Working Capital Management

What is working capital?

Working capital is the amount of resources available for conducting the day to day
operations of an organisation. The definition of working capital is fairly simple, it is
the difference between an organisation’s current assets and its current liabilities. Of
more importance is its function which is primarily to support the day-to-day financial
operations of an organisation, including the purchase of stock, the payment of
salaries, wages and other business expenses, and the financing of credit sales.

Working capital comprises a number of different items and its management is difficult
since these are often linked. Hence altering one item may impact adversely upon other
areas of the business. For example, a reduction in the level of stock will see a fall in
storage costs and reduce the danger of goods becoming obsolete. It will also reduce
the level of resources that an organisation has tied up in stock. However, such an
action may damage an organisation’s relationship with its customers as they are forced
to wait for new stock to be delivered, or worse still may result in lost sales as
customers go elsewhere.

Extending the credit period might attract new customers and lead Extending the credit
period might attract new customers and lead to an increase in turnover. However, in
order to finance this new credit facility an organisation might require a bank
overdraft. This might result in the profit arising from additional sales actually being
less than the cost of the overdraft.

Management must ensure that a business has sufficient working capital. Too little will
result in cash flow problems highlighted by an organisation exceeding its agreed
overdraft limit, failing to pay suppliers on time, and being unable to claim discounts
for prompt payment. In the long run, a business with insufficient working capital will
be unable to meet its current obligations and will be forced to cease trading even if it
remains profitable on paper.

On the other hand, if an organisation ties up too much of its resources in working
capital it will earn a lower than expected rate of return on capital employed. Again
this is not a desirable situation.

Net working capital = Current assets – Current liabilities

WORKING CAPITAL MANAGEMENT

Includes all the activities taken with the aim of monitoring and controlling all the
aspects of current assets and current liabilities in order to avoid the risk of insolvency
and maximize the return on assets. This is because working capital has cost in terms
of either;
 The cost of funding it; or
 The lost investment opportunities due tied up cash not being deployed in other
uses.

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OBJECTIVES OF WORKING CAPITAL MANAGEMENT
Working capital management aims at finding out the optimum:
 Working capital investment.
 Working capital financing combination.

WORKING CAPITAL FINANCING

The following alternatives of working capital financing are available:
1. Short-term finance.
2. Long-term finance.
3. Long-term and short-term finance, in an ascertained proportion.

Many companies finance the working capital with the combination of short-term and
long-term so as to reap the advantages inherent in both financing vehicles and to
minimise the disadvantages associated with them.

Short-term financing has the advantage of being cheap and matching the current
assets with current liabilities. However the risk associated with short-term financing
tend to outweigh the advantage of cheap cost. Below are the renowned risks
associated with short-term financing:
1) Renewal Problem
 Short-term finance may need to be continually negotiated as various
facilities expire (e.g. bank overdraft, bank loan, creditors period etc)
 Sometimes it may be difficult to renew the short-term finance due to
bad economic conditions or worsening company’s financial situation.
2) Negotiation cost
 Because every time the credit facilities expire they need to be renewed,
management time spent on negotiation is enormous. Management time is
costly if translated in monetary terms.
3) Interest rate stability: As the Company is continuously renewing its funding
arrangements, it is likely that it will be facing fluctuation in short-term interest.

Example below will be used to discuss total working capital management concepts:

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Lecture example1
The balance sheets of Bryan Ltd at 30 April 20X0 and 30 April 20X1 are given
below:
20X0 20X1
£'000 £'000
Assets
Tangible
Cost or valuation 51,000 63,000
Accumulated depreciation (12,500) (16,300)
38,500 46,700
Current assets
Stock 16,400 18,400
Trade debtors 19,100 20,600
Sundry debtors and prepayments 3,100 4,000
38,600 43,000
Less current liabilities
Trade creditors (11,400) (18,400)
Accruals (3,400) (4,200)
Bank overdraft (13,700) (4,800)
Net currect assets 28,500 27,400
10,100 25,600
Total assets less current liabilities 48,600 72,300
Less: 7% Debebtures (£20m issued 1 May 20X0) (20,000) (40,000)
28,600 32,300

