Working capital, credit & ar management
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Working Capital, Credit and Accounts Receivable Management
Reference: ETM Chapter 6 & 7
STFM Chapter 5 & 6
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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
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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.
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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
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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.
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Reasons to Offer Credit
• Competition
• Market Share
• Promotion
• Credit Availability to Customers
• Customer Convenience
• Profit
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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.
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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
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Analysis of Credit Extension
NPV = Sales – Collection Expense - Variable
1+(Cost of Cap. X Coll. Days) Costs
If NPV > 0 then Extend Credit
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Forms of Credit Extension
• Installment Credit
• Revolving Credit
• Letters of Credit
• Open Account
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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
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The Five C’s of Credit
• Character
• Capacity
• Capital
• Collateral
• Conditions
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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.
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Cost of Trade Credit
Cost of Trade Credit =
Early Payment Discount x 365
--------------------------------- ---------------------------------
(1 – Early Payment Discount) (Net Payment Period -
Discount Payment Period)
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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.
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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).
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DSO
• Can give an indication of overall collection efficiency.
• Changes in sales volume, payment patterns, or strong seasonablity in sales can distort DSO.
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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:
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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.
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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
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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.
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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
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A/R Financing
• Unsecured Bank Borrowing
• Secured Bank Borrowing
• Captive Finance Company
• Third Party Financing Institutions
• Credit Card
• Factoring
• Private Label Financing
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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
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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.
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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.
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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.
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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
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Collection Procedures
• Companies tend to be more aggressive the larger the receivables balance
• Companies understand the good-will tradeoff when selecting collection methods
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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
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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)