Question

Discuss the observed trend in the cash conversion cycle for publicly traded firms

With all else constant, what impact will an increase in the DPO have on the cash conversion cycle and the company's cash and marketable securities?

Answer 1

Cash conversion cycle: Converting cash in hand into inventory, sales and account receivables and then back in cash.The CCC represents the net length of time that funds are tied up in operating working capital.

CCC = DIO + DSO - DPO

where DIO = days inventory outstanding

DSO = days sales outstanding

DPO = days payable outstanding

Cash conversion cycle in publicly traded firms-

Observed trend : dramatic downward trend in the CCC

• In 1975, the annual median CCC was 101.66 days.

• From 1975 throughout the 1980s, the median value for the CCC dropped in a fairly steady fashion, reaching a value of 78.68 days in 1989.

• By 2001, the annual median CCC dropped to 50.05 days. Other than a slight spike in 2006 and 2007 (likely due to the financial crisis),

(The data source is Static provider websites)

The median CCC dropped from 101.66 days in 1975 to 49.98 days in 2016. The 51.68 day reduction in the CCC is significant.

Reasons : There are 3 element include in CCC so the reason of the decrease may be

1) Decreases in days inventory outstanding: This can be done by improving sales efficiency of firms, improvements in inventory management techniques , Improvement in supply chain management (ie availability of goods at right time on right place) etc.

2) Decreases in Days sales outstanding: Improvement in efficiency of corporate collections, Implementation of New payment technologies, Regulatory development (ie better provisions for recovery of debts),

3) Increase in days payable outstanding: The firms can reduced their collection periods while simultaneously increasing their time to pay. The net result is a shorter CCC.( discuss in second part of question)

Second part of question:

Impact of increase in DPO While other factors are constant: If we discuss in an easy way the impact is we have cash in hand or cash equivalents like marketable securities for more time if we don’t pay outstanding as soon as we pay before we retain outstanding for a longer period.

The CCC period will decrease although

This will not be benificial for firm because if we have cash in hand we have no use of it until we invest it in business activities or in other streams.

As the question said clearly that other factors are constant “ We can’t use it in business as if we purchase inventory/ raw material there must be capacity to use in production or maintain it.

If we invest in market there are chances of return but the possibility of loss is much higher than it.

Conclusion

The DPO SHOULD NOT BE INCREASED UNLESS THERE ARE DEFINITELY HIGHER BENEFITS OF INCREASING IT. Than to maintain it on present level.

The Interest to be paid on outstanding should be much lesser than return from investment or if invest in operating activities the cost benefit of increasing it should be higher.