Working Capital Finance

Working Capital Investment

Working Capital

• Working capital is simply the money needed for day-to-day business.

• This money is needed to keep the company alive.

• It is the management of each current asset and each current liability that is essential to the business.

Working capital = net current assets = current assets - current liabilities

Current Assets

• Cash

• Inventories

• Receivables

Current Liabilities

• Overdraft

• Payables < 1year

• Short-term loans

Objectives of Working Capital Management

Working capital management has two main objectives:

• To increase the profits of a business

• To ensure sufficient liquidity to meet short-term obligations as they fall due.

Liquidity Versus Profitability Problem

Consider this.

You are the Director of a new company selling Gadgets. Demand is looking good. Your natural inclination is probably to buy more in, to sell in the future. We call this a short-term investment.

You have invested in inventory to boost profits - this is one of the objectives of working capital.

However, you know you also must pay the lease on your office - luckily you have set aside a little for this. We call this liquidity.

Maintaining enough to pay short term payables. This is another of the objectives of working capital.

So, we would like to use the working capital for both Short-term investment and Liquidity

Hopefully you can see that part of you wants to invest the money and other wishes to save to pay bills. This is the conflict of working capital objectives.

Minimizing the risk of insolvency while maximizing the return on assets.

Managing Working Capital

The management of working capital is important to the financial health of businesses of all sizes.

The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way.

However, there is evidence that small businesses are not very good at managing their capital.

The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash.

These are:

• Speculation - To take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount.

• Precaution - As an emergency fund for a firm.

• Transaction - Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have. Efficient management of working capital is extremely important to any organization.

Holding too much working capital is inefficient, holding too little is dangerous to the organization’s survival.

Investing in working capital has a cost, which can be expressed either as:

• The cost of funding it, or

• The opportunity cost of lost investment opportunities because cash is tied up and unavailable for other uses.

Working Capital Planning

Different businesses will have different approaches to working capital investment, i.e. to the level of net working capital held, due to:

1. General Factors Affecting Working Capital Levels

• The nature of the industry: The level of working capital required will be influenced by the nature of the industry. E.g. a supermarket will receive much of their sales in cash (or credit or debit card), so it will be able to operate with minimal receivables. However, this would not be possible for a food wholesaler (supplying supermarkets) which is likely to be selling mainly on credit.

• Policies of competitors: A company will be unwilling to lose business to a rival offering its customers more favourable credit terms.

• Seasonal factors: There may be a need to allow inventory to be higher as a season of peak sales approaches.

2. Company Specific Factors

The level of net working capital will also depend on a company’s sales and its working capital strategy. If sales are higher, then net working capital will normally rise too (as receivables and inventory will rise).

However, different companies will plan to allow net working capital to rise at different rates depending on their working capital investment strategy.

Policies Regarding Working Capital Management

• Aggressive Approach - Aims to keep inventories and receivables as low as possible. Payables are maximized (suppliers paid as late as possible). This prioritizes liquidity but may create trading problems.

• Conservative Approach - Allows high levels of inventories and receivables and plans to pay suppliers on time (which keeps payables low). This aims to reduce the risk of trading problems (e.g. stock-outs) but may compromise liquidity.

Planning Overall Working Capital Needs

Working Capital Ratios

A company’s working capital policies can be quantified by analyzing:

• inventory days (the number of days of sales or production held as inventory)

• payables days (the length of time taken to pay suppliers)

• receivables days (the length of time taken by customers to pay)

These ratios can be used to quantify the level of working capital required to support future sales.

Working Capital

Cash Operating Cycle (Working Capital Cycle)

The cash operating cycle (also known as the working capital cycle) is the length of time between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods. The faster a firm can ‘push’ items around the cycle the lower its investment in working capital will be.

Calculation of the Cash Operating Cycle

For a manufacturing business, the cash operating cycle is calculated as

Raw materials holding period X

WIP holding period X

Finished goods holding period X

Receivables collection period X

Less: payables payment period (X)

X

For a wholesale or retail business, there will be no raw materials or WIP holding periods, and the cycle simplifies to:

Inventory holding period X

Receivables collection period X

Less: payables payment period (X)

X

Raw materials holding period = (Raw material/Raw material usage or Raw material purchases) × 365

WIP holding period = (WIP/Cost of Production or Cost of goods sold) × 365

Inventory days (or inventory turnover period) = (Finished goods/Cost of sales) × 365

Inventory turnover (no of times) = Cost of sales/Average inventory

This gives investors an idea of how long it takes a company to turn its inventory (including work in progress) into sales. Generally, the lower (shorter) the better, but it is important to note that the average varies from one industry to another.

Receivables days = (Receivables/ (credit) sales) × 365

This measures the average number of days it takes for the company to collect revenue from its credit sales. This ratio reflects how easily the company can collect on its customers. It also can be used as a gauge of how loose or tight the company maintains its credit policies.

Payables days = (Payables/ (credit) purchases) × 365

It measures the average amount of time you use each dollar of your trade credit. A longer average payable period allows you to maximise your trade credit. This means that you are delaying spending cash

The cycle may be measured in days, weeks or months and it is advisable, when answering an exam question, to use the measure used in the question.

