Working Capital, Credit and Accounts Receivable Management

Reference: ETM Chapter 6 & 7 STFM Chapter 5 & 6

Cash Flow Cycle of a Business

Purchase of Materials Payment for Materials Sale of Product Collect A/R

Days Inventory Days Payables Days Receivables Cash Conversion Cycle

Day 1 Day 30 Day 45 Day 75

Working Capital Cash Flow Cycle: Cash Conversion Cycle

Formulas for three time periods are necessary to calculate the cash conversion cycle. Inventory Days' Inventory = 365 Days Cost of Goods Sold

Days' Receivables

Accounts Receivable 365 Days Annual Sales

Days' Payables

Accounts Payable = 365 Days Cost of Goods Sold

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

Credit Policy and Collections

Order Placed

Order Received < Inventory >

Sale Accounts Collection < Receivable > < Float >

Cash Received

Time ==> Accounts < Payable > Invoice Received Disbursement < Float > Payment Sent

Cash Paid

Objectives of Credit Management

Creating, preserving, and collecting A/R. Establishing and communicating credit policies. Evaluation of customers and setting credit lines. Ensuring prompt and accurate billing. Maintaining up-to-date records of accounts receivables. Initiating collection procedures on overdue accounts.

Reasons to Offer Credit

Competition Market Share Promotion Credit Availability to Customers Customer Convenience Profit

Credit and A/R Management:

Fit Into the Financial Organization

A credit manager or a captive finance company is the administrator of credit policies. Credit policies and collections will impact cash flows so credit and cash managers must work together. Reasons for credit and cash manager interaction include the accuracy of cash flow forecast, banking network management, and accounts receivable updating.

Cost Associated With a Credit Policy

Credit Department Costs Credit Evaluation Costs A/R Carrying Cost Discounted Payments Selling and Production Cost Collection Expenses Bad Debts

Analysis of Credit Extension

NPV = Sales Collection Expense 1+(Cost of Cap. X Coll. Days)

- Variable Costs

If NPV > 0 then Extend Credit

Forms of Credit Extension

Installment Credit Revolving Credit Letters of Credit Open Account

Common Terms of Sales

Cash Before Delivery (CBD) Cash on Delivery (COD) Cash Terms Net Terms Discount Terms Monthly Billing Bill of Lading or Documentary Collection Seasonal Dating

The Five Cs of Credit

Character Capacity Capital Collateral Conditions

Cost of Trade Credit

From a sellers viewpoint, the cost of the discount must be weighted against the benefit of receiving early payment. From buyers viewpoint, the cost of trade credit is an opportunity cost. A buyer should take the discount if its cost of borrowing is less than the cost of foregoing the discount. Alternatively, a buyer should forego the discount if investment rates are higher than the cost of foregoing the discount.

Cost of Trade Credit

Cost of Trade Credit =
Early Payment Discount x 365

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

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

(1 Early Payment Discount)

(Net Payment Period Discount Payment Period)

Annualized Cost of Trade Credit

Example Assuming terms of 2/10, net 45, the cost of not taking the discount can be determined as follows:
Cost of Trade Credit = Early Pmt Discount 365 v 1 - Early Pmt Discount Net Pmt Period - Discount Pmt Period .02 365 .02 365 v v = = .0204081 v 10.428571 1 - .02 45 - 10 .98 35

= .2128 = 21.28%

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

Account Receivable Monitoring and Control

Monitoring and control is the responsibility of the credit manager. Receivables turnover
least favored technique

Monitoring conducted on individual accounts through aging schedules. Monitoring conducted at the aggregate level using days sales outstanding (DSO).

DSO

Can give an indication of overall collection efficiency. Changes in sales volume, payment patterns, or strong seasonablity in sales can distort DSO.

Days Sales Outstanding (DSO)

Assume that a company has outstanding receivables of $350,000 at the end of the first quarter and credit sales of $425,000 for the quarter. Using a 90-day averaging period, the DSO for this company can be computed as follows:
Avg. Daily Credit Sales = Sales During Period $425,000 = = $4,722.22 Number of Days in Period 90 Outstanding A/R $350,000 = = 74.11 Days Avg. Daily Credit Sales $4,722.22

DSO =

If the companys credit terms are net 60, the average past due is computed as follows:
Average Past Due = DSO - Avg. Days of Credit Terms = 74.11 Days - 60 Days = 14.11 Days

Aging Schedule
Is a list of the percentage and/or amounts of outstanding A/R classified as current or past due. Used primarily to identify past due accounts. Can be prepared at the aggregate level or customer-by-customer. Subject to distortions due to sales variations.

Aging Schedule
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
Age of Accounts
0 30 days 31 60 days 61 90 days 91 + days Total

A/R
$1,750,000 $375,000 $250,000 $125,000 $2,500,000

% of A/R
70% 15% 10% 5% 100%

A/R Balance Pattern

Gives the percent of credit sales in a time period that remains oustanding at the end of each time period. Based on aging schedules. It is not directly affected by sales variations. A useful tool in cash flow forecasting because it can be used to project A/R levels and collections.

A/R Balance Pattern

Month Sales
January February March April

Sales
$250,000 $300,000 $400,000 $500,000

Remaining A/R from Month Sales at End of March

$50,000 $165,000 $380,000

Remaining A/R as a % of Month Sales

20% 55% 95%

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 March sales + 35% of February sales + 20% of January sales: Estimated April inflows = (0.05 x $500,000) + (0.40 x $400,000) + (0.35 x $300,000) + (0.20 x $250,000) = $340,000

A/R Financing
Unsecured Bank Borrowing Secured Bank Borrowing Captive Finance Company Third Party Financing Institutions Credit Card Factoring Private Label Financing

Evaluate Changes in Credit Policy

Credit term change decision variables

effect on dollar profits sales effect receivables effect return on investment effect
default probability

credit limits opportunity cost of funds invested in receivables companys overall cost of capital

Cash Application

Cash application is the process of matching and applying a customers payment against accounts receivable. Done via an Open Item or a Balance Forward system.

Open Item System

Used in commercial transactions. Each invoice is recorded separately in an account receivable file. Payments are matched to the particular invoice in the file.

Balance Forward System

Used in retail applications. Credit limits are established for each individual. As purchases are made, A/R increase. Payments are applied against the aggregate A/R outstanding.

Collection Procedures
Typical collection effort

initial contact within 10 days of delinquency then reminder letter followed by phone call sales force notified last resort, reference to collection agency/legal action

Collection agency

Phase 1 - computer generated collection letter, when accounts are 45 to 90 days past due Phase 2 - commissioned collectors used

Collection Procedures
Companies tend to be more aggressive the larger the receivables balance Companies understand the good-will tradeoff when selecting collection methods

International Credit Management

Credit policy analysis

lengthening terms increases exchange rate risk also increases default risk harder to get D&B reports harder to get bank credit information

Modifying monitoring and collections

legal remedies for late payment or nonpayment differ by country

Legislation Affecting Credit and Collections

Robison-Patman Act (1936) Usuary Laws Truth in Lending Act (1969) Fair Credit Reporting Act (1971) Fair Credit Billing Act (1975) Equal Credit Opportunity Act (1975) Fair Debt Collection Practice Act (1978)