Working-capital policy decisions
Compare the cash released by a policy with its effects on sales, credit losses, service and supplier terms. A shorter cash conversion cycle is useful only when the business can sustain it without larger offsetting costs.
Price the discount you give up
- Period borrowing cost
- Discount ÷ (1 - discount), with the discount as a decimal.
- Extra credit days
- Net payment deadline - discount deadline.
- Simple annualized cost
- Period cost × 365 ÷ extra credit days.
This convention does not compound. Compare financing alternatives using a consistent annualization basis and consider fees.
See the decision
The cost of skipping an early-payment discount
Supplier terms are 2/10, net 40: pay 98% on day 10 or 100% on day 40. Use a 365-day year and a simple annualized comparison, not compounding.
- 01
Day 10
Pay 98% and take discount
- 02
Extra 30 days
Finance 98% of invoice
- 03
Day 40
Pay 100%; 2/98 period cost
Compare the 24.83% simple annualized cost with available comparable funding and liquidity constraints before forgoing the discount.
How to apply these ideas
1. Measure the cycle
Cash cycle = inventory days + receivable days - payable days.
Use consistent period lengths and the appropriate flow for each balance. Receivable days use credit sales; inventory days typically use cost of goods sold. A payable-days convention may use purchases where available; state it explicitly.
Watch for: Using sales dollars to estimate inventory investment without adjustment.
2. Credit policy
Balance incremental sales margin against collection and default costs.
Longer customer terms can increase revenue and receivables. Evaluate incremental margin, financing cost, bad debts and collection expense. An average DSO change alone does not show whether the policy creates value.
Watch for: Treating every sale made on credit as immediate cash profit.
3. Inventory policy
Trade carrying cost against service and replenishment risk.
Lower inventory can release cash but increase stockouts or expedited freight. Check supplier lead time, variability and the bottleneck before cutting buffers. Average inventory is not the same as the peak cash need.
Watch for: Reducing stock without testing service consequences.
4. Supplier terms
Compare discounts with the implied cost of delaying payment.
Forgoing an early-payment discount can be expensive relative to other funding. Use a stated day-count convention and compare comparable annual rates. Also consider supplier reliability and whether extended terms are negotiated or simply late payment.
Watch for: Calling unpaid invoices free financing regardless of terms.
Study the topic
Working-capital policy decisions: explanations and applications
Compare credit, inventory and supplier-payment policies using incremental profit, cash investment and operating risk. Corporate finance remains the parent for funding and the overall cash cycle.
By MiloPrep editorial team. Original teaching explanations and illustrative cases; official curriculum references are listed below.
Evaluate the full incremental credit policy
More generous credit may increase sales and contribution while increasing receivables, bad debts and administration. Compare those changes rather than treating sales growth as profit. Specify whether the receivable investment is valued at sales or at the cash-cost basis required by the case. Apply the funding rate to the appropriate investment and time horizon.
Separate expected credit losses from the opportunity cost of funds tied up. A receivable can eventually be collected in full and still require financing while outstanding. New sales may also change capacity, inventory or service costs. Include those effects when the facts make them incremental and avoid counting them twice in the contribution margin.
| Policy change | Potential benefit | Cost or risk to test |
|---|---|---|
| Looser customer credit | More sales and contribution | Bad debts, funding and collection effort |
| Lower inventory buffer | Less cash tied up and holding cost | Stockouts and disruption |
| Faster collection | Lower financing requirement | Discount cost or customer impact |
| Longer supplier payment | Short-term cash relief | Lost discounts and supply relationship |
| More cash reserves | Resilience and flexibility | Return forgone on alternative uses |
Balance ordering, holding and shortage consequences
The basic economic order quantity model balances annual ordering cost with annual holding cost under stable demand, fixed order cost and a constant holding rate. EOQ equals the square root of 2 × annual demand × cost per order divided by annual holding cost per unit. State the model assumptions before applying it to uncertain demand or quantity discounts.
Reorder point concerns when to order, not how much. Under a simple deterministic model it equals demand during lead time; a safety stock buffer can address uncertainty under a specified service policy. Cutting stock below the amount needed during replenishment may reduce the balance sheet while creating costly shortages. Check lead-time variation and supplier concentration.
Match the cash-cycle improvement to a real resource change
Reducing inventory days can release cash when physical inventory actually falls at a comparable cost and service level. A ratio improvement caused only by a price change or write-down is not the same cash release. Likewise, a receivable-days reduction should be tied to collections and credit terms rather than a change in the sales denominator alone.
