The 2/10 Net 60 Decision at a Tier-3 Auto Supplier
Sunrise Autocomp, a Tier-3 components supplier near Pune, closes the year with sales of ₹6 crore, entirely on credit. Its average balances show receivables at 60 days of sales, inventory at 75 days of sales and payables at 45 days of purchases; purchases run at ₹3 crore a year. The bank cash credit facility costs 13% per annum and is presently almost fully drawn. A polymer supplier, which accounts for the whole ₹3 crore of purchases, has offered terms of "2/10, net 60" - a 2% discount for payment within 10 days, otherwise the full amount is due in 60 days. The CFO wants to decline the discount because "2% looks small", and plans instead to stretch payables to 75 days to release cash. The MD wants the arithmetic before the board meeting, along with a view on whether the stretch plan creates legal exposure in India.
1. Compute the firm's operating (cash conversion) cycle and the working capital it must finance. What does the cash credit interest bill look like?
Read the worked answer
Operating cycle = inventory days + receivable days − payable days = 75 + 60 − 45 = 90 days.
A 90-day gap means the firm funds three months of sales before suppliers and customers settle.
Daily sales = 6,00,00,000 ÷ 365 = ₹1,64,384.
Working capital requirement ≈ 90 × 1,64,384 = ₹1.48 crore (rounding to ₹1.48–1.49 crore).
Interest at 13% on a fully drawn ₹1.48 crore = ₹19.2 lakh a year, or about ₹1.6 lakh a month - roughly 3.2% of sales. That is a substantial slice of a Tier-3 supplier's margin, and it is the number the CFO should be attacking.
Diagnostic point: the cycle is long because inventory (75 days) is the biggest single component, not receivables. Any proposal that does not touch inventory or payables is only tinkering at the edge, and stretching payables is the only lever that improves the cycle without operational change - which is exactly why it is tempting and exactly why it deserves the scrutiny in the third task.
2. Evaluate the 2/10 net 60 offer against the 13% cash credit. Should Sunrise take the discount? Show the comparison in rupees and as an annualised rate.
Read the worked answer
Annualised cost of forgoing the discount = (2 ÷ 98) × (365 ÷ 50) = 2.0408% × 7.3 = 14.9%.
Because 14.9% is the effective price of the supplier's 50 extra days of credit, and the bank charges 13%, borrowing from the bank to pay early is cheaper.
Rupee check on ₹3 crore of purchases:
- Discount earned = 2% × 3,00,00,000 = ₹6,00,000.
- Extra borrowing = 3,00,00,000 × 50/365 = ₹41,09,589; interest at 13% = ₹5,34,247.
- Net gain = 6,00,000 − 5,34,247 = ₹65,753 a year.
Verdict: take the discount, but recognise how thin the margin is - roughly 0.4 percentage points of spread on ₹3 crore. Two caveats decide it in practice. First, the cash credit is already near its limit, so confirm ₹41 lakh of headroom exists; if the bank instead charges a fresh processing fee or a higher rate, the gain evaporates. Second, the discount only helps if Sunrise can pay every invoice in 10 days; partial adoption leaves the expensive invoices in place while adding complexity.
3. The CFO proposes stretching payables to 75 days instead. Quantify this against the discount decision and assess the risks, including Indian legal exposure.
Read the worked answer
Cash released: moving payables from 45 to 75 days frees 30 days of purchases = 30 × (3,00,00,000 ÷ 365) = 30 × ₹82,192 = ₹24.66 lakh, saving interest of ₹24.66 lakh × 13% = ₹3.21 lakh a year.
But the options are mutually exclusive. Stretching to 75 days forfeits the 2% discount worth ₹6 lakh. Net effect versus taking the discount: 3.21 − 6.00 = −₹2.79 lakh. The stretch plan is the costlier of the two, which is the same conclusion the 14.9% vs 13% comparison already signalled - the discounted route wins on pure arithmetic.
Risks the CFO has not priced:
- Legal. Under the MSMED Act, payments to registered micro and small suppliers fall due within 45 days, and delayed payment attracts compound interest at three times the RBI's notified bank rate. A 75-day policy is therefore not merely aggressive; it is a statutory exposure if the polymer supplier is MSME-registered.
- Supply. A single-source supplier losing 30 days of cash will ration material, re-quote, or demand advance payment - catastrophic for a plant running on tight schedules.
- Signalling. Stretched creditors depress the credit rating, which raises the cost of the very facility being conserved.
Recommendation: take the discount, target inventory (75 days) for the real savings, and keep payables at or within the 45-day legal window.