Financial Management Assignment: Analysis of Working Capital and Risk

This financial management assignment analyzes the cash conversion cycle, overtrading, and various financing strategies. It examines the significance of the cash conversion cycle in determining working capital needs and explores the implications of overtrading, including the need for short-term financing. The assignment provides an analysis of a company's financial data, highlighting the increase in its cash conversion cycle, expansion of working capital, and rise in short-term financing. It also discusses strategies for financing working capital requirements, such as working capital loans, bank overdrafts, and receivable-based financing. Furthermore, the assignment differentiates between risk and uncertainty, exploring tools like scenario analysis and real options for appraising investments under these conditions. The assignment concludes by discussing the importance of alternative financing and providing recommendations to improve the firm's financial position.

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

overtrading and under-trading so as to optimise the profitability of the operations (Brealey,
Myers and Allen, 2014).
With regards to the given firm, it is apparent that from 2009 to 2010, there is an increase in
the cash conversion cycle from 50 days to 64 days. Higher cash conversion cycle would
imply that the company takes higher amount of time to recover the initial cash invested. This
implies that the company would require higher short term financing in order to ensure that the
business operations remain unaffected. Based on the given financial information for the
company, the working capital has expanded in 2010 as compared to 2009 which is evident
below.
Working capital (2010) = Current Assets – Current Liabilities = 43-33.6 = £ 9.4 million
Working capital (2009) = Current Assets – Current Liabilities = 20.5 -12.4 = £ 8.1 million
Another noteworthy aspect is the sharp rise in the short term financing by the company in
2010 when compared to 2009. This is evident by considering thee overdrafts which has
increased from £4.2 million in 2009 to a level of £13.1 million in 2010. It is evident that there
has been an increase of about 200% in the overdrafts which is the primary means of short
term funding being used by the company. Considering the above, it is fair to say that the
company is overtrading and needs to be cautious (Petty et. al., 2015).
1.3 There are different strategies which a firm may follow for financing the working capital
requirements. One of the traditional strategies in this regards is to avail a working capital loan
from bank or other financial intermediaries. Also, bank overdrafts is a common strategy
which is used where incremental funds beyond the cash present may be drawn from the
existing bank account for some interest (Parrino and Kidwell, 2014). Besides, receivable
based financing may also be deployed where money can be obtained by keeping receivables
as collateral or selling them outrightly. Further, short term financing options such as
commercial papers may also be used (McLaney, 2014).
1.4 The company currently faces the issue of overtrading and hence risks facing capital
crunch in the short term which may have adverse impact on the business activities coupled
with the reputation of the firm suffering. In order to avoid the same, measures need to be
taken by the company to enhance the liquidity by tapping on alternative finance sources.
Bank overdraft has also significantly increased and it is unlikely that it could continue to act
as source of future financing (Petty et. al., 2015). The most appropriate alternative financing

is receivables based financing considering that receivables from 2009 to 2010 has grown in
excess of 100% and thus these can be used to easy the cash crunch in the short term. Further,
the company can also offer lucrative discounts to the account receivables on making
prepayments within a specified time period. Similarly, incentives in form of small
incremental payments can be made to creditors so that payment may be deferred (McLaney,
2014).
Task 2
Even though in common parlance risk and uncertainty are used interchangeably but there is
significant difference between the two terms. With regards to risk, it is possible for the
predicting the possible future outcome along with the underlying possibility. However, in
case of uncertainty, it is not possible to ascertain the possibility of a given future outcome
(McLaney, 2014). Considering the risk allows determining possible future outcomes with
respective occurrence probabilities, hence it can be managed which is not possible for
uncertainty. Quantification and measurement is also possible for risk which is not an option
under uncertainty owing to which decision making under uncertainty is tougher than decision
making under risk (Brealey, Myers and Allen, 2014).
Two possible tools to deal with risk or uncertainty with regards to appraising investments are
scenario analysis and real options. Scenario analysis tends to incorporate risk by measuring
the respective possibility of various scenarios. Thus, the weighted average NPV is computed
to determine whether a project is feasible considering the underlying risk (Parrino and
Kidwell, 2014). Similarly, in long term investments, real options may be inserted which
enable the management to deal with uncertainty by providing them flexibility to quit out of
the project or postpone the same even after beginning has been made (Damodaran, 2015).

References
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
McLaney E. (2014) Business Finance: Theory and practice, 10th ed., London: Pearson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia