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Question: In this case you are playing the role of a newly hired treasury analyst that is tasked with impro...
In this case you are playing the role of a newly hired treasury analyst that is tasked with improving the liquidity position and overall financial management of Firm Y. Firm Y was incorporated 10 years ago and operates in the manufacturing industry. Your first tasks involve benchmarking and forecasting.
To begin your new position, you have been tasked with benchmarking Firm Y’s liquidity position. In terms of the key performance indicators to benchmark, your treasurer states that the “Current and quick ratios provide the best measures of our firm’s overall state of liquidity. In general, higher values for both indicate that our firm is more liquid. In fact, our recent current and quick ratios have been lower than our industry peers, so we need to increase them.”
Based on your understanding of liquidity management, you note that the cash conversion cycle and its components are critical. For this reason you have collected the information that appears in Table 1 (for your firm (Firm Y), Firm A, and the Industry Average). In terms of the comparison reference groups, a two-way comparison will be utilized: Firm Y against Firm A (the market leader in the manufacturing industry) and Firm Y against the industry average of all manufacturers. Firm A is roughly the same age as Firm Y but has significantly greater scale. Specifically, Firm A has revenues of $500M, while Firm Y has revenues of $75M.
An intern has assembled the following quantitative information for comparison purposes.
Table 2
DSO |
DIO |
DPO |
CCC |
|
Firm Y |
95 |
40 |
30 |
105 |
Firm A |
59 |
15 |
35 |
39 |
Industry Average |
90 |
50 |
30 |
110 |
Question 1: Assess the treasurer’s statement on using the current and quick ratios to evaluate firm liquidity. Do you agree or disagree and why?
Question 2: Evaluate and comment on Firm Y’s liquidity position based on the DSO, DIO, and DPO and CCC relative to those metrics for Firm A and the Industry Average.
Question 3: Discuss any foreseeable problems associated with the two-way comparisons of the cash conversion cycle (i.e., Firm Y to Firm A or Firm Y versus Industry Average).
ANS. 1 current and quick ratios are good to asses liquidity of the company. these ratios measures the capability of a company's ability to meet its short term abilities from its current assets or quick assets. 2:1 is considered to be the ideal ratio as it states double the availability of current asset over its single current liability. a steady current and quick ratio keeps the company in good financial health.
ANS 2. CCC = DIO + DSO - DPO
CCC or cash conversion cycle has three components, days sales outstanding, days inventory outstanding and days payment outstanding
CCC determines the time period for converting a dollar outflow of cash into the relative cash inflow.
firm Y CCC components still matches with the industry average to the great extent but there is substantial difference with firm A, the market leader, which is far bigger than firm Y as mentioned in their revenue size too. DSO is much higher than firm A, as more of credit sales are made over cash sales but industry average states this a common thing over the industry.
DIO represents more production time which is lesser than industry average but higher over firm A. that means firm A must be having technologically updated faster machines.
DPO is accounts payable outstanding is again lesser than industry average but alot higher over firm A WHICH means firm A must offer discounts on early payments of their sales or promote more cash sales.
ANS 3. problems foreseeable are
FIRM A is expected to continue in lead over the industry and in order to come closer to firm A, firm Y should focus on inventory management, early sales realisation and payables.
CCC can also affects the timely deployment of cash in business. if cash is generated timely it can be reinvested timely. thus untimely deployment of cash can make the process go longer
CCC also affects cash management and operating efficiency and thus regulating overall financial health of the firm.