Management of working capital (3) – Receivables and Payables
1 Introduction
The purpose of this chapter is to look at ways in which companies may manage receivables and payables more efficiently and thus reduce the level of working capital.
2 Receivables
The reason for the existence of receivables is that the business is prepared to sell to customers on credit. The higher the receivables, the more cost there is for the company – both in terms of the interest cost and in terms of the greater risk of losses through bad debts.
An easy solution would be to stop selling on credit and to insist on immediate cash payment, but this would risk the losing of customers if competitors offer credit.
There is no ‘best’ level for receivables – it depends very much on the type of business and the credit terms offered by competitors – but it is in the interest of all companies to keep the level of receivables as low as possible in the circumstances.
2.1 Points to consider as part of efficient management:
Credit checks and credit limits - before granting credit customers should be assessed as to their ability to pay, and credit limits set for all accounts
use credit rating agencies (e.g. Dun & Bradstreet)
ask for trade and bank references from new customers
analyse the payment record of existing customers
assess the financial statements of large customers
review credit limits regularly
Credit terms and settlement discounts:
these will be greatly influenced by competition and trade custom
the company must quantify the cost of any settlement discounts and decide whether the benefits outweigh the cost
ensure that customers are aware of the terms and settlement discounts by printing them on orders, invoices and statements
ensure that any discount policy is enforced – most customers will attempt to take the discount as a matter of course, whether or not they have paid on time.
Collection procedures:
Set clearly defined procedures to be followed. Set timings for issuing demand letters, making chasing telephone calls, and stopping deliveries.
Decide when outside assistance is needed (e.g. the use of collection agencies or lawyers)
Compare the cost of taking direct legal action with that of using outside help.
Charge interest on overdue invoices:
2.2 Invoice discounting and factoring
Invoice discounting is the selling of an invoice to a third party (usually a bank) for a lower (discounted) amount. This way the supplier gets cash immediately and it is the bank who has to wait for payment (hence the lower or discounted amount).
Factoring is paying another company to administer all or part of the receivables ledger.
Depending on the fee paid to the factor, different facilities may be bought.
The basic level of factoring involves paying the factor to handle all the administration – maintaining the sales ledger and collecting the debts.
For a higher fee, the factor will advance money to the company before the debts have been collected. For example, the factor may advance 80% of the value of sales immediately on invoicing.
For a higher fee still, the factor may accept responsibility for any bad debts – the company is effectively insured against bad debts. This is known as ‘non-recourse factoring’. (Normal factoring, where the company keeps the responsibility for any bad debts, is known as ‘with-recourse factoring’)
2.3 Examination arithmetic on receivables management
Most arithmetical questions in the examination relating to receivables management involve consideration as to whether or not a change in collection policy is worthwhile.
There are two techniques that you must be aware of – being able to consider whether or not it is worthwhile offering a simple settlement discount, and being able to consider whether or not a change in collection policy (either by using discounts or using a factor) is worthwhile.
Apply each percentage to the base the question names. A settlement discount is a percentage of the credit sales of the customers expected to take it, not of the receivables balance and not of total sales; a factor’s fee is a percentage of credit sales too. What is set against those costs is the finance cost saved on the fall in receivables — the reduction in the balance, multiplied by the borrowing rate.
(a) Simple settlement discount
Customers currently take three months credit. We are considering offering a discount of 4% for payment within one month.
Sales are $12,000,000 p.a..
We are paying overdraft interest of 20% p.a..
Calculate the effective % cost p.a. of the discount.
Should we offer the discount?
(b) Change of policy
A company has sales of $20,000,000 p.a..
Customers currently take credit as follows:
Days | %’age |
30 | 20% |
60 | 50% |
90 | 30% |
They are considering offering a discount of 1% for payment within 30 days. It is estimated that 60% of customers will take advantage of the discount (and that the remainder will take a full 90 days).
The company’s bank overdraft rate is 15% p.a..
Calculate the net cost or benefit of the change of policy.
Should they offer the discount?
(assume 365 days in a year)
Our sales are $10,000,000 p.a. and customers currently pay as follows:
Month | % of time |
1 | 20% |
2 | 30% |
3 | 50% |
We are considering whether or not to factor our debts. The factor will pay us 100% of debts after 1 month. The fee is 2% of turnover. As a result we will be able to lose some credit control staff at a saving of $20,000 p.a..
The company’s bank overdraft rate is 18% p.a.
Calculate the net cost or benefit p.a. of changing to the new policy.
3 Payables
Payables may be used as a source of short-term finance. If a company delays payment by a further month then they now have a further months use of the cash.
However, delaying payment may lose the company its credit status with the supplier and could result in supplies being stopped.
Additionally, the company could lose the benefit of any settlement discount offered by the supplier for early payment.
In exactly the same way as for receivables, we can calculate the annual effective cost of refusing any settlement discount offered, and compare this with the cost of financing working capital.
A supplier offers a 2% discount if invoices are paid within 10 days of receipt. Currently we take 30 days to pay invoices and therefore do not receive the discount.
Calculate the annual % effective cost of refusing the discount.
Example 5
A company currently takes 40 days credit from suppliers on the basis that this is ‘free’ finance.
Annual purchases are $100,000 and the company pays overdraft interest of 13%.
Payment within 15 days would attract a 1.5% quick settlement discount.
Should the company pay sooner in order to take advantage of the discount
Now read the following technical article available on the ACCA website:
“Management of foreign accounts receivable”
“Receivables collection”
Management of receivables and payables
10 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
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