Question

1. Why cash conversion cycle is important to measure company’s liquidity?

2. Why investors focus on ROIC and Debt/Cap Ratio?

3. How do you justify higher Debt/Cap Ratio?

Answer 1

Answer:-

(1) Cash Conversion Cycle(CCC) - It measures the time period for which the funds are tied up with Business.It is very important and very effective metric for any company in the manufacturing sector.

Cash Conversion Cycle is an important metric for a business to determine the efficiency at which the companyis able to convert its inventory into sales and then into cash.A Business loves to see lower value of the cycle scince it is conducive to healthy working capital levels,cash flows, liquidity and profitability of a firm.

Cash Conversion Cycle is calculated as follows:

CCC= A/C receivable days (DSO) + Inventory days (DIO) - A/C payable days (DPO)

Cash Conversion Cycle process is shown below in the flow chart -

Firm Buys inventory on credit ----> Firm Pays for Inventory---->Firm Sells product ----> Firm receives payment

(A/c payable)CASH OUT (A/c receivable) CASH IN

(2) Investors focus on ROIC and Debt/Cap ratio:-

ROIC (Return on Invested Capital) is most important and overlooked matrix of management evaluation. In a specific sector many investors compare earnings ,earnings growth ,dividend and yield.However two similar companies generate the same return o Equity, but one utilizes twice the debt capital ,management should not be viewed as generating equivalent shareholders value .ROIC evaluates company earnings to its total capital investment by combining both shareholders equity and total debt.The ability of mangement to produce profits from the available capital created through equity and through debt issuance gives a clear picture of management effectiveness,especially in capital intensive businesses.

ROIC can be self calculated as shown below in the formula-

Net Profit (Net earnings) divide by total investment (total debt plus total equity ) then multiply by 100 arrive at a percentage.

Adding a return on invested capital ratio to its basic stock research may assist in identifying better quality management that could provide better shareholder returns.

(3) Justifying higher Debt/cap ration-

Debt ratio is a financial ratio that measures the extent of a company leverage.A high ratio also indicates that a company may be putting itself at a risk of default on its loans if interest rates to rise suddenly. Debt rario of 0.4 or lower are considered better,while a debt ratio of 0.6 or higher makes it more difficult to borrow money.A higher ratio increases the difficulty of getting loansfor new projects as lender see the company as a risky project. Accepatable debt to equity ratios differ among industries.

Dept typically has a lower cost of capital compared to equity.maily because of its senority in case of Liquidity. Many companies may prefer to use debt over equity for capital financing.D/E ratio is typically considered along with few other variables.The total debt and total equity of a company together combine to equal its total capital,also accounted for as total assets.