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

The Dupont equation is Return on Equity = Profit Margin*Total assets turnover*Equity multiplier.

If the company has higher receiveables as compared to sales it shows company has relaxed customer policy. The relaxed policy, which will hold high current assets in relation to sales will help in improving the operating problems of the company like unsatisfied customers as customers would be happy with higher credit period, and any other shortages. But due to increase in current assets the total assets turnover would lead to increase in total assets turnover which would result in lowering of return on equity.

b) The cash conversion cycle is the time taken by the company to convert the cash on hand into inventory, accounts payable, through sales and accounts receivable and back into cash.

Company having lower cash conversion cycle would lead to increase in profitability of the company as the number of days to convert cash into cash is less, this will help the company to make more sale in short time and receive cash which will lead to improve profitability and liquidity position of the company. Say if a company A has 83 days of cash conversion cycle and another company B has 95 days of cash conversion cycle than company A would have higher profitability as comapred to that of company B due to increase in sales and decrease in finance cost and other cost for storing the stock.