The financial structure of a company is important for the management and shareholders as it defines the various modes of financing the company uses to support its operations. The two main components of a financial structure; short-term and long-term components, help in identifying two different aspects of a business. The liquidity ratios of a business indicate the ability of a firm to meet short-term obligations. These ratios depend on the short-term borrowings or liabilities of the company. The liquidity ratios also indicate the current stability of the firm. The level of working capital of a company also affects the profitability of a company. The optimum level of working capital is the point where working capital requirements maximize the profitability of the firm. The level of working capital is dependent on the level of current assets and current liabilities.
The three major current assets and liabilities other than cash which affects the level of profitability are accounts receivable, accounts payable and inventories. The cash conversion cycle depends on these three components and this cycle can be amended by changing the levels of current liabilities to maximize the returns of the company. Managers of many companies try to attain a level of cash conversion cycle where maximum profit is attained. Many companies use accounts payable as a short-term financing tool although the cost of using it is quite high it directly affects the level of working capital and cash conversion cycle. The cash conversion cycle denotes the time period between a collection of receivables and payment of payables. At an optimum level, the cash is collected early on receivables and payment is deferred on payables which frees up a considerable amount of cash which can be reinvested in the business to maximize profitability. Credit and finance managers are continuously involved in evaluating this optimum level of cash conversion cycle and working capital to increase the growth rate and returns of the company.
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