SESSION 16 MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE

1601
OVERVIEW
Objective
To consider the factors involved in the granting and accepting of trade credit.






CREDIT
CONTROL
MANAGEMENT OF
ACCOUNTS
PAYABLE
INVOICE
DISCOUNTING
AND FACTORING
Invoice discounting
Debt factoring
SETTLEMENT
DISCOUNTS
Credit as a source of finance
Advantages of trade credit as
a source of finance
Granting credit
Credit periods and settlement discounts
Credit rating
Collection procedures
Charging interest on overdue invoices



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1 CREDIT CONTROL
1.1 Granting credit
Should credit be granted at all? Consider normal trade practice, but also consider
leading a change. Providing credit may stimulate sales.
What is the true cost to the business of customer credit? This will be influenced by the
risk of bad debts and the cost of financing accounts receivable.
1.2 Credit periods and settlement discounts
Credit periods can be changed to respond to competition but will be largely influenced
by trade custom.
Settlement discounts again influenced largely by accepted practice within the
industry. The company must ensure the discounts allowed expense does not exceed the
benefit in terms of reduced finance costs.
Having defined the credit periods and settlement discounts, the company must make
sure that customers are aware of them by stating the terms:
on orders;
on invoices;
on statements.
The settlement discount policy must be enforced, since some customers will attempt to
take the settlement discount whether they pay on time or not.
1.3 Credit rating
This is a crucial policy area. The company must balance the risk inherent in granting credit
against the necessity to allow enough credit to support the level of business.
Credit limits should be set for all accounts, based upon:
an assessment of the customers financial statements;
the use of credit rating agencies (e.g. Dun and Bradstreet);
contacting credit managers in other firms to exchange information;
references from the customers bank or accountant, although these may be of limited
value;
the impression of credit-worthiness gained when visiting customers premises and
meeting the management;
review of the aged accounts receivables ledger to identify customers who have
significant debts outstanding for long periods.
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1.4 Collection procedures
Establish timings for issuing letters of demand, making chasing telephone calls, and the
point when further deliveries should stop.
Ensure credit controllers liaise with sales management to avoid insensitive collection
procedures that may damage customer relations.
Consider using a stop list i.e. suspending supplies.
Decide when outside assistance is needed to collect overdue debts. Lawyers, trade
associations and debt collection agencies may be considered.
1.5 Charging interest on overdue invoices
Some powerful companies have a reputation for paying their small suppliers very slowly.
Therefore in November 1998 the UK government introduced the Late Payment Act.
This legislation allows small suppliers to charge large companies 8% above central bank
interest rate on invoices unpaid after 30 days.
2 INVOICE DISCOUNTING AND FACTORING
2.1 Invoice discounting
Definition

Selling selected sales invoices to a third party for a discounted cash sum.

The process is as follows:
A company issues an invoice to a customer and sends a copy to the discounter.
The discounter pays the company a percentage of the invoice value e.g. 90%, and takes
responsibility for collecting the debt from the customer.
The customer pays the discounter.
The discounter then pays the company the 10% balance due minus fees. Fees include
finance charges (linked to base rate) on the cash advance and often an administration
fee of 0.2% - 0.5% of invoice value.
The process operates with recoursei.e. the company keeps the risk of bad debts. Even
so companies will often find that they are only able to discount the invoices of
customers with high credit ratings.
Therefore discounting is most advantageous for companies which are selling to
customers with high credit ratings and a good payment record.

