ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 4: Management of working capital: inventory control
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Category C inventory items, for which inventory holding costs are low and
insignificant. Holding excessive amounts of these inventory items would not
affect costs significantly.
The ABC approach to inventory control is to control each category of inventory
differently, and apply the closest control to those items in the most costly category,
A. For example:
Category A items might be controlled by purchasing the EOQ as soon as the
inventory level falls to a set reorder level.
Category B items might be controlled by a periodic review system, with orders
placed to restore the inventory level to a maximum level.
Category C items might be purchased in large quantities, and controlled by
means of a two-bin system.
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Paper F9
Financial management
CHAPTER
5
Management of receivables
and payables
Contents
1 Costsandbenefits ofgivingcredit
2 Themanagementoftradereceivables
3 Debtfactorsandinvoicediscounting
4 Settlementdiscounts
5 Managementofworkingcapitalforforeigntrade
6 Managementoftradepayables
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Costs and benefits of giving credit
Benefits of giving credit
Cost of giving credit
1 Costs and benefits of giving credit
Business entities that sell to other businesses normally sell on agreed credit terms.
Often ‘standard’ credit terms are applied for most business transactions, such as 30
days or 60 days from the date of the invoice. Most sales to consumers are for cash,
but some businesses might even sell to consumers on credit.
It is generally assumed that if customers are allowed time to pay what they owe, they
will take the full period of credit. For example, if a customer is allowed 30 days to pay
an invoice, it is generally assumed that the customer will not pay until day 30.
1.1 Benefits of giving credit
By giving credit, sales volume will be higher. Higher sales volumes result in higher
contribution, and higher profit.
If a business does not give credit to customers, customers are likely to buy from
competitors who do offer credit.
1.2 Cost of giving credit
There are several costs of giving credit.
Finance costs: There is a finance cost. Trade receivables must be financed. The
longer the period of credit allowed to customers, the bigger the investment in
working capital must be. The cost of investing in trade receivables is usually
calculated as: Average trade receivables in the period × Cost of capital for the
period
Bad debt costs: Selling on credit creates a risk that the customer might never pay
for the goods supplied. The cost of bad debts is usually measured as the amount
of sales revenue due from the customers, that is written off as non-collectable.
Administration costs: Additional administration costs might be incurred in
negotiating credit terms with customers, and monitoring the credit position of
customers. In dealing with problems about the cost of trade receivables, you
should consider only the incremental administration costs incurred as a
consequence of providing credit.
Example
Green Company currently offers customers 30 days’ credit. Annual credit sales are
$12 million, the contribution/sales ratio is 25% and bad debts are 1% of sales. The
company has estimated that if it increased credit to 60 days, total annual sales
would increase by 10%, but bad debts would rise to 1.5% of sales. The cost of capital
for Green Company is 9%.
Chapter 5: Management of receivables and payables
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Assume that a year has 360 days.
Required
Estimate the effect on annual profit of increasing the credit period from 30 to 60
days.
Answer
Annual sales will increase from $12 million to $13.2 million.
$
Currentaveragereceivables 30/360×$12million 1,000,000
Averagereceivableswith creditof60days 60/360×$13.2million 2,200,000
Increaseinaveragereceivables 1,200,000
Annual interest cost of increase in trade receivables = $1,200,000 × 9% = $108,000.
$ $
Annualcontributionwithcredit30days3,000,000
Annualcontributionwithcredit60days3,300,000
Increaseinannualcontribution300,000
Baddebtswithcredit30days(1%×$12million) 120,000
Baddebtswithcredit60days(1.5%×$13.2million) 198,000
Increaseinbaddebts 78,000
Annualinterestcostofextrareceivables 108,000
Totalextracostoflongercredit186,000
Netannualgainfromincreasingcreditto60days114,000
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The management of trade receivables
Giving credit
Monitoring payments
Efficient collection of debts
Bad debts and reducing bad debts
2 The management of trade receivables
Giving credit to customers results in higher costs, in particular higher interest costs
and some bad debts. These costs must be kept under control. To do this, trade
receivables must be properly managed.
