Ceylon Tea Exports: Cash Conversion and Supplier Discounts
Ceylon Tea Exports has annual revenue of LKR 3.6bn and COGS of LKR 2.7bn. Receivables are LKR 720m, inventory LKR 540m, and payables LKR 405m. The company runs a LKR 500m overdraft at 14% and is close to its limit. A large supplier offers a 1.5% discount for payment within 10 days instead of the normal 45 days. The purchasing director wants to take the discount; the finance director worries about liquidity. A factor has offered to buy 60% of receivables (LKR 2.16bn of annual sales) with a 1.5% service fee and an 80% advance at 12% on advances; the factor will reduce the company's DSO on factored sales to 30 days. The company's DSO is currently 73 days and its DIO is 73 days. The bank has indicated it may not renew the overdraft at the current limit.
1. Calculate the cash conversion cycle and the cash tied up in working capital. How serious is the liquidity gap?
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Using a 365-day year: DSO = receivables / revenue × 365 = 720 / 3,600 × 365 = 73.0 days. DIO = inventory / COGS × 365 = 540 / 2,700 × 365 = 73.0 days. DPO = payables / COGS × 365 = 405 / 2,700 × 365 = 54.8 days.
Cash conversion cycle = DSO + DIO − DPO = 73.0 + 73.0 − 54.8 = 91.2 days. Cash tied up = receivables + inventory − payables = 720 + 540 − 405 = LKR 855m. Against a LKR 500m overdraft, the un funded gap is about LKR 355m, or 41.5% of the working capital requirement.
The gap is serious because the bank may not renew the limit. A 91-day cycle means the company finances about three months of sales before cash comes back. The immediate priorities are to collect receivables, reduce inventory and negotiate payables; otherwise a supplier discount or growth in sales will worsen the overdraft pressure.
2. Evaluate the supplier's 1.5% discount for payment within 10 days instead of 45 days. Should the company take it?
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The cost of forgoing the discount is: (1.5 / 98.5) × (365 / 35) = 0.01523 × 10.43 = 15.9% a year. This exceeds the 14% overdraft rate, so on pure cost grounds the discount is worth taking if the company can finance the earlier payment.
Approximate the annual purchases subject to the discount by COGS of LKR 2.7bn. The discount saving is 1.5% × 2.7bn = LKR 40.5m. Paying 35 days earlier requires extra finance of 2.7bn × 35/365 = LKR 258.9m. At 14%, the interest cost is LKR 36.2m. Net benefit ≈ LKR 4.3m a year, which is positive but thin.
The liquidity constraint is decisive. The overdraft is already near its limit, and the bank may not renew it. Taking the discount would increase the immediate cash outflow and could breach the limit. Recommendation: take the discount only on the portion of purchases that can be financed within a negotiated higher limit, or ask the supplier for a staged extension. Do not take it across the board while the overdraft renewal is uncertain.
3. Evaluate the factoring proposal. What should management do?
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Factored sales are LKR 2.16bn. Current receivables on those sales = 73/365 × 2.16bn = LKR 432m. At a 30-day DSO, receivables would be 30/365 × 2.16bn = LKR 177.5m, a reduction of LKR 254.5m. The factor advances 80%, so an immediate cash release of about 0.80 × 432 = LKR 345.6m is possible if it purchases the existing receivables.
Costs: service fee = 1.5% × 2.16bn = LKR 32.4m. Financing charge on the advance = 12% × 345.6m = LKR 41.5m. Total cost ≈ LKR 73.9m. Interest saving on the overdraft from the cash released = 14% × 345.6m = LKR 48.4m. On these terms factoring destroys about LKR 25.5m of value a year, before any bad-debt savings.
Management should use factoring only if it releases overdraft capacity that cannot otherwise be obtained, or if the factor's credit control reduces bad debts and collection costs. Otherwise, negotiate a lower service fee, use invoice discounting instead of full factoring, or sell only the slowest-paying accounts. The decision should be linked to the bank renewal: if the overdraft is withdrawn, factoring may be expensive but necessary for survival.