Cheung Sha Precision Components: the 143-day cash cycle and a yen payable
Cheung Sha Precision Components Ltd makes machined parts in Tsuen Wan. Revenue is HK$240 million, cost of goods sold is 70% of revenue, receivables are 78 days (terms are 45), inventory is 95 days and payables are 30 days. The HK$40 million overdraft is drawn to HK$34 million at 7.5%. A factor has offered to advance 80% of assigned receivables at HIBOR + 300bp (HIBOR is 4.3%) plus a 0.6% service fee, and claims it will cut receivable days to 35. It will not cover the US customer that generates 38% of revenue. Separately, a Japanese supplier of HK$45 million of annual purchases has offered 2/10 net 60 on all invoices. Cheung Sha also owes JPY 480 million in 90 days. Spot is HKD 0.0518 per JPY, the 90-day forward is 0.0526, a 0.0520 strike call option costs HKD 0.0009 per JPY, and the treasurer expects spot to be 0.0545 at payment. About 20% of Cheung Sha's revenue is invoiced in JPY.
1. Calculate the operating cycle and the working capital financing requirement, and assess whether the factoring offer is worth taking.
Read the worked answer
The cycle and the money tied up
Operating (cash conversion) cycle = 95 + 78 − 30 = 143 days.
| Component | Basis | Amount (HK$m) |
|---|---|---|
| Inventory | 168 × 95/365 | 43.7 |
| Receivables | 240 × 78/365 | 51.3 |
| Less payables | 168 × 30/365 | (13.8) |
| Financing requirement | 81.2 |
Against a HK$40 million overdraft drawn to HK$34 million, the gap is being funded by supplier strain and by deferring capital spend - a HK$47 million shortfall that will surface within a quarter.
Is factoring worth it?
- Only 62% of receivables are assignable (the US customer is excluded). Assignable receivables = 62% × 51.3 = HK$31.8 million; 80% advance = HK$25.4 million of cash.
- Cost: service fee 0.6% on assigned turnover of about HK$148.8 million = HK$0.89 million a year, plus interest at 7.3% (HIBOR + 300bp) - cheaper than nothing but more expensive than the 7.5% overdraft only after the fee is added.
- Cash released if assigned receivables fall to 35 days: from 31.8 to 14.3, i.e. HK$17.5 million.
Verdict: the all-in cost of roughly 8–9% exceeds the overdraft, so factoring is not the cheapest money. But it buys three things the overdraft cannot: HK$25 million of immediate liquidity against a fully drawn facility, credit control for the smaller customers, and a lower concentration of receivable risk. Take it selectively for the second-tier customers only, and treat the US customer separately with credit insurance - a single 38% exposure is a solvency issue, not a working capital issue.
Attacking the 95-day inventory (a 30-day reduction releases HK$13.8 million) is cheaper than any financing.
2. Evaluate the supplier's 2/10 net 60 terms and state the decision.
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Cost of the discount foregone
Early settlement discount of 2% for paying 50 days early:
Cost of giving up = (2 ÷ 98) × (365 ÷ 50) = 2.041% × 7.3 = 14.9% a year
That is the effective annual cost of not taking the discount. Cheung Sha's marginal cost of short-term funds is the 7.5% overdraft. Since 14.9% > 7.5%, the discount should be taken.
Dollar test on HK$45 million of annual purchases
- Discount earned = 2% × 45.0 = HK$0.90 million
- Extra financing needed: paying on day 10 instead of day 60 means funding 98% of the purchases (HK$44.1 million) for 50 extra days: 44.1 × 50/365 × 7.5% = HK$0.45 million
- Net gain = HK$0.45 million a year, for a 14.9% return on borrowed money costing 7.5%.
Conditions before committing
- The overdraft must have capacity to fund HK$44.1 million for 50 days - it does not at present, so this decision is downstream of the factoring and inventory decisions.
- Confirm the supplier's credit terms are genuine and stable; a 2% discount that disappears next quarter is not a 14.9% return.
- Check the JPY invoices are on the same terms - a 2% discount on a currency exposure is a different calculation.
- If cash is genuinely short, a 14.9% implicit cost means it is worth borrowing at up to 14.9% to take it; the overdraft at 7.5% is comfortably inside that.
Priority order: reduce inventory (cheapest), take the discount (14.9% return for 7.5% cost), factor second-tier receivables, and negotiate longer terms with domestic suppliers.
3. Recommend how to manage the JPY 480 million payable due in 90 days, with supporting numbers.
Read the worked answer
First, hedge the net exposure, not the gross
About 20% of revenue is JPY-invoiced, roughly HK$48 million a year, or HK$12 million a quarter. That is a natural offset. Ignoring it over-hedges and turns a hedging programme into a currency position.
Net payable ≈ JPY 480m − (12.0 ÷ 0.0518) ≈ 480 − 232 = JPY 248 million, though timing mismatches mean the offset is imperfect and the gross payable is still contractually due.
Cost of each route on the gross JPY 480 million
| Route | HKD cost at expected spot 0.0545 |
|---|---|
| Do nothing | 480 × 0.0545 = 26.16m |
| 90-day forward at 0.0526 | 480 × 0.0526 = 25.25m |
| 0.0520 call, premium 0.0009 | premium 0.43; exercised at 0.0520 = 24.96 + 0.43 = 25.39m |
Scenario if JPY falls to 0.0490
- Forward: 25.25m (locked)
- Option: 480 × 0.0490 = 23.52 + 0.43 = 23.95m - the option wins by 1.30m because it can be abandoned.
- Unhedged: 23.52m
Recommendation
- Hedge 100% of the net exposure and at least 70% of the gross. The payable is a known, certain obligation - this is not a speculation, it is removing a risk the company is not paid to bear.
- Use forwards for the core 70% - cheapest at the expected rate and administratively simple. Forwards commit the company to a rate, so pair them with the certainty of the underlying payable.
- Use the option for the remaining 30% if the JPY exposure is matched against JPY revenue that could fall; the HK$0.43 million premium is a real cost but it buys the ability to walk away.
- Do not leave it unhedged because the treasurer expects 0.0545. A forecast is not a hedge; if the treasurer is right the forward still beats spot by HK$0.9 million, and if wrong the company is protected.
- Document the policy - approved instruments, counterparty limits (bank lines, ISDA in place), maximum tenor, no naked positions, monthly mark-to-market reporting to the board. The auditor will ask for it, and the treasurer's expectation of 0.0545 is exactly the kind of view that a written policy is designed to contain.