Working capital, credit & ar management

Working Capital, Credit and Accounts Receivable Management

Reference: ETM Chapter 6 & 7

STFM Chapter 5 & 6

Cash Flow Cycle of a BusinessPurchase of

MaterialsPayment for

MaterialsSale ofProduct Collect A/R

Days’ Inventory

Cash Conversion Cycle

Days’ Receivables

Days’ Payables

Day 1 Day 30 Day 45 Day 75

Working Capital Cash Flow Cycle: Cash Conversion Cycle

InventoryDays' Inventory = × 365 Days

Cost of Goods Sold

Accounts ReceivableDays' Receivables = × 365 DaysAnnual Sales

Accounts PayableDays' Payables = × 365 Days

Cost of Goods Sold

Cash Conversion Cycle = Days' Inv. + Days' Recs. - Days' Payables

Formulas for three time periods are necessary to calculate the cash conversion cycle.

Credit Policy and Collections

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid

Objectives of Credit Management

• Creating, preserving, and collecting A/R.

• Establishing and communicating credit policies.

• Evaluation of customers and setting credit lines.

• Ensuring prompt and accurate billing.

• Maintaining up-to-date records of accounts receivables.

• Initiating collection procedures on overdue accounts.

Reasons to Offer Credit

• Competition

• Market Share

• Promotion

• Credit Availability to Customers

• Customer Convenience

• Profit

Credit and A/R Management:Fit Into the Financial Organization

• A credit manager or a captive finance company is the administrator of credit policies.

• Credit policies and collections will impact cash flows so credit and cash managers must work together.

• Reasons for credit and cash manager interaction include the accuracy of cash flow forecast, banking network management, and accounts receivable updating.

Cost Associated With a Credit Policy

• Credit Department Costs

• Credit Evaluation Costs

• A/R Carrying Cost

• Discounted Payments

• Selling and Production Cost

• Collection Expenses

• Bad Debts

Analysis of Credit Extension

NPV = Sales – Collection Expense - Variable

1+(Cost of Cap. X Coll. Days) Costs

If NPV > 0 then Extend Credit

Forms of Credit Extension

• Installment Credit

• Revolving Credit

• Letters of Credit

• Open Account

Common Terms of Sales

• Cash Before Delivery (CBD)

• Cash on Delivery (COD)

• Cash Terms

• Net Terms

• Discount Terms

• Monthly Billing

• Bill of Lading or Documentary Collection

• Seasonal Dating

• Consignment

The Five C’s of Credit

• Character

• Capacity

• Capital

• Collateral

• Conditions

Cost of Trade Credit

• From a seller’s viewpoint, the cost of the discount must be weighted against the benefit of receiving early payment.

• From buyer’s viewpoint, the cost of trade credit is an opportunity cost.

• A buyer should take the discount if its cost of borrowing is less than the cost of foregoing the discount.

• Alternatively, a buyer should forego the discount if investment rates are higher than the cost of foregoing the discount.

Cost of Trade Credit

Cost of Trade Credit =

Early Payment Discount x 365

--------------------------------- ---------------------------------

(1 – Early Payment Discount) (Net Payment Period -

Discount Payment Period)

Annualized Cost of Trade Credit

Example Assuming terms of 2/10, net 45, the cost of not taking the discount can be determined as follows:

21.28% = .2128 =

10.428571 .0204081 = 35

365.98.02 =

10 -45365

.02 - 1.02

=

PeriodPmt Discount - PeriodPmt Net 365

DiscountPmt Early - 1DiscountPmt Early

=Credit Trade ofCost

If the company can borrow at less than 21.28%, it should do so and use the borrowed funds to pay early and take the discount.

Account Receivable Monitoring and Control

• Monitoring and control is the responsibility of the credit manager.

• Receivables turnover

least favored technique

• Monitoring conducted on individual accounts through aging schedules.

• Monitoring conducted at the aggregate level using days’ sales outstanding (DSO).

DSO

• Can give an indication of overall collection efficiency.

• Changes in sales volume, payment patterns, or strong seasonablity in sales can distort DSO.