Good management of trade receivables involves systems for:
deciding whether to give customers credit, and how much credit to give them
monitoring payments
collecting overdue payments.
2.1 Giving credit
There should be procedures for deciding whether to give credit to a customer, and if
so, how much. The procedures should differ between existing customers wanting
extra credit, and new customers asking for credit for the first time. This is because
existing customers already have a credit history. A company knows from experience
whether an existing customer is likely to pay on time, or might have difficulty with
payments.
When deciding whether or not to give extra credit to an existing customer, the
decision can therefore be based largely on whether the customer has paid promptly
in the past, and so whether on the basis of past performance the customer appears
to be a good credit risk.
For new business customers, a variety of credit checks might be carried out.
Asking for trade references from other suppliers to the customer who already
give credit
Asking for a reference from the customer’s bank
Making credit checks to discover whether any court judgements have been made
against the customer for non-payment of debts
Credit checks on small businesses can be purchased from credit reference
agencies
For business customers, asking for a copy of the most recent financial statements
and carrying out a ratio analysis. Banks can usually persuade a business
customer to provide a copy of its financial statements for decisions about
granting a bank loan; but it is much more difficult for non-banks to do so, for
decisions about giving trade credit
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Using reports from the company’s salesmen. If a company sales representative
has visited the business premises of the customer, a report about the apparent
condition of the customer’s business might be used to decide about whether or
not to offer credit.
Usually, a company establishes credit policy guidelines that should be followed
when giving credit to a new business customer. For example, a company might
have a credit policy that for a new business customer, subject to a satisfactory credit
check, it would be appropriate to offer credit for up to $2,000 for 30 days. This credit
limit might then be reviewed after several months, if the customer pays invoices
promptly within the credit terms.
The credit terms set for each customer will consist of:
A credit period: The customer should be required to pay invoices within a stated
number of days. Credit limits of 30 days or 60 days are common.
A credit limit: This is the maximum amount of credit that the customer will be
permitted. The limit is likely to be small at first for a new customer, increasing as
the trading relationship develops.
Interest charges on overdue payments: It might also be a condition of giving
credit that the customer agrees to pay interest on any overdue payment.
However, interest charges on late payments can create bad feeling, and
customers who are charged interest might take their business to a rival supplier.
Interest charges on late payments are therefore uncommon in practice.
(Note: Credit checks on individuals should be carried out by companies that give
credit to customers, such as banks and credit card companies. Many companies,
however, might give credit to corporate customers but ask for cash payment/credit
card payment from individuals.)
2.2 Monitoring payments
A company should have a system for monitoring payments of invoices by
customers. A regular report should be produced listing the unpaid debts, and which
of these are overdue. This report might be called an ‘aged debtors list’.
A typical report might summarise the current position by showing how much
money is owed by customers and for how long the money has been owed. A simple
example of a summary is shown below.
Total 0 – 30 days 31 – 60 days 60 – 90 days Over 90
days
$ $ $ $ $
Receivable 17,894,100 12,506,900 4,277,200 1,045,000 65,000
The report will also provide a detailed list of the unpaid invoices in each time
period. By monitoring regular reports, the team responsible for collecting payments
can decide which customers to ‘chase’ for payment and also to assess whether
collections of receivables is under control. In the example above, if the company has
normal credit terms of 30 days, it might be concerned that such a large amount of
receivables – over $5 million, remain unpaid after 30 days.
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2.3 Efficient collection of debts
When credit is given to customers, there should be efficient procedures for ensuring
that customers pay on time, and that action is taken to obtain overdue payments.
Procedures for efficient debt collection include the following:
sending invoices to customers promptly, as soon as the goods or services have
been provided.
sending regular statements to credit customers, showing how much they owe in
total and how much is currently due for payment. Statements act as a reminder
to customers to make a payment.
ensuring that credit terms are not exceeded, and the customer is not allowed to
take longer credit or more credit than agreed.