Called up share capital 10,000 10,000

Share premium account 5,000 5,000
Revaluation reserve 5,000 5,000
Profit and loss account 8,600 12,300
28,600 32,300

The summarised profit and loss accounts of Bryan for the year ended 30 April 20X0 and
20X1 are:
20X0 20X1
£'000 £'000
Sales 58,000 66,000
Cost of Sales (43,000) (49,000)
Gross Profit 15,000 17,000
Operating expenses (10,000) (10,500)
Profit from operations 5,000 6,500
Interest payable (1,400) (2,800)
Net profit fot the year 3,600 3,700
Dividend (450) (300)
3,150 3,400
Additional information
1. The opening stock for the year ended 20X0 was £ 14,000.
2. Purchases amounted to £45,400 and £51,000 for 20X0 and 20X1 respectively.

Required:
a. Calculate the necessary working capital ratios from the data above.
b. Comment briefly on the movements of these ratios between the two years.

WORKING CAPITAL RATIOS

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The levels of current assets required to be maintained by the company depend much
on the size of the respective company. Therefore, there is no one level that is
considered to be suitable to all companies. A use of ratio analysis helps to identify the
levels at which a company maintains its current assets. Below is a discussion on
common working capital ratios, illustrated by the use of the above example.

1. Current Ratio
Is a ratio between current assets and current liabilities. It indicates the ability of
the Company to pay its short-term financial obligations out of its current assets.

It is calculated as:
Current ratio = Current assets
Current liabilities

A current ratio of 1 and above normally indicates better liquidity depending on

the nature of the business. In many businesses ideal current ratio is 2.

For Bryan:
20X0 20X1
Current ratio 36,800 1.35:1 43,000 1.57:1
28,500 27,400

2. Quick Ratio
Gives the same indication as the current ratio. But this ratio excludes stock, as
stocks often can not be converted into cash in a short notice.

It is calculated as:
Quick ratio = Current assets – stocks
Current liabilities
For Brian

20X0 20X1
Quick ratio 38,600 - 16,400 0.78:1 43,000 - 18,400 0.9:1
28,500 27,400

An ideal quick ratio is at least 1. Depending on the industry, a quick ratio from
0.8 is considered acceptable.

- The current and quick ratios have improved significantly. The major
noticeable changes with working capital are the overdraft, which is assumed to
have been reduced by the debenture loan, and trade creditors.

3. Stock holding period

Gives an indication of the time taken for a particular stock to be sold. The
survival of any business depends on how quick its stocks are sold and hence
turned into revenues. Therefore, the shorted stock holding period is considered
to be more favourable than the longer period.

It is calculated as:
Stock holding period = Average stock x 365 days
Cost of sales

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 For Bryan:

20X0 20X1
Stock holding period 1/2 (14,000 + 16,400) x365 Days 1/2 (16,400 + 18,400) x365 Days
43,000 129 49,000 130

The days the company holds stock has not changed to signify any concern.

4. Debtors collection days

Is a rough measure of the number of days it takes for credit customers to pay for
the goods they are supplied.

This ratio should be kept at minimum in order to boost the company’s cash
flow. Therefore, the lower the better.

It is calculated as:
Debtors’ collection days = Closing debtors x 365 days
Credit sales
For Bryan:
20X0 20X1
Debtors' collection period 19,100 x 365 Days 20,600 x 365 Days
58,000 120 66,000 114

Average collection days have improved from 20X0 to 20X1. However, it seems
the company’s credit policy is very loose.
NB: Only trade debtors have been considered in our calculations. A question
might ask for total debtors’ collection days. This will include the sundry
debtors.

5. Creditors’ payment days

Is a rough measure of the period the company takes to pay for the supplies
received on credit. It indicates the suppliers’ credit policy as well as the
company’s negotiation power.

This ratio should be aimed at the highest possible. However, a consideration

needs to be made of loosing suppliers’ goodwill or any penalty charges that
might be imposed for late payments. Ideally, the higher the creditors’ payment
dates the better.

It is calculated as:
Creditor’s payment period = Closing creditors x 365
Credit purchases
For Bryan:
20X0 20X1
Creditors' payment period 11,400 x 365 Days 18,400 x 365 Days
45,400 92 51,000 132
The creditors’ payment days show a significant improvement over the two
years.
CASH OPERATING CYCLE
Cash operating cycle, also known as working capital cycle is the length of time
between a business paying for its raw materials and receiving cash from its customers.

