Working Capital Management (3) – Accounts Payable and Receivable
1 Introduction
We discussed the importance of payables earlier in the context of the cash operating cycle. In this chapter we will look at the factors that need considering in the good management of payables.
2 Trade credit
Rather than paying immediately for goods and services purchased from suppliers, it is standard practice to take credit i.e. to delay making payment. This benefits the cash flow of the business and is effectively a means of obtaining short-term finance (as opposed to, for example, running an overdraft).
However, although taking credit is a normal feature of business, it is important that we monitor the payment of our payables and bear in mind two important considerations:
If we take too long to pay then we risk losing the goodwill of our suppliers and they may refuse to allow us credit in the future (or in the extreme, refuse to supply to us)
Taking too long to pay may result in us losing discounts offered by suppliers for early payment.
2.1 Types of amounts payable
Keep records by supplier or obligation, with invoice/credit-note references, due dates and payment status. Trade credit is an operating liability; a bank loan is a separate financing liability.
Type | What is owed |
|---|---|
Trade payables | Invoiced amounts for goods/services bought on credit |
Accrued expenses | Services already received but not yet invoiced or paid |
Other payables | For example payroll deductions, tax or interest due |
3 Discounts for early payment
If suppliers offer a discount for early payment, then delaying payment will lose us the discount and we can calculate cost of not getting the discount as an effective interest rate.
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.
Solution
Consider an invoice for $100. Currently this is paid in full after 30 days; going for the discount would mean that $98 is paid after 10 days. The company's cash has fallen by $98 20 days earlier and in exchange $2 is saved. It's like investing $98 for 20 days to earn $2
The return on that investment is 2/98 over 20 days = 2.0408%
To convert the rate r (as a decimal) for a period of p days to an annual rate R, the formula is
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.020408)365/20 = 1.4458
R = 0.4458 or 44.58%
This is the effective cost of paying 30 days after the invoice and not receiving the discount instead of paying after 10 days
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?
Solution
To obtain the discount the company would have to pay 40 – 15 = 25 days sooner.
For an invoice of $100, the company would then pay $98.5, saving $1.5 over 25 days.
The return over 25 days is 1.5/98.5 = 1.5228% = 0.015228
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.015228)365/25 = 1.2469
R = 0.2469 or 24.69%
As this is greater than the overdraft interest rate of 13% the company should pay more quickly to receive the discount. Receiving the discount is worth 24.69% and borrowing more to pay earlier would cost only 13%.
Alternative solution
Assume that current sales are $1m per year (it doesn't matter what figure you choose).
Current payables are $1m/365 x 40 = $109,589
New payables would be $1m/365 x 15 = $41,096
Fall in payables = $109,589 - $41,096 = $68,493
To achieve this fall in payables more cash has to be with suppliers and to finance that costs 13%. Therefore, the annual cost of paying suppliers more quickly is 13% x $68,493 = $8,904
In return, the company wins a 1.5% discount on all its purchases and this will be worth:
1.5% x $1m = $15,000 pa
It is worth paying $8,904 in bank interest to obtain $15,000 in discounts, so pay earlier and win the discount.
4 Methods of paying suppliers
There are various alternative ways of paying suppliers as listed below. The method chosen will very much depend on the amount to be paid and the nature of the amounts that are owing.
Payment in cash
Payment by cheque
Standing orders and direct debits. A standing order is when the payer agrees to pay a constant amount per period (eg per month) to a payee (recipient of the money). It uses a transfer between bank accounts. A direct debit is when the payer gives authorisation to the payee to transfer amounts as needed from the payer's bank account to the payee's bank account.
Electronic funds transfer (eg internet banking)
4.1 Controlling supplier accounts and payments
Match each invoice to the purchase order and goods-received evidence; check quantity, price, discounts and tax. Obtain authorisation and resolve differences before payment.
Reconcile supplier statements with the payables ledger and investigate missing invoices, duplicate charges and unmatched credits.
Prepare a due-date payment schedule. Use approved payment methods, independently verify changes to bank details and separate invoice approval, payment release and reconciliation. Take worthwhile discounts without damaging liquidity.
5 Receivables
Many of the same principles apply to receiving payment from customers. Typically customers will be given 30 days of credit and to encourage payment within that time discounts are often offered. The annual cost of giving discounts can be surprisingly expensive.
Before comparing rates, settle which side of the discount you are on, because the same rate is a return to one party and a cost to the other. A customer that pays early to take a discount is in effect lending to its supplier, so taking it is worthwhile if the rate beats the cost of the customer's own overdraft. A supplier that offers the discount is in effect borrowing from its customers, so offering it is worthwhile if the rate is cheaper than the supplier's own overdraft. A discount worth 8.5% a year can therefore suit both a supplier paying 10% on its overdraft and a customer paying 7%. Compare compound annual rates, worked out as in the examples above: a 0.9% discount for paying 30 days earlier is 11.5% a year compounded (on a 360-day year) and beats an 11% overdraft, while the simple rate of 10.8% (0.9% × 12) would wrongly reject it.
A company makes sales of $1.2m/year and currently offers no discount for prompt payment. Accordingly, customers are paying after 60 days instead of the required 30 days. The company has estimated that if it offers a 2.5% discount for payment within thirty days, 80% of its customers will pay in that time.
Calculate the annual % effective cost of offering the discount
Solution
For an invoice of $100, instead of paying $100 after 60 days, a customer who goes for the discount will pay $97.5 after 30 days. The company gains an extra $97.5 for a month for a cost of $2.50
Cost over 30 days = 2.5/97.5 = 0.02564
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.02564)365/30 = 1.36
R = 0.36 or 36%
Note: the 20% who ignore the offer of the discount do not affect the cash balance and cost nothing by way of receiving a discount.
6 Chapter 3 questions
Question 1
A business pays its suppliers after 70 days. The suppliers start to offer a discount of 3% for payment within 30 days. What is the effective annual cost of NOT taking up this offer?
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Question 2
What is the name of the payment method where the payer gives authorisation to the payee to transfer amounts as needed from the payer's bank account to the payee's bank account.
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Working Capital Management (3) – Accounts Payable and Receivable
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