Example:

Day 1 Buy an item on credit (Payable)

Day 5 Sell the item on credit (Receivable)

Day 8 Pay for the item

Day 10 Receive the cash for the item

How long is the item in stock for?

4 days

How long is the receivable period?

5 days

How long is the payable period?

7 days

Days How long between having to pay and receiving the cash

The 2 days is the cash operating cycle. It is how long between paying for an item and eventually receiving the cash.

This Period Needs Funding Somehow

Look again at the illustration and you may see how it is calculated:

Inventory days

4

Receivable days

5

Payable days

(7)

Cash operating cycle

2

Note The CASH Needed in The Gap Can Get Bigger By:

• Cycle gets longer (need more cash in proportion to the extra days in cycle)

• Sales increase (need more cash in proportion to the extra sales made)

The Length of The Cycle Will Depend Upon:

• Liquidity v profitability decisions (e.g., credit terms offered)

• Management efficiency

• Industry norms (supermarkets very short - construction industry very long)

An increase in the length of the cash operating cycle will increase the level of investment in working capital.

Nature of Business Operations

• Different industries have, not surprisingly, different cash operating cycles.

• My academies, for example, hold very little stock (because I’m tight?) – no because we sell services!

• Compare that to We Sell Lots of Stuff plc who hold lots of stuff (inventories).

• Many retailers sell direct to the smelly, unwashed public and so have very few receivables - others sell to other businesses and so offer credit terms.

• If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term.

• A short cash cycle reflects sound management of working capital. A long cash cycle denotes that capital is occupied when the commercial entity is expecting its clients to make payments.

Negative Cash Operating Cycle

Here they are getting payments from the clients before any payment is made to the suppliers.

Instances of such business entities are commonly those companies, which apply Just in Time techniques, for example Dell, as well as commercial enterprises, which purchase on credit and sell for cash, for instance Tesco.

Working Capital Requirement

It is very common in questions to be told that in addition to the cash needed to buy a machine, cash is also needed immediately to finance working capital requirements. The working capital requirements relate to such things as the carrying of inventory of raw materials and the financing of receivables resulting from the sales.

Unless told differently, we always assume that the working capital results in a cash outflow at the time it is needed, that the requirement remains for the life of the investment, but that it is released (and therefore results in a cash inflow) at the end of the project.

Note that in several recent exam questions the examiner has stated within the question that the machine in question will be replaced at the end of its life. This implies that the product will continue to be made and that therefore the working capital will still be needed. In this case you should not recover the working capital at the end of the project.

Cash Operating Cycle 1

Cash Conversion Cycle 2

Receivable Days

Sales To Net Working Capital Ratio

A more direct way of identifying the possibility of a cash shortfall if sales rise too rapidly is to use the sales/net working capital ratio.

The ratio of:

Sales revenue/ (Receivables + Inventory – Payables)

The Sales to Working Capital ratio measures how well the company's working capital is being used to generate sales. An increasing Sales to Working Capital ratio is usually a positive sign, indicating the company is more able to use its working capital to generate sales. This ratio is much more effectively used over a number of periods.

This ratio can help uncover questionable management decisions such as relaxing credit requirements to potential customers to increase sales, increasing inventory levels to reduce order fulfilment cycle times, and slowing payment to vendors and suppliers in an effort to hold on to its cash.

Example:

Management Co – Extracts from annual accounts

Year 1

$

Sales 864,000

Inventory: Finished goods 86,400

Receivables 172,800

Payables (96,400)

Net working capital 162,800

Sales/net working capital ratio = 864,000/162,800 = 5.3071

Required:

What increase in the level of net working capital (i.e. cash) is needed to support higher sales, if sales are forecast to rise by $200,000 over the next year? (Working to the nearest $100)

Solution:

Sales/Net Working Capital

The correct answer is: $37,700

$864,000 + $200,000 = $1,064,000

$1,064,000/5.3071 = $200,486

This is an increase of $200,486 – $162,800 = $37,686 or $37,700 to the nearest $100

This represents the increase in cash due to movements in working capital.

Alternative Solution:

$200,000 / 5.3071 = $37,685 or $37,700 to the nearest $100

Liquidity Ratios

• The Current Ratio

The current ratio is the standard test of liquidity.

Current ratio = Current assets/Current liabilities

A company should have enough current assets that give a promise of ‘cash to come’ to meet its commitments to pay its current liabilities. Superficially, a ratio in excess of 1 implies that the organisation has enough cash and near-cash assets to satisfy its immediate liabilities.

However, interpretation needs to be conducted with care. Too high a ratio implies that too much cash may be tied up in receivables and inventories. What is ‘comfortable’ varies between different types of business.

• Quick Ratio or Acid Test Ratio

Quick Ratio = (Current assets less inventories)/Current liabilities

Companies are unable to convert all their current assets into cash very quickly. In some businesses where inventory turnover is slow, most inventories are not very liquid assets, and the cash cycle is long. For these reasons, we calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.

Working Capital – Over Trading & Over Capitalization Risks

There are two main risks of not monitoring working capital:

• Over-capitalization

• Overtrading

Overtrading

Overtrading or undercapitalization arises when a company has too little capital to support its level of business activity.

Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall due. Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall due.

Overtrading:

• Is often associated with a rapid increase in turnover.

• Investment in working capital does not match the increase in sales.

• Could be indicated by a deterioration in inventory days.

• Possibly because of stockpiling in anticipation of a further increase in turnover, leading to an increase in operating costs.

• Could also be indicated by deterioration in receivables days, possibly due to a relaxation of credit terms.

• As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-term sources of finance, including overdraft, trade payables and leasing.

• Can also be indicated by decreases in the current ratio and the quick ratio.

Managing the risk of overtrading/undercapitalisation

To deal with this risk a business must either:

• Plan the introduction of new long-term capital

• Improve working capital management

• Reduce business activity

Over-Capitalization

Over-capitalization means that an entity has an excess of working capital.

Entities that carry excessive inventories, receivables and cash with few payables have over-invested in current assets.

This presents an opportunity cost since such resources could be used to generate returns elsewhere in the entity.

Inventory Levels

Managing Inventory

The Objectives of Inventory Management

Inventory is a major investment for many companies. Manufacturing companies can easily be carrying inventory equivalent to between 50% and 100% of the revenue of the business. It is therefore essential to reduce the levels of inventory held to the necessary minimum.

The Balancing Act

Costs of High Inventory Levels

Keeping inventory levels high is expensive owing to:

1. Foregone interest from tying up capital in inventory

Holding costs:

• Storage

• Stores administration

• Risk of theft/damage/obsolescence.

Costs of Low Inventory Levels

If inventory levels are kept too low, the business faces alternative problems:

1. Stockouts:

• Lost contribution

• Production stoppages

• Emergency orders

2. High re-order/setup costs

• Lost quantity discounts.

The Challenge

The objective of good inventory management is therefore to determine:

1. The Optimum Re-Order Level – how many items are left in inventory when the next order is placed

2. The Optimum Re-Order Quantity – how many items should be ordered when the order is placed for all material inventory items. Optimal order quantity, also known as the economic order quantity (EOQ), represents the ideal amount of inventory a business should have at any given time to meet demand without holding too much excess stock.

EOQ MODEL

The economic order quantity (EOQ): The optimal ordering quantity for an item of inventory which will minimise inventory related costs.

The EOQ model links the order quantity placed with a supplier to inventory related costs.

Inventory related costs

Holding costs

Ordering costs

Purchasing costs

E.g. warehousing, insurance, obsolescence, and opportunity cost of capital.

Holding costs increase if the order size increases.

E.g. costs of administering orders, and delivery costs.

Ordering costs decrease if the order size increases.

E.g. the amount paid for purchases from suppliers.

Purchasing costs may decrease if the order size increases if bulk discounts are offered.

Optimum position is where holding costs = ordering costs. At this point the total cost will be minimised.

Quantifying Inventory Holding Costs

If a firm orders an amount (Q) from a supplier, holds zero opening inventory and receives the order immediately then the level of inventory at the start of the period is Q. By the end of the period, we can assume that the inventory level has been run down to zero.

This can be illustrated as follows:

The average inventory level is (starting inventory + closing inventory)/2 which can be expressed as Q/2. Total holding costs can therefore be calculated as:

= CH × q/2

Where Q is the initial order and CH = Annual cost of holding one unit in inventory

Quantifying Inventory Ordering Costs

If a firm holds zero inventory at the start of the period, the number of orders that it will need to place will be determined by the annual demand in units (D) and the order size (Q). For example, if 120 units are required (i.e. demanded) and the order size is 20 units then there will be 120 ÷ 20 = 6. This can be expressed as D/Q.

If Co = Cost of placing an order, then total ordering costs can be calculated as:

= Co × D/Q

Quantifying Purchasing Costs

If order size affects the purchase price, purchasing costs will need to be considered. Purchasing costs are calculated as:

= annual demand × purchase price of one unit

EOQ formula

To minimise total inventory related costs of a company, there is an ideal (economic) order size which can be identified using the EOQ formula.

EOQ = √ (2CoD/ CH)

Where:

Co = cost per order D = annual demand Ch = cost of holding one unit for one year

Assumptions/Criticisms:

• The ordering cost is constant.

• The annual demand for the item is constant and it is known to the firm.

• Quantity discounts don't exist.

• The order is received immediately after placing the order.

• No buffer stock is required

• Ignores hidden stock holding costs (unreliable suppliers etc.)

• Ignores benefit of stock holding (choice etc.)

Bulk Purchase Discounts

If bulk purchase discounts are available, the simple EOQ formula cannot be used and we need to adjust our approach as follows:

Step 1: Calculate EOQ, ignoring discounts.

Step 2: If the EOQ is below the quantity qualifying for a discount, calculate the total annual inventory cost arising from using the EOQ:

Total annual inventory cost = purchase costs (D × P where P is purchase price) + ordering costs (Co × D/Q) + holding costs (CH × Q/2)

Step 3: Recalculate total annual inventory costs using the order size required to just obtain each discount. Take the available discount into account within the purchase costs.

Step 4: Compare the totals from steps 2 and 3 and select the lowest cost option.