Trade discounts have an opportunity cost when forgone. Compare the discount percentage with the amount that would have been paid early, and annualize over the extra credit period using the stated convention. A high computed rate does not create borrowing capacity that the company does not have; liquidity constraints and transaction costs still belong in the recommendation.
Work it through
Worked example: The cost of skipping an early-payment discount
Supplier terms are 2/10, net 40: pay 98% on day 10 or 100% on day 40. Use a 365-day year and a simple annualized comparison, not compounding.
| Input | Value |
|---|---|
| Discount forgone | 2% of invoice |
| Amount financed | 98% of invoice |
| Extra credit | 30 days |
| Simple annualized cost | 24.83% |
- 1
Thirty-day cost = 2 / 98 = 2.0408%.
- 2
Simple annualized cost = (2 / 98) × (365 / 30) = 24.83%. An effective compounded annual rate would be different.
Compare the 24.83% simple annualized cost with available comparable funding and liquidity constraints before forgoing the discount.
Work through the alternatives
More worked cases: working-capital policy decisions
Original teaching scenarios. Each case states its assumptions, shows the working and explains the limits of the conclusion.
Extra sales can be offset by financing and credit losses
A policy is expected to add $100,000 annual sales at 30% contribution margin. Additional average receivable investment, already measured on the required cash-cost basis, is $40,000. Funding costs 12%; additional annual bad-debt and administration costs are $8,000 and $3,000. No other effects occur.
| Incremental annual item | Amount |
|---|---|
| Contribution from added sales | $30,000 |
| Financing cost: 12% × $40,000 | -$4,800 |
| Bad debts | -$8,000 |
| Administration | -$3,000 |
| Net expected benefit | $14,200 |
- Calculate contribution, not revenue, as the sales benefit.
- Net benefit = 30,000 - 4,800 - 8,000 - 3,000 = $14,200. Test whether the volume, losses and cash-investment assumptions are credible.
What the result means: The policy has a positive modeled benefit, but approval still depends on the liquidity needed to carry the additional receivables and the downside credit exposure.
Calculate order size separately from reorder timing
Annual demand is 10,000 units, ordering cost $40 and annual holding cost $2 per unit. Daily demand is 40 units, lead time five days and safety stock 60 units. Apply the basic EOQ model with no discounts.
| Decision | Calculation | Result |
|---|---|---|
| Order size | √(2 × 10,000 × 40 / 2) | 632.46 units |
| Expected lead-time demand | 40 × 5 | 200 units |
| Reorder point | 200 + 60 | 260 units |
- EOQ balances ordering and holding cost under the stated stable-demand model. Operational rounding must respect pack sizes and constraints.
- The reorder point triggers replenishment when the relevant inventory position reaches 260 units; it is not the quantity to order.
What the result means: Quantity and timing answer different questions. Reassess the model if demand, lead time or unit prices change materially.
Practice this topic
Check your understanding
Try each short application before opening its explanation. These are original learning checks, not official exam questions or a score prediction.
1. Annual cost of goods sold is $365,000. Inventory falls by eight days at the same cost basis and service level. What is the implied reduction in average inventory?
Show answer and explanation
$8,000.
Daily cost is $1,000; multiply by eight days. This is a balance reduction, not automatically an $8,000 annual profit increase.
2. Terms are 1/10, net 40. What is the 30-day cost rate of forgoing the discount?
Show answer and explanation
1/99, approximately 1.0101%.
The additional $1 finances the $99 that would have been paid early on a $100 invoice. Annualization is a separate step.
Questions about working-capital policy decisions
- Does extending payables always improve the company?
- No. It can forfeit discounts, damage supplier relationships or cause supply interruption. Compare the cash benefit with those costs.
- Why divide the discount by 98 rather than 100?
- In this example, 98 is the amount that could have been paid early and is instead financed for the extra period. The additional 2 is the financing cost.
Sources and scope
Curriculum mapping: Part 2, Section B, Corporate Finance. The official outline assigns 20% to the entire domain, not to this individual technique. These are selected study notes, not complete curriculum coverage.
Official curriculum references establish scope and expected skills. The explanations, diagrams and numerical cases are independent teaching material from MiloPrep, not official questions or source-validated solutions. Curriculum references checked 2026-10-10.
- IMA Content Specification Outlines (effective September 2024) ↗
Supports: Part 2, Section B, beginning on printed page 10. Domain names, weights and curriculum boundaries.
- IMA Learning Outcome Statements (effective September 2024) ↗
Supports: Part 2 B.4: working capital, continuing on page 22; printed page 21. Curriculum scope, not verification of this original worked example.
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