Short-term finance
Working capital policy
Work out what supplier credit really costs, and decide when to take an early-payment discount.
Learning objectives
- Explain how receivables, inventory and payables policies tie up or release cash
- Calculate the annual cost of forgoing an early-payment discount
- Decide whether to take a discount by comparing that cost with the cost of borrowing
Working capital policy decides how much cash is tied up in running the business: how long customers take to pay (DSO), how long stock sits on shelves (DIO), and how long the company takes to pay suppliers (DPO). Their combination is the cash conversion cycle, DSO + DIO − DPO.
Rawdah Home Retail Co. (fictional) shows why it matters. In FY2025 its DSO was 25.0 days, DIO 110.0 days and DPO 55.0 days: a cash conversion cycle of 80.0 days that must be financed. Paying suppliers later looks like free financing, but it often isn't: many suppliers offer a discount for paying early, and skipping that discount is a loan with a very high interest rate.
Simple annual cost = d ÷ (1 − d) × 365 ÷ (N − D) Effective annual cost = (1 + d ÷ (1 − d))^(365 ÷ (N − D)) − 1
- d
- discount for paying early (e.g. 2%)
- D
- days within which the discount applies
- N
- days until the full invoice is due
- N − D
- the extra days of credit you 'buy' by giving up the discount
Why the rate is so high. The discount looks small because it is quoted for a single invoice, but it buys only a short extra period of credit. Paying 2% for 20 days is like paying that rate 18.25 times a year. Short periods turn small percentages into large annual rates, the same compounding logic as any other interest rate.
Each lever has a cost. Working capital policy is a set of trade-offs, not a race to the shortest cycle:
- Receivables: tighter credit terms release cash but can lose customers who expect to pay later.
- Inventory: leaner stock frees cash but risks empty shelves and lost sales, especially for a retailer in peak season.
- Payables: paying later keeps cash in the business, but may forfeit discounts and strain suppliers.
A conservative policy holds more stock and cash and offers generous terms: safer, but more capital tied up. An aggressive policy runs lean: cheaper to finance, but more exposed to shocks.
Deciding on a discount, step by step:
- Convert the terms into an effective annual cost of skipping the discount.
- Compare it with the company's marginal cost of funds: the rate on the facility it would draw to pay early, or the return it earns on idle cash.
- If the cost of skipping is higher, take the discount; if not, pay on the due date (not later).
- Size the gain in riyals, because a high rate on a small supplier may not be worth the administrative effort.
If the company has no spare cash and no facility to draw on, the comparison is academic: it can't pay early. That is one reason firms keep an undrawn credit line, and the next lesson's cash budget shows when they will need it.
Calculate
A supplier offers terms of 1/15 net 45: 1% off if paid within 15 days, otherwise the full amount is due in 45 days. What is the effective annual cost of skipping the discount? (365-day year.)
Check your understanding
Rawdah's FY2025 cash conversion cycle is about 80 days, mostly because of 110 days of inventory. Which change would release the most cash for each day it improves?
Challenge: Should Rawdah take the early-payment discount?
A supplier offers Rawdah Home Retail Co. (fictional) terms of 1.5/10 net 45. Rawdah would fund early payment from its revolving credit facility. Calculate the simple and effective annual cost of skipping the discount and the decision ("Take the discount" or "Pay on the due date"). Then size the trade-off in riyals: the extra borrowing needed to pay 35 days earlier (on the discounted amount), the discounts earned, the interest on that borrowing and the net annual gain (before tax).
| A | B | |
|---|---|---|
| 1 | Assumptions (Rawdah Home Retail Co.) | Value |
| 2 | Annual purchases from the supplier (SAR m) | 400.0 |
| 3 | Early-payment discount | 1.50% |
| 4 | Discount period (days) | 10 |
| 5 | Net period: invoice due (days) | 45 |
| 6 | Revolving credit facility rate | 7.00% |
| 7 | Days in the year | 365 |
| 8 | ||
| 9 | Analysis | Value |
| 10 | Annual cost of skipping the discount (simple) | |
| 11 | Annual cost of skipping the discount (effective) | |
| 12 | Decision | |
| 13 | Extra borrowing to pay on day 10 (SAR m) | |
| 14 | Discounts earned per year (SAR m) | |
| 15 | Interest on the extra borrowing (SAR m) | |
| 16 | Net annual gain from taking the discount (SAR m) |
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