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The efficiency of the cash operating cycle depends on how faster a firm can push
working capital items around the cycle.

Short operating cycle signifies lower working capital investment.

The length of the operating cycle needs to be maintained at a lower level to minimize
the investment in working capital, but without affecting the liquidity.

Cash operating cycle is calculated as:

DAYS
Stock holding period XXX
add: Debtors' collection period XXX
Less: Creditors' payment period (XXX)
Cash Operatin cycle (in days) XXX

If the company is involved with manufacturing as well, the cash operating cycle will
be lengthened by the periods of raw materials holding and work in progress holding.

Bryan’s Cash operating cycle will be:

DAYS
20X0 20X1
Stock holding period 129 130
add: Debtors' collection period 120 114
Less: Creditors' payment period (92) (132)
Cash Operatin cycle (in days) 157 112

Cash operating cycle has improve over the two years. However, the information is not
sufficient to allow us to comment whether this cycle is good or bad. The operating
cycle could be compared with other companies in the industry or with an overall
industrial expected operating cycle.

WORKING CAPITAL MANAGEMENT AND SOLVENCY

Working capital ensures that optimum working capital is maintained in order to avoid
the effects of having less working capital to meet the organisation’s obligations
whenever they come due. If no sufficient cash is available, the organisation is likely to
have liquidity problems. A Company with less working capital to meet its operations
is said to be over trading.

On the other hand, keeping too much of working capital results into tying up the
organisation’s cash. This cash could have been used in other profit generating
projects. A Company maintaining excessive working capital than its operational needs
is said to be over capitalized.

The symptoms of over capitalisation can be identified through poor accounting ratios
i.e. liquidity ratios being too high, or stock turnover periods being too long.

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OVER TRADING
An over trading organisation is characterized with rapid increase in turnover without
having sufficient working capital to match the capacity expansion.

Over trading organizations are often not able or not willing to raise long-term capital
and thus tend to rely heavily on short-term sources of finance such as overdraft and
trade creditors.

Symptoms of over trading

 Rapid increase in turnover.
 Fall in liquidity ratios.
 Sharp increase in the sales-to-fixed assets ratio.
 Increase in stocks in relation to turnover.
 Increase in the trade credit period (debtors).
 Increase in short-term borrowing and decline in cash balance.
 Fall in profit margins.

Risks of over trading

Short-term finances can be withdrawn relatively quickly if creditors loose confidence
in the business or if there is a general tightening of credit in the economy resulting to
liquidity problems and even bankruptcy, even though the organisation is profitable.

It follows that the solution to over trading is a change of mode of financing from
short-term to long-term finance such as loan or equity funds.

WORKING CAPITAL IMPROVEMENT TECHNIQUES

Improving the raw material stocks and reducing safety stocks
 This involves reducing the order size when purchasing.
 Precaution must be exercised as this might result into more frequent ordering and
therefore more ordering cost and also a loss in quantity discount.
 It might also increase the probability of stock-out and the associated costs.

Delay the payment to creditors

 This will improve the cash available to meet other commitments.
 However, this technique in short-term oriented. In the long-term it may result into
loss of cash discounts and if repeated, might result into loss of suppliers’ goodwill
and possibly higher unit cost being charged.

Improving debtors collection period

 This can be achieved by constantly reviewing the credit policy and by offering
incentives for early payment.
 Care should be taken not to result into high control costs and loss of sales.

Reduction in stocks of finished goods

 The stock held, should however not be too low to affect sales due to delays in
supplying customers.

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Use of Just In Time (J.I.T) system
 A well-established link in the supply chain is needed. Any slight delay in supplies
may result in loss of customers, or high costs to meet emergency demand.

Working Capital Management

[Techniques]
STOCK CONTROL
CIMA official terminology defines stock control as ‘the systematic regulation of
stock levels with respect to quantity, cost and lead-time.’ And the objective of stock
control is to minimise costs associated with holding stock.

REASONS FOR KEEPING STOCK

Businesses need enough stock to meet:

i- Their normal demand, and
ii- Any emergency demand.

