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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

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working capital credit and accounts receivable management
Working Capital, Credit and Accounts Receivable Management

Reference: ETM Chapter 6 & 7

STFM Chapter 5 & 6

cash flow cycle of a business

Purchase of


Payment for


Sale of


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
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
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
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
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
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
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
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
Forms of Credit Extension
  • Installment Credit
  • Revolving Credit
  • Letters of Credit
  • Open Account
common terms of sales
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
The Five C’s of Credit
  • Character
  • Capacity
  • Capital
  • Collateral
  • Conditions
cost of trade credit
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 credit14
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
Annualized Cost of Trade Credit


 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
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).
  • 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
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
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 schedule20

Age of Accounts


% of A/R

0 – 30 days



31 – 60 days



61 – 90 days



91 + days






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
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 pattern22

Remaining A/R from Month Sales at End of March

Remaining A/R

as a % of Month Sales

Month 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 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
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
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
  • 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
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
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
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 procedures29
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
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
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)