Riverside Components: Discount Terms, a Thin Credit Line, and a CNC Machine
Riverside Components is a 28-employee manufacturer with $2.4 million in annual sales and a $150,000 revolving line of credit at 9.5% interest, of which $120,000 is undrawn. Its controller reports days sales outstanding of 62 days against an industry median of 45, inventory turnover of 4.2, a current ratio of 1.9, and a quick ratio of 0.81. The largest supplier has offered 2/10, net 30 on roughly $600,000 of annual purchases, replacing the current net-30 terms. Separately, the operations manager wants a $180,000 CNC machine, financed over five years at 8%, that would add capacity for 4,000 units a year at a $22 price and $13 variable cost and would eliminate a $28,000 annual outsourced finishing contract. Demand for the added output is not yet contracted; the sales manager estimates 2,500 to 4,000 units. The owner wants to commit to both this week and asks you, the newly hired business manager, for a one-page recommendation.
1. Quantify the annualized cost of forgoing the supplier's 2/10, net 30 terms, and decide whether Riverside should draw on its line of credit to take the discount.
Read the worked answer
Cost of forgoing the discount. The firm would be paying 2% to keep its money 20 extra days: (0.02 ÷ 0.98) × (365 ÷ 20) = 0.02041 × 18.25 = 37.2% annualized.
Dollar comparison. Qualifying purchases are $600,000, so the discount is worth $12,000 a year. Financing the 20-day gap at 9.5% costs roughly $600,000 × 0.095 × (20 ÷ 365) ≈ $3,120. Net benefit ≈ $8,880, and the peak draw is only about 20 days of purchases (~$33,000), well inside the $120,000 undrawn.
Decision. Take the discount, with conditions. The effective return is about 27 points above the line rate, far better than any alternative use of the cash. Confirm in writing that the discount applies to the full $600,000, and confirm the bank will not reprice the line. Two cautions: a quick ratio of 0.81 means the $120,000 cushion is the firm's only slack, so the $33,000 draw must be released by faster collections rather than consumed; and in a month when Riverside cannot pay within 10 days, it should skip that month's discount rather than pay late and lose it.
2. Evaluate the CNC machine purchase. Compute the annual operating benefit, the first-year cash flow after debt service, and simple payback, then advise whether to proceed now, sequence it, or decline.
Read the worked answer
Operating benefit. Added contribution is 4,000 × ($22 − $13) = $36,000; plus $28,000 of contract elimination = $64,000 a year before tax.
Financing. $180,000 at 8% over five years: payment = 180,000 ÷ 3.9927 (present value annuity factor) ≈ $45,080 a year. Year-one cash flow ≈ $64,000 − $45,080 = +$18,900.
Payback. 180,000 ÷ 64,000 ≈ 2.8 years, attractive against a five-year asset life - if the volume is real.
But the sales forecast is 2,500 to 4,000 units, not 4,000. At 2,500 units the benefit falls to $22,500 + $28,000 = $50,500, and cash flow after debt service drops to about $5,400. Payback stretches beyond 3.5 years and the machine barely covers its own financing.
Recommendation - sequence, do not decline. Execute the discount decision now (near-riskless ~$8,900). Sign the machine only when letters of intent cover about 3,000 units, or when the outsourced contract can be cancelled mid-term without penalty. Ask the bank for conditional approval now so the deposit and the supplier draw do not hit the quick ratio in the same quarter.
3. Identify the two liquidity signals in the data that most worry you, quantify the larger one, and prescribe one concrete action for each.
Read the worked answer
Signal 1 - quick ratio 0.81. Current liabilities exceed cash, receivables, and marketable securities; the firm is being funded by inventory and the bank line. Action: build a 13-week rolling cash forecast and open negotiations with the top three suppliers for net-45 terms, which resets the working-capital cycle without borrowing.
Signal 2 - DSO of 62 days against a 45-day median. At $2.4 million of sales, receivables are about $408,000; at the median they would be about $296,000, so roughly $112,000 is trapped in receivables. Action: invoice at shipment, require deposits or COD for new accounts, and run a weekly aging review with a named owner and a call date for every account past 45 days; stop open-credit sales to the two worst payers.
Avoid the obvious trap. Offering customers 2/10, net 30 to speed collections costs the seller about 37% annualized - nearly four times the 9.5% line. Collection discipline and deposits are cheaper than a customer discount. Note also that inventory turnover of 4.2 should be checked for obsolete stock before it is counted as a liquidity source.