COSTS ASSOCIATED WITH HOLDING STOCK

i- Purchase cost:
Is the cost of acquiring materials. This cost varies with the number of units
purchased. Often a unit price is reduced when large quantities are bought.
Hence a business can strive to reduce the total purchase cost by purchasing in
large quantities.

ii- Holding costs:

Are all costs incurred as a result of holding stock. Often they increase with the
level of stock held. Examples include interest on capital, cost of storage space,
insurance for stock, administration costs etc. Hence a business can reduce this
cost by ordering small quantities to avoid holding stock.

iii- Ordering costs.

These are costs incurred every time an order is placed. These costs can be
reduced by placing few orders but in large quantities.

iv- Stock out costs.

Are all costs associated with holding no stock when needed.

From the above analysis of stock related costs, we find that by aiming at reducing one
type of cost we might find ourselves in danger of increasing another type of cost. It is
this conflict of cost minimisation that calls for a mechanism necessary to establish
stock levels that can minimise the overall costs, and act as control measures and
warning signs for stock replacement purposes.

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A good stock control system is the one that will manage to keep all, holding costs,
ordering costs and stock out costs, at the minimum.

Three systems can be used to control stock levels:

1. Basic EOQ.
2. Just In Time (JIT) system
3. Material Requirement Planning

ECONOMIC ORDER QUANTITY (EOQ)

When determining how much to order at a time, an organisation will recognise that:
 as order quantity rises, average stock rises and the total annual cost of holding
stock rises
 as order quantity rises, the number of orders decreases and the total annual re-
order costs decrease.

The total of annual holding and re-order costs first decreases, then increases. The
point at which cost is minimised is the EOQ. This cost behaviour is illustrated by the
graph in Figure 1.

Is the quantity of stock ordered each time, which minimises the annual costs of stock
ordering and stock holding.

Figure 1

The way in which this EOQ is calculated is based on certain assumptions, including:
o constant purchase price
o constant demand and constant lead-time
o holding-cost dependent on average stock
o order costs independent of order quantity.

The assumptions result in a pattern of stock that can be illustrated graphically as

shown in Figure 2.

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Figure 2

The Formula
Using the standard ACCA notation in which:
CH = cost of holding a unit of stock for a year
CO = cost of placing an order
D = annual demand
also:
TOC = total annual re-ordering cost
THC = total annual holding cost
x = order quantity
then:
average stock = x/2
THC = x/2 × CH
and:
number of orders in a year = D/x
TOC = D/x × CO
The total annual cost (affected by order quantity) is:
C = THC + TOC = x/2 × CH + D/x × CO
This formula is not supplied in exams – it needs to be understood (and remembered).
The value of x, order quantity, that minimises this total cost is the EOQ, given by an
easily remembered formula:

Use of EOQ Formula

You need to take care over which figures you put into the formula, particularly in
multiple-choice questions. The areas to beware of fall into two categories:
a) Relevant costs – only include those costs affected by order quantity. Only
include those holding costs which (in total in a year) will double if you order
twice as much at a time. Only include those order costs which (in total in a
year) will double if you order twice as often. (Thus, fixed salaries to
storekeepers or buying department staff will be excluded.)

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 b) Consistent units – ensure that figures inserted have consistent units. Annual
demand and cost of holding a unit for a year. Both holding costs and re-
ordering costs should be in £, or both in pence.

Bulk Discounts
A common twist to exam questions is to ask students to evaluate whether bulk
discounts are worth taking. While prices reduce, total annual holding costs will
increase if more stock is ordered at a time, so the matter needs a little thought. The
common approach is one of trial and error. This involves finding the total annual cost
(holding cost, re-ordering cost and purchasing cost) at the level indicated by the EOQ
and at the level(s) where discount first becomes available.

Figure 3 shows total costs (now including cost of purchasing the stock) plotted against
order quantity with discount incorporated.

Figure 3

Point A represents the cost at the order quantity indicated by the EOQ. If stock is
ordered in larger quantities, total costs will increase to point B1, at which stage bulk
discounts are available, bringing the costs down to point B. Any calculations will
involve finding which cost out of A, B or C is the lowest, as Example 1 will show.