Procedures for chasing overdue payments include:
telephone calls
reminder letters
taking a decision to withhold further supplies and further credit until an
overdue debt is paid.
In extreme cases, measures might include:
using the services of a debt collection agency.
sending an official letter from a solicitor, threatening legal action.
legal action – obtaining a court judgement against the customer to force the
customer to pay. This is a measure of last resort, to be taken only when there is a
breakdown in the trading relationship.
2.4 Bad debts and reducing bad debts
When a company gives credit, there will be some bad debts. Bad debts are an
expense in the income statement and have a direct impact on profitability. A
company should try to minimise its bad debts, whilst accepting that even with
efficient collection procedures some losses are unavoidable. For example some
customers might become insolvent and go out of business still owing money.
There are several ways in which bad debts can be reduced:
More extensive and careful credit checking procedures when deciding whether
to give credit to customers
More efficient collection procedures
Reducing the amount of credit in total. As the total amount of credit given to
customers increases, there will be an increase in the cost of bad debts, and the
proportion of receivables that become bad debts. Reducing the total amount of
credit will therefore reduce bad debts. However reducing the amount of credit to
customers will probably result in lower sales revenue and lower gross profit.
Chapter 5: Management of receivables and payables
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Example
A company has annual sales of $20 million and all customers are given credit of 60
days. Gross profit on sales is 40%. Currently bad debts are 1.5% of sales. The cost of
capital for the company is 10%.
Management is concerned about the high level of bad debts and they estimate that
by reducing credit terms to 30 days for all customers, bad debts can be reduced to
0.5% of sales. However total sales revenue is likely to fall by 5% as a consequence of
making the credit terms less generous.
Required
Calculate the estimated effect on annual profit of reducing the credit terms from 60
days to 30 days.
Answer
Current situation
Annual gross profit on current level of sales = 40% × $20 million = $8,000,000.
Current average trade receivables = (60/365) × $20 million = $3.29 million.
Current level of bad debts = 1.5% × $20 million = $300,000
$
Cost of investment in trade receivables (10% × $3.29 million)
329,000
Cost of bad debts 300,000
629,000
Consequences of reducing credit to 30 days
Average trade receivables = (30/365) × 95% of $20 million = $1.56 million.
Bad debts = 0.5% × 95% of $20 million = $95,000
$
Fall in gross profit (5% × $8,000,000)
400,000
Cost of investment in trade receivables (10% × $1.56 million)
156,000
Cost of bad debts 95,000
651,000
The effect of offering stricter credit terms would be to reduce annual profit by
$22,000 (651,000 – 629,000) due to the loss in sales and gross profit that would occur.
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Debt factors and invoice discounting
Debt factors and the services they provide
The costs of factoring services
Benefits and disadvantages of using a factor
Evaluation of a factor’s services
Invoice discounting
3 Debt factors and invoice discounting
3.1 Debt factors and the services they provide
Companies might use a factoring organisation to assist with the management of
receivables and also to help with the financing of receivables.
Debt factors are specialist organisations. They specialise in:
assisting client firms to administer their trade receivables ledger
providing short-term finance to client firms, secured by the trade receivables
in some cases, providing insurance against bad debts.
The services of a debt factor can be particularly useful for a small-to-medium-sized
company that:
has a large number of credit customers
does not have efficient debt collection procedures and therefore has a fairly high
level of bad debts, and
does not have sufficient finance for its working capital.
A debt factor offers three main services to a client business:
the administration of the client’s trade receivables
credit insurance
debt finance.
Trade receivables administration
A factor will take over the administration of trade receivables on behalf of a client. It
sends out invoices on behalf of the client. Each invoice shows that the factor has
issued the invoice, and the invoice asks for payment to be made to a bank account
under the control of the factor. The factor collects the payments, and chases
customers who are late with payment. The factor is also responsible for the client’s
trade receivables ledger, recording details of invoices and payments received in the
ledger on behalf of the client.