Question

1. Explain how different amounts of current assets and current liabilities affect firms’ profitability.
2. Discuss how the cash conversion cycle is determined, how the cash budget is constructed, and how each is used in working capital management.
3. Explain how companies decide on the proper amount of each current asset—cash, marketable securities, accounts receivable, and inventory.

Answer 1

Ans 1 Current asset are the highly liquid asset as they quickly converted into cash.The current asset contains stock which is highly liquid asset, which increase cash after selling in this way it impact the profitability of firm as gross profit is higher when stock level is high. Generally working capital is affected by the current liability instead of profitability directly. As we know when current asset is more than liability working capital is positive.Positive working capital helps in getting cheaper loan which increases profitability of business by paying less interest on loan.

Ans 2 Cash conversion cycle comprises ability of business that how quick a firm can convert inventory into cash through sales and account receivable , cash into inventory and payable.So cash conversion cycle is calculated by fast conversion of inventory, accounts payable & receivables into cash again.

Cash budget is constructed by forecasting needs of cash inflow and outflow for a business.Excess of inflow over outflow leads to surplus Vice versa as deficit.

Working capital is required for running daily business activities.If less working capital needed to run business it shows good profitability instead if more working capital is needed have an adverse effect on profit as business cash generation is low from operations. To meet out this situation firm use cash budget and cash conversion cycle to manage receivables and payàbles and apply changes in cash as required.

Ans 3 For cash a company can determine by proper recording of physical cash and by preparing cash accounts, if discrepancy is found must be rectified.

Marketable securities carry a value as per rates prevailing in market, so it is determined according to its carrying value.

For accounts receivables proper AR ageing must be maintained.It is determined by how much selling is made and how much amounts is received from opening balances dues to particular customer. Also tallied by debtors accounts, if there is any decripancies found must be rectified.

To determine inventory various methods for inventory valuation are there such as LIFO, FIFO which will be decided according to need of business.