indicate that the profitability of manufacturing firms will increase. Industrial firms must accurately estimate and evaluate the entity’s cash flows. They accurately identify long-term cash inflows and outflows. They should manage their investment strategies in the abundance of cash correctly and find cost-effective fundings in the time of cash shortages. As a result, due to the changing world economy, technological advances and the increasing global competition among the industrial firms, it is crucial that these companies should increase their effort to optimize the cash conversion cycle for greater profitability.
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