The Overdraft That Looks Profitable on Paper
Zawadi Traders, a wholesaler, has applied to your bank for a KES 5,000,000 overdraft. The relationship manager's memo shows: revenue KES 42,000,000, net profit margin 6%, and a 'healthy' return on equity of 18%. On reading the statements you note: receivables days have risen from 45 to 92; payables days have fallen from 60 to 30 because suppliers now demand cash on delivery; inventory days are 75; the overdraft would be used to 'bridge' the gap. The business has no long-term debt but the owner has personally guaranteed the facility. Interest on the overdraft would be 14% per annum, and the bank's internal minimum for this sector is a 1.25:1 current ratio and a maximum 60-day cash cycle.
1. Compute the cash conversion cycle and assess whether the overdraft is funding a temporary gap or a structural problem.
Read the worked answer
Cash conversion cycle (CCC). CCC = inventory days + receivables days − payables days = 75 + 92 − 30 = 137 days.
The bank's maximum is 60 days. The business is 77 days over the limit.
What the number means. The firm ties up cash for 137 days between paying suppliers and collecting from customers. At revenue of KES 42,000,000, one day of sales is about KES 115,068. A 137-day cycle implies roughly KES 15.8m of working capital locked in the operating cycle. The requested KES 5m overdraft is far too small to 'bridge' that gap and would be consumed almost immediately.
Temporary or structural?
- The trend is deteriorating: receivables days doubled (45→92) and payables days halved (60→30). Both movements push the same way - more cash out, later cash in.
- Suppliers moving to cash on delivery is a permanent change in terms, not a blip.
- The overdraft is therefore funding a structural working-capital deficit, not a seasonal or one-off timing gap. An overdraft is a revolving, short-term instrument and is the wrong tool for a permanent funding need.
Profitability is not the issue. A 6% margin on KES 42m is KES 2.52m profit, but profit is not cash. The 18% ROE flatters the picture because there is no long-term debt; it says nothing about liquidity.
2. Recommend the credit decision and the conditions you would attach, showing how you would quantify the facility size.
Read the worked answer
Decision. Decline the KES 5,000,000 overdraft as requested. It would be fully drawn within weeks and would not resolve the 137-day cycle.
Quantifying a defensible facility. If the bank were to lend against the cycle, the sustainable need is the gap between the 60-day target and the current 137-day cycle:
- Excess days = 137 − 60 = 77 days.
- At ~KES 115,068 per day, that is roughly KES 8.86m of excess working capital - already more than the request, confirming the request is understated and the problem is structural.
- A facility sized to the target cycle (60 days) would be about 60 × 115,068 ≈ KES 6.9m, but only if the cycle is brought to target.
Conditions if the bank chooses to support.
- Reduce receivables days from 92 to 60 within two quarters - set a monthly ageing target and require reporting.
- Re-negotiate supplier terms back toward 45 days; cash-on-delivery for a wholesaler is unsustainable.
- Consider a term loan or invoice-discounting facility matched to the permanent need, rather than an overdraft.
- Personal guarantee retained, with a refreshed statement of affairs.
- Covenants: current ratio ≥ 1.25:1, CCC ≤ 60 days, monthly management accounts and receivables ageing.
- Review trigger: any further deterioration in receivables days.
Rationale. The facility must match the nature of the need. A permanent working-capital deficit needs term funding and operational fixes; an overdraft would only defer the problem and increase the bank's exposure.