Funding a 104-Day Cycle
Meridian Traders, a wholesale distributor of electrical fittings in Siliguri, sells ₹6.0 crore a year; its net margin has never crossed 3%. The balance sheet shows inventory of ₹1.10 crore, receivables of ₹98 lakh, payables of ₹44 lakh, and a bank cash-credit overdraft of ₹1.60 crore at 14% interest. Cost of goods sold is about 90% of sales. The owner wants to fund a ₹60 lakh warehouse expansion entirely by a term loan, which would take debt to roughly three times equity; interest coverage is currently about 1.8 times. A bank has offered a scheme under which a 2% cash discount is expected to bring receivables down to 30 days; alternatively a supplier offers 1% discount for payment within 10 days instead of 30. The accountant has prepared no cash budget for the coming year and cannot state the firm's peak working-capital requirement.
1. Compute Meridian's operating cycle and net working capital, and judge whether its working capital position is sound.
Read the worked answer
Operating cycle = inventory days + receivable days − payable days.
- Cost of goods sold ≈ 90% of ₹6.0 crore = ₹5.4 crore, i.e. about ₹14.8 lakh a day; sales per day ≈ ₹16.4 lakh.
- Inventory: ₹1.10 crore ÷ ₹14.8 lakh ≈ 74 days
- Receivables: ₹98 lakh ÷ ₹16.4 lakh ≈ 60 days
- Payables: ₹44 lakh ÷ ₹14.8 lakh ≈ 30 days
- Operating cycle ≈ 74 + 60 − 30 = 104 days
Net working capital = current assets (1.10 + 0.98 = ₹2.08 crore) − current liabilities (0.44 + 1.60 overdraft = ₹2.04 crore) ≈ ₹4 lakh, under 1% of sales.
Judgement: the firm is not comfortably financed; it is financed at the edge. Inventory and receivables are being carried by a cash-credit limit, meaning permanent working capital is funded by short-term borrowing that a bank can decline to renew. With a 104-day cycle, one large customer paying late forces a default on suppliers. The interest bill alone - about ₹22 lakh a year at 14% - is larger than the entire net margin, which explains why a firm with ₹6 crore turnover feels cash-starved.
2. Evaluate the two discount offers on their numbers. Should Meridian accept either?
Read the worked answer
Cash discount of 2% to customers: if all customers avail it, cost = 2% of ₹6.0 crore = ₹12 lakh a year. Benefit = receivables fall from 60 to 30 days, releasing 30 × ₹16.4 lakh ≈ ₹49 lakh of funds, saving 14% interest ≈ ₹6.9 lakh, plus some saving in bad debts. Net cost is about ₹5 lakh, so as offered it should be rejected. A counter-offer of 1% for payment within 15 days, or interest charged on dues beyond 45 days, retains most of the collection benefit at half the cost.
Supplier discount of 1% for payment in 10 days: gain = 1% of purchases of about ₹5.4 crore = ₹5.4 lakh. Cost = paying 20 days earlier, requiring roughly ₹5.4 crore × 20/365 ≈ ₹29.6 lakh of extra borrowing at 14% ≈ ₹4.1 lakh. Net gain ≈ ₹1.3 lakh, which is the same as saying the annualised value of the discount (1/99 × 365/20 ≈ 18.4%) exceeds the 14% cost of funds. On numbers alone, accept this one.
But the real constraint is liquidity, not arithmetic. The firm cannot take either decision safely while it has no cash budget: the supplier discount demands cash 20 days earlier in exactly the weeks when the overdraft is tightest. Prepare a twelve-month cash budget first, then take the supplier discount and negotiate the customer discount.
3. Advise the owner on financing the ₹60 lakh warehouse expansion, given interest coverage of 1.8 times and debt at three times equity after the loan.
Read the worked answer
Interest coverage of 1.8 is thin. With interest of about ₹22.4 lakh on the existing overdraft, coverage of 1.8 implies EBIT of roughly ₹40 lakh. A ₹60 lakh term loan at even 12% adds ₹7.2 lakh of interest, taking total interest to about ₹29.6 lakh and pushing coverage down to roughly 1.36 times. That leaves almost no cushion: a 20% fall in EBIT would wipe out the margin of safety, and lenders treat coverage below about 2 as a warning sign.
Debt-equity of 3:1 is high for a trading business with 2–3% net margins. Trading on equity is favourable only when the return on the additional investment exceeds the cost of debt; an expanded warehouse must earn more than 12–14% pre-tax, which at low margins requires very high stock turnover - an assumption the firm has not tested.
Advice: (i) fund the expansion partly from retained earnings or fresh owner/partner capital, taking debt to no more than about 1.5:1; (ii) phase the warehouse - build 60% now, the rest on demonstrated throughput; (iii) shift permanent working capital (roughly ₹1.6 crore) to long-term funding so that the term loan is not serviced out of a cash-credit limit; (iv) prepare the cash budget and a projected debt-service coverage statement before approaching the bank.