Working Capital, Credit and Working Capital, Credit and Accounts Receivable Accounts Receivable ManagementManagement

FRESH CLASSES OF ICAPFRESH CLASSES OF ICAP MODULE B MODULE B

FINANCIAL ACCOUNTING & FINANCIAL ACCOUNTING & ECONOMICS.ECONOMICS.

MODULE D COST ACCOUNTING.MODULE D COST ACCOUNTING. KHALID AZIZKHALID AZIZ 0322-33857520322-3385752

FRESH CLASS OF PIPFAFRESH CLASS OF PIPFA

FOUNDATION FOUNDATION INTERMEDIATEINTERMEDIATE FINALFINAL

KHALID AZIZKHALID AZIZ 0322-33857520322-3385752

Cash Flow Cycle of a Cash Flow Cycle of a BusinessBusiness

Purchase ofMaterials

Payment forMaterials

Sale ofProduct Collect A/R

Days’ Inventory

Cash Conversion Cycle

Days’ Receivables

Days’ Payables

Day 1 Day 30 Day 45 Day 75

Working Capital Cash Flow Working Capital Cash Flow Cycle: Cycle: Cash Conversion CycleCash Conversion Cycle

InventoryDays' Inventory = × 365 Days

Cost of Goods Sold

Accounts ReceivableDays' Receivables = × 365 DaysAnnual Sales

Accounts PayableDays' Payables = × 365 Days

Cost of Goods Sold

Cash Conversion Cycle = Days' Inv. + Days' Recs. - Days' Payables

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

Credit Policy and Credit Policy and CollectionsCollections

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid

OrderOrder Order Order Sale Sale Cash Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent PaidReceived Sent Paid

Objectives of Credit Objectives of Credit ManagementManagement

Creating, preserving, and collecting A/R.Creating, preserving, and collecting A/R. Establishing and communicating credit policies.Establishing and communicating credit policies. Evaluation of customers and setting credit Evaluation of customers and setting credit

lines.lines. Ensuring prompt and accurate billing.Ensuring prompt and accurate billing. Maintaining up-to-date records of accounts Maintaining up-to-date records of accounts

receivables.receivables. Initiating collection procedures on overdue Initiating collection procedures on overdue

accountsaccounts..

Reasons to Offer CreditReasons to Offer Credit

CompetitionCompetition Market ShareMarket Share PromotionPromotion Credit Availability to CustomersCredit Availability to Customers Customer ConvenienceCustomer Convenience ProfitProfit

Credit and A/R Management:Credit and A/R Management:Fit Into the Financial OrganizationFit Into the Financial Organization

A credit manager or a captive finance company A credit manager or a captive finance company is the administrator of credit policies.is the administrator of credit policies.

Credit policies and collections will impact cash Credit policies and collections will impact cash flows so credit and cash managers must work flows so credit and cash managers must work together.together.

Reasons for credit and cash manager Reasons for credit and cash manager interaction include the accuracy of cash flow interaction include the accuracy of cash flow forecast, banking network management, and forecast, banking network management, and accounts receivable updating.accounts receivable updating.

Cost Associated With a Cost Associated With a Credit PolicyCredit Policy

Credit Department CostsCredit Department Costs Credit Evaluation CostsCredit Evaluation Costs A/R Carrying CostA/R Carrying Cost Discounted PaymentsDiscounted Payments Selling and Production CostSelling and Production Cost Collection ExpensesCollection Expenses Bad DebtsBad Debts

Analysis of Credit Analysis of Credit ExtensionExtension

NPV = NPV = Sales – Collection Expense Sales – Collection Expense - - VariableVariable

1+(Cost of Cap. X Coll. Days) Costs1+(Cost of Cap. X Coll. Days) Costs

If NPV > 0 then Extend CreditIf NPV > 0 then Extend Credit

Forms of Credit ExtensionForms of Credit Extension

Installment CreditInstallment Credit Revolving CreditRevolving Credit Letters of CreditLetters of Credit Open AccountOpen Account