Step 5: Repeat for all discount levels

Example:

Demand is 100 units per month. Purchase cost per unit £10. Order cost £20

Holding cost 10% p.a. of stock value.

Required:

Calculate the minimum total cost with a discount of 2% given on orders of 350 and over.

Solution

Calculate EOQ in normal way (and the costs)

Calculate costs at the lower level of each discount above the EOQ

Sq. root 2 x 20 x 1200 / 1 = 219

Ordering Costs= Order cost per unit x (Annual Demand / Order amount)

= 20 x 1200 / 219

= 110

Holding Costs= Holding Cost per unit x (Order amount / 2)

= 1 x 219 / 2 = 110 = 220

At Discount Level 350

Ordering Costs = Order cost per unit x (Annual Demand / Order amount) = 20 x 1200 / 350 = 69

Holding Costs = Holding Cost per unit x (Order amount / 2)

= 0.98 x 350 / 2 = 171.5 = 240.5

240.5 is higher than 220 (it would be as EOQ is the best level)

However, we now need to consider the 2% price discount

Discount = 2% x 1200 x 10 = 240

Clearly with the discount being offered the company should take the discount and order at 350

So, EOQ looks at how much to order, now let’s look at when. The answer should be obvious - it is when you run out of stock. However, you need to reorder before that to give the stock time to arrive. So, you don’t re-order when there’s zero stock you have to re-order before then. We call this the lead time.

It is the amount of stock you use up normally in the time it takes the stock to arrive after buying it - this is the re-order level. However, we often re-order before it gets down to this amount - just to be on the safe side. This extra amount is known as buffer stock

Lead time – the lag between when an order is placed, and the item is delivered

Buffer inventory – the basic level of inventory kept for emergencies. A buffer is required because both demand and lead-time will fluctuate, and predictions can only be based on best estimates.

Re-order level = maximum usage × maximum lead time

Maximum inventory level = re-order level + re-order quantity –(minimum usage × minimum lead time)

The maximum level acts as a warning signal to management that inventories are reaching a potentially wasteful level.

Minimum inventory or buffer safety inventory = re-order level – (average usage × average lead time)

The buffer safety level acts as a warning to management that inventories are approaching a dangerously low level, and that stock-outs are possible.

Average inventory = buffer safety inventory + (re-order/2)

This formula assumes that inventory levels fluctuate evenly between the buffer safety (or minimum) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received, safety inventory and re-order quantity)

Using EOQ with Buffer Stock

• Calculate Buffer stock (if not given)

• Calculate EOQ and costs ignoring buffer stock

• Add on HOLDING costs for buffer stock

Reasons for holding inventory

• To Deal with Unexpected Demand: Inventory acts as a buffer to meet sudden spikes in customer demand without delaying delivery.

• To Deal with Unexpected Delays in Delivery: Having stock on hand ensures that operations continue smoothly despite unforeseen supply chain disruptions.

• To Make Use of Bulk Discounts: Purchasing in bulk often comes with discounts, reducing costs, which can justify holding more inventory than immediately needed.

• To Buy When Prices Are Low: Companies may stock up on inventory when prices are favorable to save on future procurement costs.

• Seasonal Production: Certain products, like fruits or agricultural goods, are only available during specific times of the year, necessitating inventory storage for off-season use.

• Technical Reasons: Some products require a maturation or aging period before being ready for sale, such as whisky aging for years to achieve quality.

Just-In-Time (JIT)

Just-in-time (JIT) is a philosophy which involves the elimination of inventory.

• An inventory strategy which reduces in-process inventory.

• In order to achieve JIT, the process must have signals of what is going on elsewhere within the process. These signals tell production processes when to make the next part.

• They can be simple visual signals, such as the presence of a part on a shelf.

• Quick communication of the consumption of old stock which triggers new stock to be ordered is key to JIT and inventory reduction.

• JIT emphasizes inventory as one of the seven wastes (overproduction, waiting time, transportation, inventory, processing, motion and product defect), and so aims to reduce buffer inventory to zero. Zero buffer inventory means that production is not protected from external shocks

JIT procurement

This is a policy of obtaining goods from suppliers at the latest possible time (i.e. when they are needed) and so avoiding the need to carry any materials or components as inventory.

JIT production

This describes manufacturing ‘to order’. As orders are received, manufacturing is triggered to fulfil those orders. This enables better product customisation, no risk of obsolescence and few holding costs. It does, however, require a highly flexible and reliable manufacturing process (in terms of what and how much is made).

5 Key Aspects to JIT

• Multi skilled workers

• Close relationship with suppliers

• Reduced set up times

• Quality

• Teams working in cells

Benefits of JIT

• Inventory Cost Reduction: Minimizes holding costs associated with warehousing and storage.

• Waste Reduction: Identifies and eliminates waste in the production process.

• Improved Quality: Easier identification and rectification of quality issues.

• Increased Efficiency: Streamlines production processes and reduces setup times.

• Flexibility and Responsiveness: Adaptable to changes in customer demand or market conditions.

• Lead Time Reduction: Minimizes lead times for production and delivery.

• Employee Involvement and Empowerment: Encourages collaboration and empowers workers.