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2.2 Debt factoring
Definition

A range of services in the area of sales administration and the collection of
amounts due from customers


Debt factors may offer three closely integrated elements:
Accounting and collection the company is paid by the factor as customers settle their
invoices or after an agreed settlement period. The factor will maintain the sales ledger
accounting function.
Credit control the factor is responsible for chasing the customers and speeding up the
collection of debts.
Finance against sales the factor advances, e.g., 80% of the value of sales immediately
on invoicing.
Accounting and collection is often carried out together with credit control. The finance that
the factor then makes available is only taken if required, as it is typically slightly more
expensive than a bank overdraft.
Factoring is becoming increasingly competitive; generally, factors will act for customers with
turnover in excess of $100,000 and invoices over $100.
The usual fees are between 0.5%- 2.5% of invoice value, plus a charge for cash advances.
2.2.1 Advantages
Administrative savings;
Provides a flexible source of finance;
Obtain benefits from the factors economies of scale;
Obtain benefits from the factors expertise.
2.2.2 Disadvantage
Cost;
Loss of customer contact/goodwill;
Possible damage to company reputation.
2.2.3 Recourse vs. Non-recourse
Factoring with recourse bad debts remain the companys problem.
Non-recourse factoring bad debts are the factors problem in effect the company is
insured against bad debts. Fees are higher.
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Example 1 Factoring (service basis/admin only)

A plc makes annual credit sales of $2m. Customers take 60 days to pay and
bad debts are 1% of sales.
Factoring is being considered. The factor would charge a service fee of 2% of
sales per annum, reduce the accounts receivable collection period to 40 days,
and it would be a non-recourse agreement. Administration savings of $10,000
per annum would be made.
Required:
Assuming a cost of working capital of 15% per annum, what is the impact on
annual profit of the factoring option that is being considered?


Solution





Example 2 Factoring (with finance)

Tipsy Ltd has annual sales of $500,000 and accounts receivable days of 60. It
pays overdraft interest at 17%.
It is approached by a factor who offers:
Immediate finance of 80% of sales at 18% interest
A guaranteed collection period of 45 days
$8,000 of administration savings
A service fee of 2% of turnover
Required:
Calculate the impact on annual profit of using the factor.


Solution
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3 SETTLEMENT DISCOUNTS
In the UK it is common to offer credit customers a discount if they pay within a certain
number of days.
To decide if this is a good policy the cost of the discount must be compared to the cost of
financing accounts receivable e.g. overdraft rate.
To allow a fair comparison the cost of the discount must be expressed as an annual effective
cost.
Example 3

Customers normally take 60 days credit. A quick payment discount of 1.5% is
offered for payment within 20 days.
Required:
Calculate the annual effective cost of the discount and conclude whether the
discount should be offered if the overdraft rate is 15%.


Solution



Example 4

Dodgy Ltd has sales of $100,000 and accounts receivable days of 60. It pays
overdraft interest at 18%.
It is considering a discount of 2% to customers who pay within 10 days. It is
estimated that 50% of customers will take the discount.
Required:
Calculate the impact on annual profit of the discount.

Solution





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4 MANAGEMENT OF TRADE ACCOUNTS PAYABLE
4.1 Credit as a source of finance
Firms can use trade credit as a flexible source of short-term finance. The firm may even
decide to pay suppliers late.

Trade credit is not, however, without cost. For example:
possible loss of credit status such that the supplier might give low priority to the
firms future orders, with consequent disruption of activities;
the supplier may raise prices in order to compensate for the finance which he is
involuntarily supplying;
the firm may lose any discounts for prompt payment;
the annual effective cost of refusing a discount should be calculated. This should be
compared to the cost of financing working capital e.g. overdraft rate;
if the cost of refusing discount > overdraft rate then the discount should be accepted.
Example 5

A supplier offers a 2% discount if the invoice is paid within 10 days of receipt,
but offers no discount if the payment is delayed for a further 20 days.
Required:
Calculate the annual effective cost of refusing the discount.

Solution
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Example 6

A company currently takes 40 days credit from its suppliers, believing this to
be free finance.
Annual purchases are $100,000 and the company pays overdraft interest at
13%.
Payment within 15 days would attract a 1 % quick settlement discount.
Required:
Calculate the effect on the profit and loss account of accepting the discount.