Example 1
Moore Limited uses 5,000 units of its main raw material per month. The material
costs £4 per unit to buy, supplier’s delivery costs are £25 per order and internal
ordering costs are £2 per order. Total annual holding costs are £1 per unit. The
supplier has offered a discount of 1% if 4,000 units of the material are bought at a
time.

Required:

a. Establish the economic order quantity (EOQ) ignoring the discount

opportunities.
b. Determine if the discount offer should be accepted.

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Example 1 solutions

Re-order levels
As important as how much to order at a time is the question of when to order more
stock. If an order is placed too late, when stocks have been allowed to run too low, a
‘stock-out’ will occur, resulting in either a loss of production or loss of sales, or
possibly both.

If orders are placed too soon, when there are still substantial supplies in stock, then
stock levels and holding costs will be unnecessarily high. The re-order level as
explained below should not be confused with the stock control levels referred to in
textbooks – this article ignores these. When it comes to calculating re-order levels,
three sets of circumstances can be envisaged.

Lead-time is zero
‘Lead-time’ is the interval between placing an order with a supplier and that order
arriving. It is unlikely that this could be reduced to zero – it would require
astonishingly co-operative and efficient suppliers. If it were possible, a re-order level
of zero could be adopted. An organisation could simply wait until it ran out of stock,
click its corporate fingers, and stock would arrive instantaneously.

Constant demand, fixed finite lead-time

The assumption of constant demand is consistent with the assumptions underlying the
EOQ formula. If suppliers take some time to provide goods, orders need to be placed
in advance of running out. Figure 4 illustrates the problem and its solution.

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Figure 4

If the lead-time is, say, 5 days, an order has to be placed before stocks have been
exhausted. Specifically, the order should be placed when there is still sufficient stock
to last 5 days, i.e:

Re-order level (ROL) = Demand in lead-time

So, if lead-time for a particular stock item is 5 days and daily demand is 30 units, the
re-order level would be 5 days at 30 units per day, 150 units.

Variable demand in the lead-time

If demand in lead-time varied, it could be described by means of some form of
probability distribution. Taking the previous example of the demand in lead-time
being 150 units, we’re considering the possibility of demand being more than 150 or
less than that. See Figure 5.
Note: This aspect of stock control produces a few problems. The EOQ formula
requires that demand (and lead-time) for a stock item be constant. Here the possibility
of demand varying or lead-time varying or both varying is introduced.
In these circumstances, a firm could place an order with a supplier when the stock fell
to 150 units (the average demand in the lead-time). However, there’s a 33% chance
(0.23 + 0.08 + 0.02 = 0.33) that demand would exceed this re-order level, and the
organisation would be left with a problem. It is therefore advisable to increase the re-
order level by an amount of ‘buffer stock’ (safety stock).
Buffer stock
Buffer stock is simply the amount by which ROL exceeds average demand in lead-
time. It is needed when there is uncertainty in lead-time demand to reduce the chance
of running out of stock and reduce the cost of such shortages.
If a ROL of 160 units was adopted, this would correspond to a buffer stock of 10 units
(and reduce the chance of running out of stock to 0.08 + 0.02 = 0.1, or 10%). A ROL
of 170 is equivalent to a buffer stock of 20 and reduces the chance of running out to
2%, and a ROL of 180 implies 30 units of buffer stock (and no chance of running
short).
Optimal Re-order Levels
This leaves the problem of how to calculate the optimal ROL. There are two common
ways in which one could determine a suitable re-order level (if the information was
available):

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 1) A tabular approach – Calculate, for each possible ROL (each level of buffer
stock) the cost of holding different levels of buffer stock and the cost incurred
if the buffer is inadequate (‘stock-out’ costs). The optimal re-order level is that
level at which the total of holding and stock-out costs are a minimum.
2) A ‘service level’ approach – An organisation has to determine a suitable level
of service (an acceptably small probability that it would run out of stock), and
would need to know the nature of the probability distribution for lead-time
demand. These two would be used to find a suitable ROL.

Formulae:

Q= 2CoD
CH
Where:
Q = Economic order quantity.
Co= Cost of placing one order
D = Periodic demand.
CH= Holding cost for one unit of stock for a period.