• Cash Flow Improvement: Frees up capital by reducing excess stock and associated costs.

• Supplier Relationships: Fosters strong relationships with suppliers for timely deliveries.

• Environmental Impact: Contributes to environmental sustainability by reducing waste.

Drawbacks of JIT

• Supply Chain Vulnerability: JIT is sensitive to disruptions in the supply chain, which can lead to production delays and stockouts.

• Dependence on Supplier Relationships: Reliance on a small number of suppliers can pose risks if there are issues with quality, financial stability, or availability.

• Limited Production Flexibility: JIT systems may struggle to adapt to sudden changes in demand or product mix, affecting efficiency.

• High Setup Costs: Frequent production changeovers can lead to increased costs associated with equipment adjustments and downtime.

• Quality Control Challenges: Maintaining consistent product quality is crucial in JIT, and any deviation can disrupt production and impact customer satisfaction

Managing Receivables

The Objectives of Accounts Receivable Management

The optimum level of trade credit extended represents a balance between two factors:

• Profit improvement from sales obtained by allowing credit

• The cost of credit allowed.

Policy Formulation

A company will have to decide whether to offer credit to its customers and if so on what terms. These are important decisions and need to be carefully considered by senior management.

The decision to offer credit can be viewed as an investment decision, intended to result in higher profits. For many businesses, offering generous payment terms (or credit period) to customers is essential in order to be competitive.

However, offering credit comes at a cost, e.g. the value of the interest charged on an overdraft to fund the period of credit, and the possibility of bad debts. So, the decision to offer credit will need to be carefully assessed to see if the benefit from the policy is greater than its cost.

In some businesses it is possible that the risk of bad debts, or the cost of managing receivables, will mean that it is not commercially viable to offer credit to customers.

For accounts receivable, the company's policy will be influenced by:

• Demand for products

• Competitors' terms

• Risk of irrecoverable debts

• Financing costs

• Costs of credit control

A Credit Policy Key Aspects:

1. Assessing creditworthiness

To minimise the risk of irrecoverable debts occurring, a company should investigate the creditworthiness of all new customers (credit risk) and should review that of existing customers from time to time, especially if they request that their credit limit should be raised.

Information about a customer’s credit rating can be obtained from a variety of sources.

These include:

• Bank references – A customer’s permission must be sought. These tend to be fairly standardised in the UK, and so are not perhaps as helpful as they could be.

• Trade references – Suppliers already giving credit to the customer can give useful information about how good the customer is at paying bills on time. There is a danger that the customer will only nominate those suppliers that are being paid on time.

• Competitors – in some industries such as insurance, competitors share information on customers, including creditworthiness.

• Published information – The customer’s own annual accounts and reports will give some idea of the general financial position of the company and its liquidity.

• Credit reference agencies – Agencies such as Dun & Bradstreet publish general financial details of many companies, together with a credit rating. They will also produce a special report on a company if requested. The information is provided for a fee.

• Company’s own sales records – For an existing customer, the sales ledgers will show how prompt a payer the company is, although they cannot show the ability of the customer to pay.

• Credit scoring – Indicators such as family circumstances, home ownership, occupation and age can be used to predict likely creditworthiness. This is useful when extending credit to the public where little other information is available. A variety of software packages is available which can assist with credit scoring.

Credit limits

Credit limits should be set to reflect both the:

• Amount of credit available

• Length of time allowed before payment is due.

The ledger account should be monitored to take account of orders in the pipeline as well as invoiced sales, before further credit is given, to ensure that limits are not breached.

2. Invoicing and collecting overdue debts

A credit period only begins once an invoice is received so prompt invoicing is essential. If debts go overdue, the risk of default increases, therefore a system of follow-up procedures is required.

Techniques for ‘chasing’ overdue debts include the following:

• Reminder letters: these are often regarded as being a relatively poor way of obtaining payment, as many customers simply ignore them. Sending reminders by email is usually more productive than using the post.

• Telephone calls: these are more expensive than reminder letters (which can be automatically generated by most accounting systems) but where large sums are involved, they can be an efficient way of speeding up payment.

• Withholding supplies: putting customers on the ‘stop list’ for further orders or spare parts can encourage rapid settlement of debts.

• Debt collection agencies and trade associations: these offer debt collection services on a fixed fee basis or on ‘no collection no charge’ terms. The quality of service provided varies considerably and care should be taken in selecting an agent.

• Legal action: this is often seen as a last resort. A solicitor’s letter often prompts payment and many cases do not go to court. Court action is usually not cost effective, but it can discourage other customers from delaying payment.

3. Monitoring the system

Management will require regular information to take corrective action and to measure the impact of giving credit on working capital investment. Typical management reports on the credit system will include the following points.

• Age analysis of outstanding debts.

• Ratios, compared with the previous period or target, to indicate trends in credit levels and the incidence of overdue and irrecoverable debts.

• Statistical data to identify causes of default and the incidence of irrecoverable debts among different classes of customer and types of trade.

Extending the Credit Period

The decision to offer extended credit can also be viewed as an investment decision, intended to boost sales and profits. The cost of extended credit is the value of the interest charged on an overdraft to fund the period of extra credit.

