Working Capital, Credit and Accounts Receivable Management

Working Capital, Credit and Accounts Receivable Management Reference: ETM Chapter 6 & 7 STFM Chapter 5 & 6

Purchase of Materials Payment for Materials Sale of Product Collect A/R Days’ Receivables Days’ Payables Days’ Inventory Cash Conversion Cycle Day 1 Day 30 Day 45 Day 75 Cash Flow Cycle of a Business

Working Capital Cash Flow Cycle: Cash Conversion Cycle Formulas for three time periods are necessary to calculate the cash conversion cycle.

Credit Policy and Collections Order Order Sale Cash Placed Received Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts Disbursement < Payable > < Float > Invoice Payment Cash Received Sent 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 - Variable 1+(Cost of Cap. X Coll. Days) 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 • Consignment

The Five C’s of Credit • Character • Capacity • Capital • Collateral • Conditions

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

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: 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: If the company’s credit terms are net 60, the average past due is computed as follows:

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.

Age of Accounts A/R % of A/R 0 – 30 days $1,750,000 70% 31 – 60 days $375,000 15% 61 – 90 days $250,000 10% 91 + days $125,000 5% Total $2,500,000 100% 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

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.

Remaining A/R from Month Sales at End of March Remaining A/R as a % of Month Sales Month Sales Sales January $250,000 $50,000 20% 55% $300,000 $165,000 February 95% $400,000 $380,000 March $500,000 April 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 Balance Pattern The total outstanding A/R balance at the end of March is: $595,000 = ($50,000 + $165,000 + $380,000) The estimate of cash inflows for April = 5% of April sales + 40% of Marchsales + 35% of February sales + 20% of January sales:

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 • company’s overall cost of capital

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

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)

Working Capital, Credit and Accounts Receivable Management