Question

a) Referencing textbook readings, lecture material, and current business resources discuss some of the advantages and disadvantages of holding high levels of current assets in relation to sales. Use the DuPont equation to help explain your answer.

b) Define the cash conversion cycle (CCC) and explain why, holding other things constant, a firm’s profitability would increase if it lowered its CCC. Provide an example.

Answer 1

Greetings,

Part 1

Return on Equity as per Du Pont equation is calculated as under -

ROE = NPM * ATR * Leverage Ratio

Where NPM = Net Profit Margin = Net Profit/ Sales

ATR = Asset Turnover Ratio = Sales/Average Total Assets

Leverage Ratio = Average Total Assets / Average Equity

Focus of Du Pont equation is to increase the ROE. An increase in any one or all of above 3 components will increase the ROE.

So disadvantage of keeping high current assets in relation to the sales is that the ATR ratio will fall and so does the ROE. But at the same time, high investment in assets means higher sales in future, so ROE may fall in the short run but may rise in future. But at the same time , one thing must be kept in mind that keeping g higher current assets nay be in the form of higher debtors, reflecting poor collection from them or higher cash balances , reflecting poor cash management. If we want to increase the investment in total assets for future growth, it should be in the fixed assets.

Part 2 -

Cash Conversion Cycle is the period during which the firm converts its working capital investment into cash. It starts from raw material procurement and ends with the collection from debtors.

CCC is the sum total of -

Inventory Holding Period

• Time during which raw material is kept into stores
• Time during which raw material remains in process (WIP)
• Time during which Finished Goods take time to be sold

Debtors Collection Period ie time during which debtors remains outstanding

Above is known as Gross CCC. If we deduct the time which suppliers give us for the purpose of payment for supplies, then it is called net CCC.

Lower the CCC, higher the profitability. It is because CCC represents the period during which the funds of the entity are blocked and funds do have a cost. So higher the period , higher the interest cost on working capital loans. So if CCC lowers, it will definitely improve the profitability.