Working Capital Management and Short-Term Finance
Working capital management and short-term finance tests the cash operating cycle, inventory, receivables and payables policies, and the choice of short-term finance. Calculations often link the cycle to the cash freed by policy changes.
Core rules
- Cash operating cycle = inventory days + receivable days - payable days. It measures the period between paying suppliers and collecting from customers.
- EOQ = √(2DO/H), where D is annual demand, O is order cost and H is holding cost per unit per year.
- Receivables policy compares incremental contribution from extra sales with extra bad debts, discount cost and financing cost.
- Short-term finance sources include overdraft, trade credit, factoring, invoice discounting and commercial paper. Factoring transfers credit control and often risk; invoice discounting retains control.
- Overtrading arises when growth outpaces working capital finance.
Worked example
Inventory days are 60, receivable days 45 and payable days 30, so the cycle is 60+45-30=75 days. If daily sales are ₦10,000 and receivable collection is reduced by 10 days, cash freed is 10×₦10,000=₦100,000, before any financing cost. For inventory, if annual demand is 10,000 units, order cost ₦50 and holding cost ₦4 per unit, EOQ = √(2×10,000×50/4)=√250,000=500 units. The reasoning: the cycle converts policy days into cash; EOQ balances ordering and holding costs.
Traps
Adding payable days instead of deducting them; using selling price instead of cost for inventory investment; ignoring the cost of a discount; treating factoring as free finance; calculating EOQ with annual demand in units but holding cost in total.