Days’ Sales Outstanding (DSO)

Assume that a company has outstanding receivables of $350,000 at the end of the first quarter and credit sales of $425,000 for the quarter. Using a 90-day averaging period, the DSO for this company can be computed as follows:

Sales During Period $425,000Avg. Daily Credit Sales = = = $4,722.22Number of Days in Period 90

Outstanding A/R $350,000DSO = = = 74.11 DaysAvg. Daily Credit Sales $4,722.22

Average Past Due = DSO - Avg. Days of Credit Terms

= 74.11 Days - 60 Days = 14.11 Days

If the company’s credit terms are net 60, the average past due is computed as follows:

Aging Schedule

• Is a list of the percentage and/or amounts of outstanding A/R classified as current or past due.

• Used primarily to identify past due accounts.

• Can be prepared at the aggregate level or customer-by-customer.

• Subject to distortions due to sales variations.

Aging Schedule

Age of Accounts A/R % of A/R0 – 30 days

31 – 60 days

61 – 90 days

91 + days

Total

$1,750,000

$375,000

$250,000

$125,000

$2,500,000

70%

15%

10%

5%

100%

Separates A/R into current and past due receivables in 30-day increments (on a customer or aggregate

basis) and can determine the percent past due

A/R Balance Pattern

• Gives the percent of credit sales in a time period that remains oustanding at the end of each time period.

• Based on aging schedules.

• It is not directly affected by sales variations.

• A useful tool in cash flow forecasting because it can be used to project A/R levels and collections.

A/R Balance Pattern

Month Sales Sales

Remaining A/R from Month Sales

at End of March

February

January

March

April

$250,000

$300,000

$400,000

$500,000

20%

55%

95%

Remaining A/Ras a % of

Month Sales

$50,000

$165,000

$380,000

The total outstanding A/R balance at the end of March is:$595,000 = ($50,000 + $165,000 + $380,000)

The estimate of cash inflows for April = 5% of April sales + 40% of Marchsales + 35% of February sales + 20% of January sales:

Estimated April inflows = (0.05 x $500,000) + (0.40 x $400,000)+ (0.35 x $300,000) + (0.20 x $250,000) = $340,000

A/R Financing

• Unsecured Bank Borrowing

• Secured Bank Borrowing

• Captive Finance Company

• Third Party Financing Institutions

• Credit Card

• Factoring

• Private Label Financing

Evaluate Changes in Credit Policy

• Credit term change decision variables– effect on dollar profits

– sales effect

– receivables effect

– return on investment effect

– default probability

– credit limits

– opportunity cost of funds invested in receivables

– company’s overall cost of capital

Cash Application

• Cash application is the process of matching and applying a customer’s payment against accounts receivable.

• Done via an Open Item or a Balance Forward system.

Open Item System

• Used in commercial transactions.

• Each invoice is recorded separately in an account receivable file.

• Payments are matched to the particular invoice in the file.

Balance Forward System

• Used in retail applications.

• Credit limits are established for each individual.

• As purchases are made, A/R increase.

• Payments are applied against the aggregate A/R outstanding.

Collection Procedures

• Typical collection effort– initial contact within 10 days of delinquency

– then reminder letter followed by phone call

– sales force notified

– last resort, reference to collection agency/legal action

• Collection agency– Phase 1 - computer generated collection letter, when

accounts are 45 to 90 days past due

– Phase 2 - commissioned collectors used

Collection Procedures

• Companies tend to be more aggressive the larger the receivables balance

• Companies understand the good-will tradeoff when selecting collection methods

International Credit Management

• Credit policy analysis– lengthening terms increases exchange rate risk

– also increases default risk

– harder to get D&B reports

– harder to get bank credit information

• Modifying monitoring and collections– legal remedies for late payment or nonpayment differ

by country

Legislation Affecting Credit and Collections

• Robison-Patman Act (1936)

• Usuary Laws

• Truth in Lending Act (1969)

• Fair Credit Reporting Act (1971)

• Fair Credit Billing Act (1975)

• Equal Credit Opportunity Act (1975)

• Fair Debt Collection Practice Act (1978)