The benefit is likely to be higher sales and therefore higher profit. The policy will be assessed by comparing whether the benefit from higher sales is greater than the finance costs associated with higher receivables.

Costs of Financing Receivables

Finance cost = Receivable balance × Interest (overdraft) rate

Receivable balance = (Credit sales × Receivable days) ÷ 365

Offering Early Settlement Discounts

There are four main reasons why a business may offer its customers discounts to pay early:

• If cash is received earlier, it will improve the supplier’s liquidity position, because it reduces the length of its cash operating cycle. This will be particularly important if a seller is suffering from cash flow problems.

• If the cash from customers is received early, the cost of financing receivables is reduced. For example, if the supplier has an overdraft agreement under which it borrows at a cost of 10% per annum, then provided that the cost of offering the discount is less than the cost of the overdraft, the supplier will be better off financially.

• When customers are deciding which payments to make to suppliers and which ones to delay, they are likely to pay those suppliers offering a discount for early payment first. From the point of view of the supplier offering the discount, this means that the incidence of bad debts is likely to be reduced, since customers will choose to pay them first if they are short of cash.

• It is possible that offering a discount may provide an incentive to new customers, because the cost of the goods from a supplier offering a discount may now be less than those of a supplier not offering a discount, provided that the potentially new customer pays within the specified time limit.

Receivables aren’t cash. So, they need funding.

Think of this being funded by an overdraft. Therefore, the overdraft rate x receivables are the cost.

In questions you will be asked to compare the current policy cost, to a new policy cost (offering early settlement discounts) to see which is cheaper

Let’s Have a Think About This:

Early settlement will mean receivables will get smaller and so the cost less

However, the discount is a cost to the company too so needs to be considered

Steps

The steps are as follows:

Step 1: Calculate current policy cost of receivables (receivables x Overdraft Interest rate)

Step 2: Calculate NEW policy cost of NEW receivables (New receivables x overdraft interest rate)

Step 3: Calculate cost of early settlement discount and add to the new policy cost

Example:

Company has credit sales of 1200 and a 3-month credit policy.

New policy is 2% early settlement discount (within 10 days) and a new credit policy for others of 2 months

20% will take the discount.

Cost of capital 10%

Solution:

Step 1: Old Policy cost of Receivables = 3/12 x 1200 = 300 x 10% = 30

Step 2: New Policy cost of Receivables after = 2/12 x 80% x 1200 = 160 x 10% = 16

+ 10/365 x 20% x 1200 = 7 x 10% = 0.7

Step 3: Cost of early settlement discount 2% x 20% x 1200 = 4.8

Cost of Old Policy = 30

Cost of New Policy = 16+0.7+4.8 = 21.5

The cost of the new policy is less and so should be taken

Factoring

Types of Arrangement

A factor can work in different ways…

• It can simply be they take over a company’s credit control department for a fee.

• It may be that the factor forwards the company some money in advance, and then collects the money from the debtors themselves and keeps the money.

• The amount forwarded here would be like a loan and so the factor would also charge interest.

Finally, if the factor does “buy” the company’s debts then the deal may be “With recourse” or “without recourse”

• With Recourse - Any bad debts get returned to the company

• Without Recourse - Any bad debts are suffered by the Factor

Advantages

• Admin Cost Saved

• Gets Cash Quickly

• More Cash available as sales grow

Disadvantages

• Can be expensive

• Could lose customer goodwill

• May give a bad impression to customers

How to do the numbers…

Compare:

• Current cost (Receivables x overdraft rate)

• New cost with Factor (New receivables x overdraft rate, Fee, net cost of forwarding money less any increase in contribution, less admin savings)

Illustration

A Company has credit sales of 200,000pa. Credit term is 30 days. The factor offers to buy 80% at an interest rate of 9%. The company can get an overdraft for 6%. The factor charges 1.5% of current credit sales.

The factor will offer customers an early settlement discount if paid in 15 days, 40% will accept this and the remainder will take 50 days to pay. Sales will increase by 5% and contribution to sales ratio is 40%

Should the factor’s offer be accepted?

Solution

Current Cost

Receivables = 30/365 x 200000 =16,438

These are financed by an overdraft at 6% = 986

TOTAL = 986

Cost of Factoring

New receivables = New sales x 15/365 x 40% = 3,452

New receivables = New sales x 50/365 x 60% = 17,260

Financed by overdraft cost at 6% = 1,242

Factor Fee = 200,000 x 1.5% = 3,000

Increase in contribution = sales increase x 40% = (4,000)

Forward Cost = new receivables x 80% x (9-6%) = 497.10

TOTAL = 739.1

The factor option costs less - so the factor’s offer should be taken up

Tricky Bits

Forwarding of cash from Factor

• You will notice in the question above I didn’t add the full cost of this forwarding money (like a loan).

What I did was take the forwarding interest rate charged less the overdraft interest rate.

• Think of it like this, the company has an overdraft of 6%. Then they get loaned some money for 9%.

They will put the money from the loan in the bank and so it will lower them overdraft.

This means they will be saving 6%. Therefore, the net cost to them is 3%.

• So always take the net cost of the forwarding interest rate less the overdraft rate.

