Growth Without the Cash to Fund It
A wholesale supplier has $8.4m in annual sales and a net profit margin of 4%. It is growing at 30% per year because two new retail customers have doubled their orders. Accounts receivable days have stretched from 38 to 67 as those customers negotiate 60-day terms, and inventory days have risen from 45 to 58 to avoid stockouts. Accounts payable days are steady at 30. The business has a $500,000 overdraft, of which $410,000 is currently drawn, and a covenant requiring the overdraft to stay below 80% utilised. The owner wants to take on a third large customer next quarter.
1. Calculate the cash conversion cycle and explain what has happened to it.
Read the worked answer
Working. Cash conversion cycle = inventory days + receivable days − payable days.
- Previously: 45 + 38 − 30 = 53 days.
- Now: 58 + 67 − 30 = 95 days.
The cycle has lengthened by 42 days. In plain terms, the business now waits 95 days between paying for stock and collecting from customers, versus 53 before. Every extra day of cycle ties up cash: at $8.4m sales, one day of sales is about $23,000, so 42 extra days represents roughly $966,000 of additional working capital absorbed - far more than the $410,000 already drawn on the overdraft.
Explanation. Growth itself has caused the squeeze. The new customers demanded longer terms (receivables up 29 days) and larger order volumes required more stock (inventory up 13 days), while suppliers were not asked for matching terms (payables unchanged). This is the classic overtrading pattern: profit is being made on paper but is locked in receivables and stock.
2. Assess whether the owner should take the third customer, and recommend two financial actions.
Read the worked answer
Assess the covenant first. The overdraft is $410,000 of $500,000 = 82% utilised - already above the 80% covenant limit. The business is in breach or on the edge before the third customer arrives. Adding volume that lengthens the cycle further would deepen the breach and could let the lender demand repayment.
Judgement. Taking the third customer without fixing working capital would be overtrading into a liquidity crisis. Growth should be paused or conditioned on cash terms.
Recommended actions.
- Shorten receivables - offer a small early-settlement discount (e.g. 1.5% for payment within 14 days) and enforce credit limits. Cutting receivable days from 67 to 45 releases roughly $500,000, restoring covenant headroom.
- Stretch payables and match terms - negotiate 45–60 day terms with suppliers so payables rise toward receivable levels, and use the improved position to convert part of the overdraft into a term facility suited to permanent working capital needs.
Only once the cycle is back under control should the third customer be accepted - and ideally on shorter terms than the first two.