Cash conversion cycle, commercial paper, bank loans, and leasing

¶ … Bank Loans, & Leasing vs. Buying

Most companies acquire their inventory on credit which results into accounts payable and sell their products on credit which results into accounts receivables where in both cases there is no involvement of cash. Cash Conversion Cycle (CCC) therefore is a matrix that determines the length of time in days taken by a company to sell its inventory, and the duration of time taken to collect receivables and the duration of time taken by a company to pay its bills.

Cash Conversion Cycle is calculated as the Average Inventory Collection Period + Average Receivables Processing Period -- Average Payables Period. For instance if company 'X' has an average Inventory Collection Period of 85 days, an Average Receivables Processing Period of 55 days and an Average Payables period of 70 days then CCC will be (85+55-70)days which will be 70 days.

The length of time a company takes to recover cash from its activities is important and a shorter period is preferred by most companies as it indicates good cash flow and availability of cash for other investment purposes. A longer period is unhealthy for companies and implies that cash is tied up and the company cannot undertake some of its core operations due to cash flow problems.

A company can shorten the cash Conversion Cycle by decreasing Inventory Days on Hand by increasing efficiency in its manufacturing process or decrease Average Collection Period by providing incentives to those who pay on time or sooner by giving small discounts to attract earlier payments or device a more reliable collection method or the company can as well increase the Days Payable Outstanding by holding onto the suppliers' payments. All these measures will increase the available cash at hand for other important transactions in the company (Investopedia, 2012).

2. Why would a company prefer Commercial Paper to a Bank Loan? What are risks? (DO THE MATH)

Commercial paper is unsecured promissory note which has a fixed maturity ranging between 1 to 270 days. It is a short-term debt instrument issued to finance short-term credit needs of large banks and corporations. Commercial paper is not backed by collateral but backed by the promise of the issuer to pay the face value at maturity; it therefore follows that only firms with excellent credit ratings from a recognized rating agency will find buyers at a reasonable price without having to give a huge discount. Commercial paper is usually sold at a discount from the face value meaning the interest is subtracted from the face value to arrive at the price and the longer the maturity date the higher the interest rate the issuer has to pay. Market forces usually have an influence on the interest rate and they fluctuate subject to the market conditions. To illustrate, Discount (D) is calculated as: D= ((Discount rate x par x days to go (to maturity))/365. The price therefore will be (Face value-Discount). For instance a $2 million issue of 90 day commercial paper quoted at 5% discount rate, the Discount will be (0.04 x $2million x 90/365)= $19,726.03