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Lecture

BU121 Lecture Notes - Cash Conversion Cycle, Asset, Corporate Finance


Department
Business
Course Code
BU121
Professor
Roopa Reddy

Page:
of 6
Entrepreneurial Finance
Monday, March 04, 2013
1:06 PM
Liquidity
Compares assets that can be quickly converted to cash with liabilities that
represent near-term needs for cash
Addresses long-term trends
Cash burn helps us see if we're in immediate need
Year end accounting figures -> gives sense of long term trend, won't
tell you tomrrow and issue is short term
Evaluates working capital management issues
Handling current assets and liabilities, things we deal with on daily
basis to operate buiness
Current Ratio = average current assets/ average current liabilities
Rule of thumb: >2, <4 - holding too much current assets when you
could be investing it to earn a higher return
Acid Test/Quick Ratio = average current assets average inventories
average current liabilities
Rule of thumb: >1
NWC (net working capital) to total assets ratio = average current
assets average current liabilities
average total assets
higher the percentage, greater the liquidity
Interpreting Cash-Related Trends
Critical factor: how many months of cash do you have?
Current ratio, quick ration, NWC are going down -> has to do with burn
rate
Receivables, inventories = money tied up (not coming back to cash)
Conversion Period Ratios
Measure average time in days required for non-cash current assets and
selected current liabilities to create/demand cash
Faster assets can be converted into cash, greater the liquidity
Tells you the actual time it's taking
Operating cycle: measures time it takes to purchase raw materials, assemble
a product, book the sale and collect on it
Selling on credit: increases pool of customers
Measuring Conversion Times
Inventory-to-Sale Conversion Period = average inventory
(cost of goods sold/365)
Measures speed of inventory
Sale-to-Cash Conversion Period = average receivables
(net sales/365)
Days of sales outstanding or average collection period (speed of
receivables)
How many days does it take to collect your receivables
Inventory to sale + Sale to Cash conversion period = average
operating cycle
Purchase to Payment Conversion Period = average payables +
average accrued liabilities
(cost of goods sold/365)
Care about speed because while that's happening, you still have to pay
payables and accruals
When operating cycle is going on (outside cycle) you still have to pay
the inside
Want to balance them
Cash Conversion Cycle = Inventory to Sale + Sale to Cash - Purchase
to Payment Conversion Period
Number of days of operation that must be externally financed
Number of days that you don't have enough cash
Should be as close to 0 as possible
Inventory Conversion Trends
Inventory sale went up: more money tied up in inventory (not a good thing-
stocking too much so need better relationship with supplier or not selling
quickly enough), don't want it to be too fast because you'll lose sales if you
don't have anything to sell
Net cash burn: if inventory is going up because sales are going up, you'll
have a build with the burn
Cash conversion cycle going up means spending more cash than bringing in
(relating back to net cash burn)
Leverage
Considers how firm acquired external financing (to support longer cash
conversion cycle)
Measures extent to which firm has used debt and its ability to meet debt
obligations
Benefit of using debt vs equity? (borrow or get from shareholders)
Interest (cheaper than dividends but higher return & risk) vs. dividends
(not obligated to pay)
Expense for borrowing is less than equity because of tax savings
(lower cost of capital, return is higher)
Risk/return tradeoff
Higher the return, higher the risk
Control vs. legal recourse
If you sell more stock, you're diluting interest (takes away some
of control, give up equity = less control) but doesn't happen for debt
Could be pushed into bankruptcy if you don't pay debt
Control vs bankruptcy