BFC2140 · Corporate Finance
Short-Term Financing & Working Capital Management
Working-capital management is the day-to-day financial management of a firm's short-term assets and liabilities — the cash, inventory, receivables and payables that fund operations. This chapter covers net working capital and the cash conversion cycle, managing accounts receivable, accounts payable and inventory, credit-extension decisions, and the cost of trade-credit terms. It is examined as Section B numerical questions (the cost of a trade-credit discount, cash-cycle days) and Section C reasoning about the trade-off between liquidity and the cost of holding working capital.
What this chapter covers
- 01Net working capital = current assets − current liabilities, and what it funds
- 02The cash conversion cycle: CCC = inventory days + receivable days − payable days
- 03Managing accounts receivable: credit terms, collections and the credit-extension decision
- 04Managing accounts payable: stretching payables versus losing early-payment discounts
- 05Inventory management and the cost of holding versus running out of stock
- 06The cost of trade credit on terms such as 2/10 net 30
- 07The liquidity-versus-profitability trade-off in setting working-capital policy
The annualised cost of forgoing a trade-credit discount
- 1 markIdentify the inputs: discount = 2% (0.02), the discount period is 10 days and the net period is 30 days, so by waiting you delay payment by 30 − 10 = 20 extra days.
- 1 markFind the cost per period of forgoing the discount: discount/(1 − discount) = 0.02/(1 − 0.02) = 0.02/0.98 = 0.020408 = 2.0408% for the 20-day delay.
- 2 marksAnnualise over the number of 20-day periods in a year: there are 365/20 = 18.25 such periods, so cost ≈ 0.020408 × (365/20) = 0.020408 × 18.25 = 0.3724 = 37.24% (simple annualisation).
- 1 markCompare with the borrowing rate: 37.24% greatly exceeds the 14% borrowing cost, so the firm should borrow if necessary and take the discount.
Key terms
- Net working capital (NWC)
- Current assets minus current liabilities — the short-term capital tied up in running the business (cash, inventory and receivables, net of payables). Managing it well means holding enough to operate smoothly without tying up more cash than necessary.
- Cash conversion cycle (CCC)
- The time between paying for inputs and collecting cash from customers: CCC = inventory days + receivable days − payable days. A shorter cycle frees up cash; lengthening it (or stretching payables) reduces the firm's financing need.
- Accounts receivable management
- Setting and enforcing credit terms, deciding which customers to extend credit to, and collecting promptly. Extending credit can boost sales but ties up cash and adds default risk, so the credit-extension decision weighs extra contribution against the cost of carrying and bad debts.
- Accounts payable management
- Using suppliers' trade credit as a financing source — paying as late as the terms allow without penalty, while weighing whether to take early-payment discounts. Stretching payables shortens the cash conversion cycle but can damage supplier relationships.
- Trade credit
- Short-term financing extended by suppliers, quoted as terms like 2/10 net 30. It is 'free' only up to the discount date; forgoing the discount to pay later has an implicit, often very high, annualised cost.
- Liquidity-profitability trade-off
- The central tension of working-capital policy: more liquid (higher) working capital reduces the risk of running short of cash but lowers returns because cash and inventory earn little; lean working capital raises returns but increases liquidity risk.
Short-Term Financing & Working Capital Management FAQ
How do I calculate the cash conversion cycle?
Add the inventory days (how long stock sits before sale) to the receivable days (how long customers take to pay), then subtract the payable days (how long the firm takes to pay suppliers): CCC = inventory days + receivable days − payable days. A positive CCC means the firm funds the gap between paying suppliers and collecting from customers; reducing inventory or receivable days, or extending payable days, shortens the cycle and cuts the financing requirement.
Why is forgoing a trade discount so expensive?
Because the discount is large relative to the short extra time you gain by not taking it. On 2/10 net 30, skipping the 2% discount buys you only 20 extra days of credit, and the per-period cost is 0.02/0.98 ≈ 2.04%. Annualised over the roughly 18 such periods in a year, that is around 37%. Almost any normal borrowing rate is cheaper, so the rule of thumb is to take the discount and, if cash is tight, finance the early payment with a cheaper short-term loan.
What is the trade-off in holding working capital?
It is liquidity versus profitability. Generous working capital — plenty of cash, ample inventory, easy credit terms — reduces the risk of stockouts, missed sales and a cash crunch, but cash and inventory earn little or no return, so it depresses profitability. Lean working capital boosts returns by freeing up cash for higher-return uses, but raises the chance of disruptions and liquidity stress. Working-capital policy is about finding the level that balances these for the firm's circumstances.
When should a firm extend more credit to customers?
When the extra after-tax profit from the additional sales the looser credit generates exceeds the cost of the extra investment in receivables plus any increase in bad debts and collection costs. Extending credit is itself an investment decision: more generous terms can win sales but tie up cash in receivables and increase default risk, so it should be assessed on the incremental benefit versus incremental cost, just like any other capital-budgeting choice.
How is working-capital management examined in BFC2140?
It is the Week 8 topic and contributes to the final (Weeks 5-12 are emphasised). Expect Section B numerical questions computing the cost of trade-credit terms or cash-cycle days, and Section C reasoning about managing receivables, payables and inventory and the liquidity-profitability trade-off. It is also part of the Exercise 4 MyLab set covering short-term financing and risk/return.
Exam move
Anchor the chapter on two computations and one idea. First, master the cash conversion cycle (inventory days + receivable days − payable days) and be able to explain how shortening each component frees up cash. Second, drill the cost-of-trade-credit formula, taking care to use discount/(1 − discount) for the per-period cost and the extra days (net minus discount period) for the period, then annualise — and always conclude by comparing the rate to the firm's borrowing cost. The unifying idea to carry into Section C is the liquidity-profitability trade-off: every working-capital choice (how much inventory, how generous the credit terms, how fast to pay suppliers) is a balance between operating safely and not tying up cash that could earn more elsewhere. Frame the credit-extension decision as an incremental cost-benefit analysis, the same logic as capital budgeting.
