Working capital credit and accounts receivable management
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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.

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Working capital credit and accounts receivable management l.jpg
Working Capital, Credit and Accounts Receivable Management

Reference: ETM Chapter 6 & 7

STFM Chapter 5 & 6


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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


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Working Capital Cash Flow Cycle: Cash Conversion Cycle

Formulas for three time periods are necessary to calculate the cash conversion cycle.


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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


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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.


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Reasons to Offer Credit

  • Competition

  • Market Share

  • Promotion

  • Credit Availability to Customers

  • Customer Convenience

  • Profit


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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.


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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


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Analysis of Credit Extension

NPV = Sales – Collection Expense - Variable

1+(Cost of Cap. X Coll. Days) Costs

If NPV > 0 then Extend Credit


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Forms of Credit Extension

  • Installment Credit

  • Revolving Credit

  • Letters of Credit

  • Open Account


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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


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The Five C’s of Credit

  • Character

  • Capacity

  • Capital

  • Collateral

  • Conditions


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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.


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Cost of Trade Credit

Cost of Trade Credit =

Early Payment Discount x 365

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

(1 – Early Payment Discount) (Net Payment Period -

Discount Payment Period)


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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.


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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).


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DSO

  • Can give an indication of overall collection efficiency.

  • Changes in sales volume, payment patterns, or strong seasonablity in sales can distort DSO.


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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:


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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.


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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


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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.


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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:


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A/R Financing

  • Unsecured Bank Borrowing

  • Secured Bank Borrowing

  • Captive Finance Company

  • Third Party Financing Institutions

  • Credit Card

  • Factoring

  • Private Label Financing


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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


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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.


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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.


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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.


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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


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Collection Procedures

  • Companies tend to be more aggressive the larger the receivables balance

  • Companies understand the good-will tradeoff when selecting collection methods


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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


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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)


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