Working Capital and Cash Conversion Cycle Management
Working capital management balances the cash locked in inventory and receivables against the credit taken from suppliers. The exam tests whether you can compute the cash conversion cycle correctly, interpret what each day of it costs, and judge whether a proposed release of cash damages the business.
The formula and its parts
CCC = DIO + DSO − DPO. Days inventory outstanding = average inventory / cost of goods sold × 365. Days sales outstanding = average receivables / revenue × 365. Days payables outstanding = average payables / cost of goods sold × 365. Inventory and payables are driven by COGS; receivables are driven by revenue. A shorter cycle releases cash; a negative cycle means suppliers and customers fund operations.
Worked example
Revenue is 1,200m, COGS 730m, average inventory 120m, receivables 148m and payables 60m. DIO = 120/730 × 365 = 60 days. DSO = 148/1,200 × 365 = 45 days. DPO = 60/730 × 365 = 30 days. CCC = 60 + 45 − 30 = 75 days. Daily COGS is 2.0m, so shaving 10 days off the cycle releases about 20m. Cutting inventory to 100m achieves it; alternatively reducing DSO to 115 days does the same. Compare the funding cost saved - say 14% on 20m - against any early-settlement discount forgone or stock-out risk created.
Judging trade-offs
A supplier offering 2/10 net 45 implies a cost of giving up the discount of 2/98 × 365/35 = 21.3% annualised, which normally exceeds the bank's borrowing rate, so the discount should be taken. Stretching payables beyond agreed terms is not free: it raises supplier prices and can trigger supply interruption.
Traps that cost marks
Mixing revenue and COGS denominators; using closing balances when the business is seasonal; celebrating a shorter cycle that was achieved by cutting safety stock and losing sales; ignoring the credit-risk cost of loosening DSO to win sales.