Lecture Example: EOQ

A Company purchases raw materials at cost of £16 per unit. The annual demand for
the raw material is 25,000 units. The holding cost per unit is £6.40 and the cost of
placing each order is £32.
Required:
Calculate the quantity that can be ordered to minimise the total cost.

Solution: EOQ

Q= 2CoD = (2x£32x25,000)/£6.40)
Ch
= 500 units.

ECONOMIC ORDER QUANTITY AND BULKY DISCOUNTS

The basic EOQ theorem assumes that materials are purchased at a constant cost per
unit. In real life, discounts are offered for purchasing in large quantities. If discounts
are available, there is a possibility of minimising the total costs at a minimum order
level to qualify for the discount. The total cost to be minimised include:
- Total material cost.
- Ordering cost, and
- Stock holding cost.

Steps
1. Calculate the total cost at the EOQ.
2. Calculate the total cost at different discount levels.
3. Compare and choose the level with a minimum total cost.

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Lecture Example: Bulky discounts
An item of stock costs £96 per unit with annual demand of 4,000 units and ordering
cost of £300 per order. Holding costs are 10% of purchases price. A supplier offers a
discount of 8% if orders are placed in 1,000 units.
Require:
Determine whether the discount is worth to take.

Solution: Bulky discounts

a. Total cost at EOQ:

EOQ = 2CoD = 2x£3,000x 4,000 = £2,400,000

CH £96x10% £9.60
= 500 units.

Costs analysis £
Purchase cost (4,000 x £96) 384,000
Ordering costs (£300 x (4,000/500)) 2,400
Holding costs £96 x 10% x (500/2) 2,400
Total cost 388,800

b. Total cost at 1,000 units (with discount)

Costs analysis £
Purchase cost (4,000 x £96 x 92%) 353,280
Ordering costs (£300 x (4,000/1,000)) 1,200
Holding costs £96 x 10% x 92% x (1,000/2) 4,416
Total cost 358,896

A Company will choose to order 1,000 units because this proves to be cheaper in total
cost. As a result, a saving of £29,904 (£388800 - £ 358,896) can be made if the
discount is taken.

MANAGEMENT OF DEBTORS
Debtors’ management involves all activities necessary to ensure that cash is collected
from credit customers within reasonable time.

Extending credit period might attract new customers and lead to an increase in
turnover. However, in order to finance this new credit facility, an organisation might
require a bank overdraft. A care needs to be taken, therefore, by the management to
strike a balance between the benefits of extending credit period and the costs arising
therefrom.

Therefore, the optimum level of trade credit extended represent a balance between:
a) Profit improvement from sale obtained by allowing credit; and
b) The cost of credit allowed.
i- Financing costs.
ii- Bad debts possibility.

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CREDIT POLICY
Management of debtors requires a credit policy be established, properly implemented
and continually monitored.

Management may resort to either of the following methods to manage its debtors:
 Strengthening business’s own credit control system.
 Debt factoring.
 Invoice discounting.
 Credit insurance.

CREDIT CONTROL SYSTEM

Effective credit control system will include the following procedure;
 Assessing customers credit worthiness.
This will involve checking the customer’s
i- Capital base, whether the customer has enough capital to meet the debt.
ii- Business culture, is a customer fond of defaulting payments?
iii- Collateral, which the company can turn to in case of a customer defaulting
payment.

The sources of credit reference will include: trade reference from existing
suppliers, bank reference, credit agencies, the press, court records, the DTI,
customer’s financial accounts and a personal customer visit.
 Setting credit limits, which should not be exceeded, except with a prior
authorisation from senior management.
 Clear communication to customers on their respective credit limits and credit
period.
 Offering a reasonable level of settlement discounts to encourage early payment.
 Keeping accurate records detailing all transactions with customers and the
amounts owing. This is normally executed by the use of aged debtors’ list, which
lists individual debtors’ balances with their respective length of time since they
became due. This list is useful to focus management’s focus on those balances that
are overdue.
 Issuing regular statements.
 Collection of overdue debts. This will include all steps taken to make sure that the
balances, which have not been after the expiry of the credit period, are collected to
minimize the rate of bad debts. Actions take will include; reminder letters,
telephone calls, withholding supplies, personal approach, using debt collection
agencies and trade association and legal action.