Common Terms of SalesCommon Terms of Sales

Cash Before Delivery (CBD)Cash Before Delivery (CBD) Cash on Delivery (COD)Cash on Delivery (COD) Cash TermsCash Terms Net TermsNet Terms Discount TermsDiscount Terms Monthly BillingMonthly Billing Bill of Lading or Documentary CollectionBill of Lading or Documentary Collection Seasonal DatingSeasonal Dating ConsignmentConsignment

The Five C’s of CreditThe Five C’s of Credit CharacterCharacter CapacityCapacity CapitalCapital CollateralCollateral ConditionsConditions

Cost of Trade CreditCost of Trade Credit

From a seller’s viewpoint, the cost of the From a seller’s viewpoint, the cost of the discount must be weighted against the benefit discount must be weighted against the benefit of receiving early payment.of receiving early payment.

From buyer’s viewpoint, the cost of trade From buyer’s viewpoint, the cost of trade credit is an opportunity cost.credit is an opportunity cost.

A buyer should take the discount if its cost of A buyer should take the discount if its cost of borrowing is less than the cost of foregoing borrowing is less than the cost of foregoing the discount.the discount.

Alternatively, a buyer should forego the Alternatively, a buyer should forego the discount if investment rates are higher than discount if investment rates are higher than the cost of foregoing the discount.the cost of foregoing the discount.

Cost of Trade CreditCost of Trade Credit

Cost of Trade Credit =Cost of Trade Credit =

Early Payment Discount x 365Early Payment Discount x 365

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

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

Annualized Cost of Trade Annualized Cost of Trade Credit Credit Example

 Assuming terms of 2/10, net 45, the cost of not taking the discount can be determined as follows:

21.28% = .2128 =

10.428571 .0204081 = 35

365.98.02 =

10 -45365

.02 - 1.02

=

PeriodPmt Discount - PeriodPmt Net 365

DiscountPmt Early - 1DiscountPmt Early

=Credit Trade ofCost

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 Account Receivable Monitoring and ControlMonitoring and Control

Monitoring and control is the responsibility of Monitoring and control is the responsibility of the credit manager.the credit manager.

Receivables turnoverReceivables turnoverleast favored techniqueleast favored technique

Monitoring conducted on individual accounts Monitoring conducted on individual accounts through through aging schedulesaging schedules..

Monitoring conducted at the aggregate level Monitoring conducted at the aggregate level using using days’ sales outstandingdays’ sales outstanding (DSO). (DSO).

DSODSO

Can give an indication of overall Can give an indication of overall collection efficiency.collection efficiency.

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

Days’ Sales Days’ Sales Outstanding (DSO) Outstanding (DSO) Assume that a company has outstanding receivables of Assume that a company has outstanding receivables of Rs350,000 at the end of the first quarter and credit sales of Rs350,000 at the end of the first quarter and credit sales of Rs425,000 for the quarter. Using a 90-day averaging period, Rs425,000 for the quarter. Using a 90-day averaging period, the DSO for this company can be computed as follows:the DSO for this company can be computed as follows:

Sales During Period $425,000Avg. Daily Credit Sales = = = $4,722.22Number of Days in Period 90

Outstanding A/R $350,000DSO = = = 74.11 DaysAvg. Daily Credit Sales $4,722.22

Average Past Due = DSO - Avg. Days of Credit Terms

= 74.11 Days - 60 Days = 14.11 Days

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

Aging ScheduleAging Schedule

Is a list of the percentage and/or amounts of Is a list of the percentage and/or amounts of outstanding A/R classified as current or past outstanding A/R classified as current or past due.due.

Used primarily to identify past due accounts.Used primarily to identify past due accounts. Can be prepared at the aggregate level or Can be prepared at the aggregate level or

customer-by-customer.customer-by-customer. Subject to distortions due to sales variations.Subject to distortions due to sales variations.

