CFA Practice Question

CFA Practice Question

Which of the following is (are) true about the cash conversion cycle?

I. It increases as the inventory turnover ratio decreases.
II. It decreases as inventory processing period decreases.
III. It is directly proportional to the payables payment period.
IV. It increases as the cash ratio decreases.
A. II & III
B. I & IV
C. I & II
Explanation: The cash conversion cycle is a measure of how long the cash is tied up in short term loans and credits. These short-term financing items include receivables, inventory and accounts payable. Therefore cash conversion cycle is defined as: CCC = (Average receivables collection period) plus (Average inventory processing time) minus (Average payables payment period).

Now, an increase in inventory ratio decreases inventory processing time, lowering the CCC. Also, an increase in the payables payment period decreases the CCC. However, CCC is independent of the cash ratio.

User Contributed Comments 8

User Comment
Jimmie Correct answer is A. Explanation beginning with Now, IS choice II.
Rguerra Jimmie, I think A is incorrect and the correct one is indeed D. Here´s why:

1) As the inventory turnover ratio decreases, so the average inventory processing period increases (given by 365/inventory turnover). Therefore, CCC which is equal to AVG Rec. Collect Period (ARCP) + AVG Inv. Proc Period (AIPP) - AVG Pay. Pay Period (APPP) increases.

2) Given that CCC = ARCP + AIPP - APPP, suppose:
Case 1: 10 = 6 + 8 - 4
Case 2: 9 = 6 + 8 - 3
Case 3: 8 = 6 + 8 - 2

In case 2 APPP decreased 25% while CCC decreased 10%
In case 3 (relative to 2) APPP decreased 33% which CCC decreased 11%

In my view, it does decrease but not in a "directly proportional" manner. I see this as somewhat a tricky wording.
dimos Rguerra 6+8-3=11!!!!! and not 9. That is why CCC is INdirectly related with APPP
mtcfa Think of it this way... if inventory turnover decreases, then inventory days (365/inventory turnover) INCREASES, thus helping out the ratio. This process goes for the other two inputs as well.
Janey Its easier if you put the different scenarios in the equation and see what happens.
nick1981 The wording is very tricky, I agree the best is to plot in rapidly some scenarios into the calculator and put pencil to paper in order to assess the different answers. I went for A cauz I was confused about the inventory, but indeed CCC worsens (more conversion days) when the inventory turnover decreases (more days of inventory processing).
takor Rugerra 6+8-2 is still 12 and not yet 8.
Mclarke I think the trick with this is to understand that a higher Inventory turnover ratio is good, however, a higher CCC ratio is actually bad - and ITR has inverse relation to CCC.
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