DEBT FACTORING
Debt factoring involves turning over the responsibility for collecting the company’s
debts to a specialist institution.

Depending on the debt financing deal agreed upon, a company can get up to three
services with the debt factor. These include:
1. Financing:

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 A factor normally provides a company with short-term finance based on the value
of its unpaid invoices. A factor will pay an agreed proportion of the value of new
invoices as soon as they are sent out to customers. The balance of the invoice
value, less factoring service charge, is repaid to the company when the debt is
eventually collected.

2. Administration of sales ledger:

A factor may also take over the responsibility for administering the client’s sale
ledger accounting, invoicing and debt collection procedure.

3. Credit protection
A factor might also agree to insure the debts of a company against bad debts risk.
On this arrangement, if the customer defaults payment, the factor takes the loss.
This is called ‘non-recourse’ factoring, whereby a factor can not turn to the
company for any bad debts arising. Otherwise, if no insurance against bad debt is
agreed by the factor, the arrangement is called ‘recourse’ or ‘with recourse’
whereby a company bears any bad debt arising.

Advantages of factoring
 Gives the company immediate access to cash, which help the company to pay for
its stocks and pay its supplies on time and hence take advantage of cash discounts.
 The company managers are relieved of the duty of keeping the sales ledger and
chasing for slow paying debtors, and instead concentrate their time on generation
of revenue.
 A factor also saves the administration costs of keeping the sales ledger and the
costs of debt collection.
 Growth can be financed through sales rather than injecting fresh external capital.
 Bad debts are minimised to a certain level or completely eliminated. Depending
on whether a ‘recourse’ or ‘non-recourse’ factoring is in place.
 The finance is secured by the debtors’ balance, hence leaving other assets such as
land and buildings for further debt finance.

Disadvantages of factoring
 Danger of loss of customers due to intervention of factor.
 Customers might doubt about the company’s liquidity and credibility because of
the use of factoring agencies.
 Loss of control. The company looses the decision power on its own customers.
 Costs. A factoring institution charge commission and finance charge on advance
which may prove to be expensive compared to other forms of shot-term financing.

Therefore, the decision to factor debts should be taken on cost benefit basis. This can
be demonstrated by the example below.

Lecture example: Debt Factoring

Cannors plc is a small engineering company with annual credit sales of £2m.
Recently, the company has witnessed increasing problem in its credit control
department. The average collection period for debtors has risen to 55 days, even
though the stated policy of the business is for payment within 30 days. Moreover, 1%

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of debtors are annually written off as bad debts. Connors plc has entered into
negotiations with a factor who is prepared to make an advance to the company
equivalent to 80% of trade debtors, based on the assumption that in the future,
customers will adhere to 30 day payment period. The interest rate for the advance will
be 11% per annum. Trade debtors are currently financed at 12%, through a bank
overdraft. The factor will take over the credit control procedure of the company. This
will not only lead to an annual saving of £15,000, but will also eliminate all bad debts.
The factor will, however, make a 2% charge of sales revenue for the provision of this
service.
Should Connors plc take advantage of the opportunity to factor its debts?

Solution: Debt Factoring

The solution will be made on the lower of cost existing credit policy and cost of
factoring.

Cost of existing credit policy £ £

Debtors' financing cost (50/365 x £2m x 12%) 32,877
Bad debts written off (2m x 1%) 20,000
52,877
Cost of factoring
Factor charges (£2m x 2%) 40,000
Factor finance charges (30/365 x £2m x 80% x 11%) 14,466
Overdraft charges (30/365 x £2m x 20% x 12%) 3,945
Less: cost savings (15,000)
43,411
Net savings fom factoring 9,466

∴ Connors Plc will benefit from entering into an agreement to factor its debts with the
agent.

INVOICE DISCOUNTING
Involves the company raising the money from specialized institution, and using its
invoices as security.

In invoice discounting, a company does not hand over administration of its credit
management procedures to invoice discounting institution.

The arrangement is, therefore, purely for cash. The discounting organisation advances
a certain proportion of invoice value (e.g. 75%), controls receipts of cash settling
those invoices and passes on the remaining 25% back to the company.

Under this arrangement, a risk on bad debts is also not passed over to the discounting
institution in anyway.

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