Bad Debts- With Recourse

No change here then (the company keeps the bad debt risk). Therefore, generally, as there’s no change - keep bad debts completely out of the workings. Easy-peasy-lemon squeeze

Just be careful though if it stays with recourse but the bad debts reduce - in that case treat this as a saving in the factor policy

Bad Debts - Without Recourse

Here the company gives its bad debts risk to the factor. Therefore, this is a saving for the company if they choose the factor option.

So, treat it like this - show as a saving in the factor option

Invoice Discounting

• An invoice discounter purchases your debts at a discount.

• They do not take over their administration etc. though.

• They tend to be one off deals on high quality debts

Debt Factoring and Invoice Discounting Compared

Imagine you’re a business holder

Factoring

Financial services companies that provide businesses with debtor finance, secured against unpaid invoices are known as Factors and Invoice Discounters.

Factors buy your trade debts and typically will pay 80% to 85% as soon as they receive a valid copy invoice.

The balance, less charges, is paid when the customer pays.

The Factor collects the debt from your customer directly but will usually agree collection policies with you, in order to ensure faster customer payment without loss of goodwill. Some Factors also provide bad debt insurance.

Invoice Discounting

With invoice discounting responsibility for collection of debts remains with you and the service is normally undisclosed to customers.

Payments that you receive are paid into a bank account administered by the Invoice

Discounter and you are then credited with the balance less charges.

Generally, invoice discounting is only available to businesses that already practice sound credit management and have the staff and accounting systems to generate reliable customer collections. Invoice Discounters, like Factors, will typically pay 80% to 85% against valid invoices.

Cost of Factoring and Invoice Discounting

• For both factoring and invoice discounting there is a service charge, normally a proportion of turnover, and a discount charge, based on the amount of finance provided.

Charges will be agreed in advance and form part of the factoring or invoice discounting agreement. For factoring the service charge is normally between 0.75% and 2.5% of turnover, depending on the workload to be undertaken.

• The charge for invoice discounting will usually be less, as less work is required. The discount charge is calculated on day-to-day usage of funds. It is likely to be comparable with normal secured bank overdraft rates.

Suitability of Factoring and Invoice Discounting

• Debtor finance is most suitable for growing businesses; finance will grow in line with the growth in turnover. Conversely, where turnover is falling the level of finance will fall. The cost of the service needs to be weighed against the costs of in-house debt collection and, for example, having sufficient cash to benefit from early payment discounts from suppliers.

• Generally, debt finance providers are looking for ‘clean’ invoices where there is clear evidence of delivery of the goods or service and a low level of disputes or credit notes. It may not be available for some industries, for example contracting, where there is a high level of retentions and variation orders.

• Providers of debt finance usually acquire your debts with recourse to you if the debtor does not pay. This means they will reclaim the amount already advanced to you should your debtor not pay in each time period.

• Alternatively, you may take out insurance against non-payment by your debtors. Many factors and invoice discounters can also provide bad debt insurance.

Managing Foreign Accounts Receivable

Foreign debts raise the following special problems.

• It may be harder to build an accurate credit analysis of a company in a distant country.

• It may be harder to chase foreign customers for payments (different time zones and languages).

• If a foreign debtor refuses to pay a debt, the exporter must pursue the debt in the debtor’s own country and may lack an understanding of the procedures and laws of that country.

Some businesses may decide to trust the foreign receivable and not take any special measures to reduce the non-payment risk. This method is known as open account and may be suitable for small transactions.

However, there are several measures available to exporters to help overcome the risks of non- payment or late payment on larger transactions.

Methods of reducing risks

• Bill of exchange: An IOU signed by the customer. Until it is paid, shipping documents that transfer ownership to the customer are withheld. Bill of exchange can also be sold to raise finance.

• Letter of credit: The customer’s bank guarantees it will pay the invoice after delivery of the goods.

• Invoice discounting: Sale of selected invoices to a debt factor, at a discount to their face value.

• Debt factoring: A local debt factor based in the export market can be especially useful in performing credit analysis and chasing for payment.

• Agree early payment with an importer: For example, by payment in advance, payment on shipment, or cash on delivery.

• Assess the creditworthiness of new customers, such as bank references and credit reports.

• Insurance: Insurance can also be used to cover some of the risks associated with giving credit to foreign customers. This would avoid the cost of seeking to recover cash due from foreign accounts receivable through a foreign legal system, where the exporter could be at a disadvantage due to a lack of local or specialist knowledge.

Payables

Trade credit is the simplest and most important source of short-term finance for many companies. Again, it is a balancing act between liquidity and profitability.

By delaying payment to suppliers, companies face possible problems:

• Supplier may refuse to supply in future

• Supplier may only supply on a cash basis

• There may be loss of reputation

• Supplier may increase price in future.

Trade credit is normally seen as a ‘free’ source of finance. Whilst this is normally true, it may be that the supplier offers a discount for early payment. In this case delaying payment is no longer free since the cost will be the lost discount.

Effective management of trade accounts payable involves seeking satisfactory credit terms from supplier and maintaining good relations with suppliers. Timely payment of invoices, in line with agreed payment terms, will prevent the possibility that late payment of invoices endangers the firm’s long-term relationship with the supplier.

