Question

1. Why does a decrease in NWC result in a cash inflow to the firm?

2. Is it possible for a firm to have negative net working capital? If so, how?

3. Would it be possible for a firm to have a negative cash cycle? If so, how?

4. What purpose does a discount on credit terms serve? What is the cost of such a discount to the offering firm?

Please answer all of the questions, if you can not answer all of the questions do not reply.

Answer 1

1.

NWC is the Net Working Capital used by a firm for running its day to day operations. It is calculated by subtracting current liabilities from current assets. We can understand the question with the help of an example

Suppose, a firm has current assets as follows - Trade receivables of $ 50,000, Inventories of $ 50,000

Current liabilities are as follows - Trade payables of $ 30,000

Hence, the NWC is 50,000 + 50,000 - 30,000 = $ 70,000

This is nothing but the funds which are blocked in running the day to day operations. So, when the trade receivables will be received or when the inventories will liquidate, the firm's NWC will go down and this will result in a cash inflow for the firm

2.

Yes, it is possible for the firm to have negative net working capital. Suppose, in the above example, the firm has trade payables of $ 130,000. In this case the firm has a NWC of -$ 30,000

Hence, when a firm has current liabilities in excess of current assets, it results in negative NWC

3.

Yes, it is possible for a firm to have negative cash cycle. This can happen when the firm sells its inventory/raw material and receives cash before it pays to the suppliers

Cash cycle is the time taken for a firm from purchasing raw materials/inventory till selling them and receiving cash for the same

Suppose, a firm buys inventory on Monday and sells them for cash on Saturday. If, it has still not paid its suppliers, it has a negative cash cycle

4.

The purpose of discount on credit terms is to motivate the debtor or the payer to pay the money before the normal credit period

Suppose, a supplier provides a credit period of 30 days and if someone pays before 30 days, then the firm gives a discount of 0.5% for early payment. This way, payment is received before the credit period

The cost of the offering firm varies from industry to industry