Financial Management - Assignment PDF

FINANCIAL
MANAGEMENT
STUDENT ID:
[Pick the date]

TASK 1
1.1 Cash conversion cycle is a metric which reflects the time period that is required to
convert the underlying investments into inventory and other enabling resources and realising
cash from sale of inventory (Damodaran, 2015). The cash conversion cycle therefore has
three essential components namely the inventory days, receivables days and payables days.
The inventory days captures the time period required to make sale from inventory
procurement. The receivables days captures the time period to realise the cash from the time
of making sale. Finally, payables days refer to the time taken to settle the trade creditors
(McLaney, 2014).
Cash Conversion Cycle = Inventory days + Receivables days – Payables days
The significance of cash conversion cycle lies in the fact that it determines the working
capital needs of the company. This is because the cash conversion cycle is the time period
during which the company is able to recoup the initial cash that was deployed. As a result, it
is preferable on the part of the company to ensure cash conversion cycle is small. A larger
cash conversion cycle would imply use of incremental working capital financing to meet the
operational business needs and hence would lead to higher interest cost (Parrino and Kidwell,
2014).
1.2 A firm is overtrading when the working capital of the company is insufficient to meet the
operational requirements of the business. Typically, there is an implicit trade-off between
liquidity and profitability. This is because the company can have higher liquidity by taking
more working capital but the associated interest cost would lower the profitability of
operations. On the other hand, a lower working capital would ensure efficient use of working
capital thereby lowering the interest cost and hence leading to higher profitability. Hence, it is
prudent that the production and sales level are maintained at a level where the existing
working capital of the firm is sufficient to meet the business needs (McLaney, 2014).. Failure
to do so can potentially lead to a situation where there is overtrading. In such a scenario, the
proportion of short term financing over long term financing tends to increase thereby
indicating that working capital is increasing as the company essentially needs higher liquidity
which may bring a drag on the profitability. It is essential that the company needs to prevent