Evaluating Discounts

If a supplier offers a discount for the early payment of debts, the evaluation of the decision whether to accept the discount is the mirror image of the evaluation of the decision whether to offer a discount to customers.

Accepting early settlement discounts from a supplier will result in a benefit (the discount) but will result in lower payables which will incur a cost to the company by increasing the cost of the interest charged on an overdraft, since money is being paid to suppliers earlier.

This can be assessed by comparing the benefit of the discount to the cost of higher finance costs associated with lower payables.

EXAMPLE

Pips Co has been offered a discount of 2.5% for an early settlement by a major supplier from which it purchases goods worth $1,000,000 each year. Pip’s normal payment terms are 30 days; early settlement requires the payment to be made within 10 days. Currently Pips has an overdraft on which it is paying 10% interest.

Required

What is the net benefit of accepting the early settlement discount (assuming a 365-day year)?

Cost

Current payables = 30/365 × 1,000,000 = $82,192

New payables = 10/365 × 1,000,000 = $27,397 (As with receivables the discount is ignored in this calculation)

Reduction in payables causes an increase in overdraft interest of $54,795 × 0.1 = $5,480

Benefit 2.5% × $1,000,000 = $25,000

Net Saving = $25,000-$5,480 = $19,520

Evaluating a Supplier Discount Using Percentages

The benefit of an early payment discount can be expressed in percentage terms.

Illustration: A company which has an overdraft costing 10% per year, is evaluating whether to accept a 1% discount for paying its invoices 30 days earlier. Assume a 360-day year.

Required: Evaluate whether to accept the discount.

No $ amounts are given here, so we must look at this in percentage terms. If the company accepted the offer and did pay 30 days early, it receives a benefit that can be expressed as a percentage as follows:

(Discount received ÷ Amount paid if discount taken) × 100 = 1% ÷ 99% = 0.0101 or 1.01%

Where 1% is the discount and 99% is the percentage of the amount due that is paid (after the 1% discount). This is the benefit of accepting the offer expressed over a 30-day period (since the company is paying 30 days early). This can be converted into an annual equivalent rate using the following formula. (This formula is not given in the exam).

(1+R) = (1+r) n

R = annual rate r = period rate (here 30 days)

n = no. of periods in a year (here 360/30 = 12)

In annual terms this is 1.010112 = 1.1282 so R = 12.82%.

Since the benefit of the discount of 12.82% is above the cost of the overdraft (10% per year) the discount should be accepted.

The same formula can be used for accounts receivable.

Managing Foreign Accounts Payable

• Currency Risk Management: Use tools like forward contracts or options to hedge against currency fluctuations.

• Payment Terms: Negotiate clear terms with foreign suppliers, considering discounts for early payment.

• Foreign Exchange Exposure: Identify and manage exposure to currency risk in payables.

• Contract Clauses: Include currency clauses in contracts to specify payment terms.

• Invoice Accuracy: Ensure accuracy in foreign currency invoices to avoid errors.

• Cash Flow Planning: Plan cash flow effectively, considering currency and payment timing.

• Technology Use: Employ accounting software for multi-currency management.

• Interest Rates: Consider interest rate differentials when payments are delayed.

• Compliance: Adhere to international accounting standards, like IFRS.

• Political and Economic Risk: Monitor political and economic conditions in supplier countries.

Final Exam Standard Example

Velm Co sells stationery and office supplies on a wholesale basis and has annual revenue of

$4,000,000. The company employs four people in its sales ledger and credit control department

at an annual salary of $12,000 each. All sales are on 40 days’ credit with no discount for early

payment. Bad debts represent 3% of revenue and Velm Co pays annual interest of 9% on its

overdraft.

The most recent accounts of the company offer the following financial information:

Velm Co is considering offering a discount of 1% to customers paying within 14 days, which it believes will reduce bad debts to 2.4% of revenue. The company also expects that offering a discount for early payment will reduce the average credit period taken by its customers to 26 days. The consequent reduction in the time spent chasing customers where payments are overdue will allow one member of the credit control team to take early retirement. Two-thirds of customers are expected to take advantage of the discount.

Required

Using the information provided, determine whether a discount for early payment of 1% will lead to an increase in profitability for Velm Co. Assume a 365-day year.

Solution

Receivables are currently taking on average ($550,000/$4,000,000) × 365 = 50 days to pay. This is in excess of Velm’s stated terms. The discount, to be taken up by 2/3 of customers, will cost the company $4,000,000 × 1% × 2/3 = $26,667. It is stated that this will bring the receivables payment period down to 26 days, which is represented by a new receivables level of $4,000,000 × 26/365 = $284,932.

This is a reduction in receivables of $265,068.

At current overdraft costs of 9%, this would be a saving of $265,068 × 0.09 = $23,856

Bad debts would decrease from 3% to 2.4% of revenue, which saves a total of $4,000,000 × 0.006 = $24,000. There would also be a salary saving from early retirement of $12,000.

So, the net effect on Velm’s profitability is as follows:

$

Saving on overdraft costs 23,856

Decreased bad debts 24,000

Salary saving 12,000

Less cost of discount (26,667)

Net saving 33,189