Page 285 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 13: Management of Cash

Notes

Did u know? What is cash conversion cycle?

The operating cycle less the average payment period is referred as the Cash Conversion
Cycle. It represents the amount of time the firms’ resources are tied up.

Example: MAX Company, a producer of paper has annual sale of 10 lakhs, a cost of
goods sold of 75% of sales, and purchases are 65% of cost of goods sold. MAX has an average age
of inventory of 60 days, an average collection period of 40 days and an average payment period
of 35 days. Thus, the cash conversion cycle for MAX is 65 days (60 + 40 – 35).

Funding Requirements of the Cash Conversion Cycle

Permanent versus seasonal funding needs: If the firm’s sales are constant, then its investment in
operating assets should also be constant, and the firm will have only a permanent funding
requirement. If the firms’ sales are cyclic, then its investment in operating assets will vary over
time with its sales cycles and the firm will have seasonal funding requirements in addition to
the permanent funding required for its minimum investment in operating assets.

Aggressive versus Conservative Seasonal Funding Strategies

 Short-term funds are typically less expensive than long-term funds. Long-term funds
allow the firm to lock in the funds over a period of time and thus avoid the risk of
increases in short-term interest.

 Long-term funding ensures that the required funds are available to the firm when needed.

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Caution Short-term funding exposes the firm to the risk that it may not be able to obtain
the funds need to cover its seasonal peaks.
Under the aggressive funding strategy, the firm funds its seasonal requirements with short-
term debt and its permanent requirements with the long-term debt. Under a conservative
funding strategy, the firm funds both its seasonal and its permanent requirement with long-
term debt.

Clearly, the aggressive strategy’s heavy reliance on the short-term financing makes it riskier
than the conservative strategy because of interest rate swings and possible difficulties in obtaining
needed short-term financing quickly when seasonal peaks occur. The conservative strategy
avoids these risks through the locked-in interest rate and long-term financing, but it is more
costly because of the negative spread between the earnings rate on surplus fund, and the cost of
the long-term funds that create the surplus. Where the firm operates between the extremes of the
aggressive and conservative seasonal funding strategies depends on management’s response
towards risk and the strength of its banking relationships.

Task In respect of a firm, on an average, accounts receivable are collected after 80 days,
inventories have an average of 100 days and accounts payable are paid approximately
60 days after they arise. Calculate the firm’s cash cycle and cash turnover assuming a 360-
day year.

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