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Corporate Finance Unit 10: Working Capital and Short-Term Finance

Day-to-day finance is about having the right amount of cash, inventory and credit at the right time. This unit covers the cash cycle, credit and inventory decisions, cash budgets and the true cost of short-term borrowing.

Covers: Operating cycle and cash conversion cycle, Liquidity ratios, Flexible vs restrictive short-term policy, Cash budgeting and float, Credit policy and the cost of trade credit, Inventory management and EOQ, Short-term borrowing costs

Study guide

Short-term finance deals with current assets and current liabilities. The operating cycle is the time from buying inventory to collecting cash from the sale: inventory period plus receivables period. The cash cycle subtracts the payables period, because paying suppliers later delays the cash outflow. Inventory period = inventory ÷ (COGS ÷ 365); receivables period = receivables ÷ (credit sales ÷ 365); payables period = payables ÷ (COGS ÷ 365). A long cash cycle means cash is tied up and must be financed, so firms try to shorten it by turning inventory faster, collecting sooner and paying later, without hurting sales or supplier relationships.

Liquidity ratios give a quick view of short-term safety. The current ratio is current assets ÷ current liabilities, and the quick ratio removes inventory, the least liquid current asset. A firm's short-term policy can be flexible, holding large balances of cash, inventory and receivables financed partly with long-term funds, or restrictive, holding small balances and borrowing short-term. Flexible policies cost more to carry but reduce shortage and refinancing risk. Many firms follow a matching approach: permanent current assets are financed long-term and seasonal needs with short-term loans.

A cash budget forecasts cash receipts and disbursements month by month to spot shortfalls in advance. Collections lag sales according to the firm's collection pattern, and the budget shows how much must be borrowed to keep a minimum cash balance. Float is the difference between the firm's book cash and the bank's balance. Disbursement float, from checks written but not yet cleared, temporarily increases bank cash; collection float, from deposits not yet credited, reduces it. Lockboxes and electronic payments speed collections, and the value of freed cash is the one-time amount freed, compared with the PV of the service fees.

Credit policy sets terms of sale, credit standards and collection policy. Terms like 2/10, net 30 give a 2% discount for paying within 10 days. A buyer who skips the discount effectively borrows 98% of the invoice for 20 days at a 2% cost, an EAR of about 44.6%, so taking the discount is usually wise if cheaper borrowing is available. For a seller, granting credit is an investment: the NPV of switching compares the one-time cost of the receivables built up with the perpetual gain in monthly profit, net of bad debts and discounts.

Inventory involves a trade-off between carrying costs (storage, insurance, the cost of tied-up money) and shortage or ordering costs. The EOQ model chooses the order size that minimizes total cost: EOQ = √(2DS ÷ H), where D is annual demand, S the cost per order and H the carrying cost per unit. At the EOQ, ordering and carrying costs are equal. A reorder point equals usage during the delivery lead time plus safety stock. Short-term loans have costs beyond the stated rate: compensating balances, discount interest and commitment fees all reduce usable funds or add charges, so always compute the effective rate on the money the firm can actually use.

Key ideas

• The cash cycle = inventory period + receivables period − payables period.
• Shortening the cash cycle frees cash that would otherwise need financing.
• The quick ratio excludes inventory and is a stricter liquidity test than the current ratio.
• Skipping trade discounts is usually very expensive credit.
• Granting credit is an investment that should have a positive NPV.
• EOQ balances ordering costs against carrying costs.
• Compensating balances, discount interest and fees raise the effective cost of short-term loans.

Formulas and rules

Common mistakes

• Adding the payables period to the cash cycle instead of subtracting it.
• Using the APR shortcut instead of the EAR when computing the cost of trade credit.
• Forgetting the factor of 2 or the square root in the EOQ formula.
• Applying bad-debt losses only to new sales when they apply to all credit sales.
• Computing a loan's effective rate on the face amount instead of the usable funds.

Before the test, make sure you can

• Calculate inventory, receivables and payables periods, the operating cycle and the cash cycle.
• Calculate current and quick ratios and interpret them.
• Compare flexible, restrictive and matching short-term policies.
• Build a simple cash budget and find the borrowing need.
• Calculate the effective cost of trade credit and decide whether to take a discount.
• Calculate the NPV of switching credit policies, including bad debts.
• Calculate EOQ, total inventory cost and the reorder point.
• Calculate effective rates on loans with compensating balances, discount interest and fees.

Words to know

Operating cycle

Time from acquiring inventory to collecting cash from the sale.

Cash conversion cycle

Operating cycle minus the payables period; days cash is tied up.

Inventory period

Average days inventory is held: inventory ÷ (COGS ÷ 365).

Receivables period

Average collection period: receivables ÷ (credit sales ÷ 365).

Payables period

Average days taken to pay suppliers: payables ÷ (COGS ÷ 365).

Current ratio

Current assets divided by current liabilities.

Quick ratio

(Current assets − inventory) divided by current liabilities.

Flexible short-term policy

Large current asset balances and more long-term financing.

Restrictive short-term policy

Small current asset balances and heavier short-term borrowing.

Cash budget

A forecast of cash receipts and payments used to plan short-term borrowing.

Float

The difference between book cash and bank cash caused by uncleared checks.

Lockbox

A bank-run collection system that speeds the deposit of customer payments.

Trade credit

Credit extended by suppliers through delayed payment terms.

Cash discount

A price reduction for paying within the discount period.

Economic order quantity

The order size minimizing total ordering and carrying costs.

Safety stock

Extra inventory held to guard against stockouts.

Compensating balance

Funds a borrower must keep on deposit with the lender.

Discount interest

A loan where interest is deducted up front from the proceeds.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.