Business Finance: Ratios, Cash Conversion Cycle, Credit Monitoring, and Agency Problem

This article covers various topics related to business finance such as earnings per share, market/book ratio, asset turnover ratio, cash conversion cycle, credit monitoring techniques, and agency problem of the firm. It also provides solutions to reduce cash conversion cycle and discusses the impact of working capital management on the profitability of the firm.

BUSINESS FINANCE

Answer 1.
(a)
Earnings per share=
Earnings available to common
shareholders
Number of shares of common stock
Price earnings
ratio=
Market price per share * Earning per
share
Book value per
share = Common stock equity
Number of shares of common stock
Market/Book ratio= Market value of share
Book value of share
Particulars 2016 2017
Earnings per share 1.50 1.64
Price- Earnings
ratio 37.50 45.82
Book value per
share 20 20.91
Market/Book ratio 1.25 1.34
(b) The primary objective of every company is to earn profits. Apart from profit
maximisation the company also has to maximise the wealth of the shareholders in order to
survive and grow in the long run. We can see that EPS is increasing over the years along with
the MPS. So, we can say that the company has been performing well in financial grounds. It
is a matter of common sense that if the earning of the company increases then the dividend of
the shareholders would also increase which would help in the appreciation of the stock price
(Taillard, 2013). PE ratio can be calculated by multiplying market price of the shares to the

EPS. Both increase in market price and EPS reflect a higher profitability. Therefore, we can
say that the increasing PE ratio also reflects the improving financial performance of the firm.
(c) Asset turnover ratio helps in evaluation the financial performance of the company. It helps
us to know whether the company is using its assets efficiently or not. A higher asset turnover
ratio is considered to be favourable because it indicates that the company is able to generate
enough sales using its assets. The ratio is considered to be good when it is higher than one
but it can be well analysed by comparing it to the industry standards. This ratio helps the
stakeholders to know the level of efficiency at which the company is operating.

Answer 2.
(a) Cash conversion cycle = Average days of inventory + Average collection period –
Average payment period.
Cash Conversion cycle
Average inventory period
4
0
Add: Average collection period
2
5
Less: Average payment period
2
0
cash conversion cycle
4
5
The two ways of reducing cash conversion cycle are-
(i) The company needs to maintain a good relation with the suppliers so that they
give them a larger payment period. It will help in faster turnaround of the cash
cycle. This approach can be adopted only when the supplier‘s business is not that
huge and he is very dependent on our business.
(ii) The efficiency of the employees can also affect the cash conversion cycle directly
as any lag in the preparation of invoice may increase the cash conversion cycle.
However, the company should upgrade its system and should try to set up an
automated system of invoice.
(b) (i)
Cost for Supplier A:
Discount Percent 2%
Total Pay Period 40
Discount Period 15
Cost for supplier A = 2*365 = 29.80

(100-2)(40-15)
Cost for Supplier B:
Discount Percent 1%
Total Pay Period 50
Discount Period 10
Cost for supplier B = 1*365 = 9.22
(100-1)(50-10)
(ii) If the discount is availed by Supplier A then his total savings will amount to 120
and if he doesn’t avail this discount then there will an interest savings of 78.9. So,
the discount should be availed because of higher savings.
If discount availed by supplier A
Outflow = 5,880.00
Savings = 120.00
If Discount Not Availed then interest saved
Interest Saved = 78.90
If the discount is availed by supplier B, then in that case the savings will be 60
whereas if he doesn’t avail the discount then there will be an interest savings of
98.63.
If discount availed by supplier B
Outflow = 5,940.00
Savings = 60.00
If Discount Not Availed then interest saved
Interest Saved = 98.63
So, the final conclusion that can be drawn is that the firm should avail discount
from supplier A.

(c) Working capital management has a direct impact on the profitability of the firm. It
is from the general idea of finance that we know that risk and return comes hand
in hand which means in order to earn higher return we must take higher risk. The
two inherent risk of the working capital management is the liquidity risk and
opportunity loss risk. Liquidity risk in terms of working capital can be defined as
the risk of being unable to pay off short term obligations of the company using the
current assets. The risk of opportunity loss arises when the company is not able to
sell goods because of improper or inefficient inventory management.
(d) Credit monitoring means keeping the track of the company’s credit history which means
that whether the company is paying interest and principal to the loan providers timely or not.
The two techniques of credit monitoring are-
Self monitoring- It is the process by which the company can assess and monitor the credit
report itself without use of any automated machine.
Automated monitoring – It means monitoring the credit history by using machines.
If the customers make slow payments to the firm then there may be an opportunity loss
because there will be a longer cash conversion cycle. So there will be very less funds
available to invest in the raw material that would help in production. Many orders could not
be taken because of the shortage of inventory and also many big customers that could give us
big orders has to be cancelled because big orders requires availability of funds.

Answer 3.
In many companies, the entire common stock is not held by the managers a part of it is held
by the shareholders also. Sometimes there may arise a situation where there is a difference of
opinion between them. This conflict of interest between the shareholders and the
management is said to be the agency problem of the firm. Likewise, this conflict may also be
between the creditors and the shareholders (Piper, 2015).
If the stakeholders of the firm are not satisfied then they would sell the shares of the
company, the share price will then fall as a result of which there will be high chances of
hostile takeover. This threat of hostile takeover of the firm encourages the management to
work in the best interest of the shareholder which will ultimately reduce the conflict of
interest thereby reducing the agency problem of the firm.

References:
Piper, M. (2015). Accounting made simple. United States: CreateSpace Pub.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.