Aging ScheduleAging Schedule

Age of Accounts A/R % of A/R0 – 30 days

31 – 60 days

61 – 90 days

91 + days

Total

Rs1,750,000

Rs375,000

Rs250,000

Rs125,000

Rs2,500,000

70%

15%

10%

5%

100%

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 PatternA/R Balance Pattern

Gives the percent of credit sales in a time Gives the percent of credit sales in a time period that remains outstanding at the end of period that remains outstanding at the end of each time period.each time period.

Based on aging schedules.Based on aging schedules. It is not directly affected by sales variations.It is not directly affected by sales variations. A useful tool in cash flow forecasting because A useful tool in cash flow forecasting because

it can be used to project A/R levels and it can be used to project A/R levels and collections.collections.

A/R Balance PatternA/R Balance Pattern

Month Sales Sales

Remaining A/R from Month Sales

at End of March

February

January

March

April

Rs250,000

Rs300,000

Rs400,000

Rs500,000

20%

55%

95%

Remaining A/Ras a % of

Month Sales

Rs50,000

Rs165,000

Rs380,000

The total outstanding A/R balance at the end of March is:Rs595,000 = (Rs50,000 + Rs165,000 + Rs380,000)

The estimate of cash inflows for April = 5% of April sales + 40% of Marchsales + 35% of February sales + 20% of January sales:

Estimated April inflows = (0.05 x Rs500,000) + (0.40 x Rs400,000)+ (0.35 x Rs300,000) + (0.20 x Rs250,000) = Rs340,000

A/R FinancingA/R Financing

Unsecured Bank BorrowingUnsecured Bank Borrowing Secured Bank BorrowingSecured Bank Borrowing Captive Finance CompanyCaptive Finance Company Third Party Financing InstitutionsThird Party Financing Institutions Credit CardCredit Card FactoringFactoring Private Label FinancingPrivate Label Financing

Evaluate Changes in Evaluate Changes in Credit PolicyCredit Policy

Credit term change decision variablesCredit term change decision variables effect on dollar profitseffect on dollar profits sales effectsales effect receivables effectreceivables effect return on investment effectreturn on investment effect default probabilitydefault probability credit limitscredit limits opportunity cost of funds invested in receivablesopportunity cost of funds invested in receivables company’s overall cost of capitalcompany’s overall cost of capital

Cash ApplicationCash Application

Cash applicationCash application is the process of is the process of matching and applying a customer’s matching and applying a customer’s payment against accounts receivable.payment against accounts receivable.

Done via an Done via an Open ItemOpen Item or a or a Balance Balance ForwardForward system. system.

Open Item SystemOpen Item System

Used in commercial transactions.Used in commercial transactions. Each invoice is recorded separately in Each invoice is recorded separately in

an account receivable file.an account receivable file. Payments are matched to the particular Payments are matched to the particular

invoice in the file.invoice in the file.

Balance Forward SystemBalance Forward System

Used in retail applications.Used in retail applications. Credit limits are established for each Credit limits are established for each

individual.individual. As purchases are made, A/R increase.As purchases are made, A/R increase. Payments are applied against the Payments are applied against the

aggregate A/R outstanding.aggregate A/R outstanding.

Collection ProceduresCollection Procedures

Typical collection effortTypical collection effort initial contact within 10 days of delinquencyinitial contact within 10 days of delinquency then reminder letter followed by phone callthen reminder letter followed by phone call sales force notifiedsales force notified last resort, reference to collection agency/legal actionlast resort, reference to collection agency/legal action

Collection agencyCollection agency Phase 1 - computer generated collection letter, when Phase 1 - computer generated collection letter, when

accounts are 45 to 90 days past dueaccounts are 45 to 90 days past due Phase 2 - commissioned collectors usedPhase 2 - commissioned collectors used

Collection ProceduresCollection Procedures

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

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

International Credit International Credit ManagementManagement

Credit policy analysisCredit policy analysis lengthening terms increases exchange rate risklengthening terms increases exchange rate risk also increases default riskalso increases default risk harder to get D&B reportsharder to get D&B reports harder to get bank credit informationharder to get bank credit information

Modifying monitoring and collectionsModifying monitoring and collections legal remedies for late payment or nonpayment differ legal remedies for late payment or nonpayment differ

by countryby country

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