Solution






4.2 Advantages of trade credit as a source of finance
Convenient and informal.
Can be used if unable to obtain credit from financial institutions.
If settlement discount s are taken, it can result in a cheap source of financing as a
period of time is still allowed before payment.
Can be used on a short-term basis to overcome unexpected cash flow crises.
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Key points

Many exam questions on this area require candidates to use working
capital management ratios in reverse e.g. to re-arrange the formula for
accounts receivable days and then use it to move from the sales figure to
the estimated level of receivables.
The other key technique is to calculate the Annual Effective Cost of
settlement discounts. Use compound interest, not simple and bring a
scientific calculator to the exam.



FOCUS
You should now be able to:

explain the role of accounts receivable in the working capital cycle;
explain how the credit-worthiness of customers may be assessed;
explain the role of factoring and invoice discounting;
explain the role of settlement discounts.
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EXAMPLE SOLUTIONS
Solution 1 Factoring (admin. only)
Annual (costs)/
savings
$
Administration savings
Bad debt reduction
Factors fee
Reduction in financing cost (W)
10,000
20,000
(40,000)
16,438

______
Net annual saving 6,438

______

WORKING
Reduction in cost of financing working capital
$
Current average accounts receivable 2,000,000
365
60

328,767
Revised average accounts receivable 2,000,000
365
40

(219,178)

_______

One-off cash flow improvement 109,589

Annual saving thereon at 15% 16,438
_______


Solution 2 Factoring (with finance)
Current accounts receivable

000 , 500
365
60
= 82,192
Finance cost (82,192 17%) = 13,973
New accounts receivable

000 , 500
365
45
= 61,644
$
Finance by factor = 61,644 80% 18%
Finance by overdraft = 61,644 20% 17%
8,877
2,096
______
10,973
______

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P & L impact:
$
Reduced interest expense (13,973 10,973)
Saved admin expense
Service fee (500,000 2%)
3,000
8,000
(10,000)

Increased profits

______
1,000
______
Solution 3 Settlement discount
It costs 1.5% to receive 98.5% of accounts receivable 40 days sooner.
40 day interest rate =
5 . 98
5 . 1
= 1.52%
Annual effective rate =
40
365
0152 . 1 1 = 1.0152
9.125
1 = 14.8%
Conclusion: This is below the overdraft rate and therefore the discount should be offered.
Note the annual effective rate has been calculated above using compound interest to compare to the
cost of overdraft where interest is also charged on a compound basis. However the examiner has
said that he would also accept the use of simple interest i.e. 1.52% 9.125 = 13.87%
Solution 4 Settlement discount
Current accounts
receivable
=
100,000
365
60
= 16,438
New accounts
receivable
=
(100,000 50%
365
10
) + (100,000 50%
365
60
)
= 1,370 + 8,219
= 9,589
$
Reduced interest expense (16,438 9,589) 18%
Discounts allowed expense 100,000 50% 2%
1,233
(1,000)

Increased profit

_____
233
_____

Note - This solution follows the examiners approach as shown in the Pilot Paper and in his
book Corporate Finance Principles and Practice (Denzil Watson and Antony Head)
However there is a strong argument that the new level of accounts receivable should be
stated net of discounts allowed i.e.
(100,000 50% 98%
365
10
) + (100,000 50%
365
60
) = 9, 561.
The examiner has stated that he would accept this variation.
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Solution 5 Supplier finance
If a company receives an invoice of $1,000 under the terms in the example, and decides to
pay after 30 days it will:
-lose the 2% discount.
-effectively have the use of $980 ($1,000 $20) for the additional 20 days.
This is an equivalent compound rate of pa % 6 . 44 1
980
20
1
20 / 365
=

+
This should be compared with the cost of financing working capital. Trade credit can
therefore be a very expensive form of financing when a cash discount is offered but refused.
Solution 6 Discount
Current accounts payable = 100,000
365
40
= 10,959
New accounts payable = 100,000
365
15
= 4,110
$
Increased interest expense (4,110 10,959) 13%
Discounts received (100,000 1%)
(890)
1,500

Increase in profit

_____
610
_____
Conclusion: The discount should therefore be accepted.