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
Materials Materials Product Collect A/R

Days’ Inventory

Days’ Payables Days’

Receivables

Cash Conversion Cycle

Day 1 Day 30 Day 45 Day 75

 Working Capital Cash Flow
Cycle:
Cash Conversion Cycle
Formulas for three time periods are necessary to calculate the cash
conversion cycle.
Inventory
Days' Inventory = × 365 Days
Cost of Goods Sold

Accounts Receivable
Days' Receivables = × 365 Days
Annual Sales

Accounts Payable
Days' Payables = × 365 Days
Cost of Goods Sold

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

Credit Policy and Collections

Order
Order Order
Order Sale
Sale Cash
Cash
Placed
Placed Received
Received Received
Received
Accounts
Accounts Collection
Collection
<<Inventory
Inventory>> << Receivable
Receivable >> << Float
Float >>

Time
Time==>
==>
Accounts
Accounts Disbursement
Disbursement
<< Payable
Payable >> << Float
Float >>
Invoice
Invoice Payment
Payment Cash
Cash
Received
Received Sent
Sent Paid
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:
Early Pmt Discount 365
Cost of Trade Credit = 
 1 - Early Pmt Discount   Net Pmt Period - Discount Pmt Period

.02 365 .02 365

=  =  = .0204081  10.428571
 1 - .02   45 - 10  .98 35

= .2128 = 21.28%

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

Outstanding A/R $350,000

DSO = = = 74.11 Days
Avg. Daily Credit Sales $4,722.22

If the company’s credit terms are net 60, the average past due is
computed as follows:
Average Past Due = DSO - Avg. Days of Credit Terms

= 74.11 Days - 60 Days = 14.11 Days

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 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

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%

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 Pattern
Remaining A/R Remaining A/R
from Month Sales as a % of
Month Sales Sales at End of March Month Sales
January $250,000 $50,000 20%
February $300,000 $165,000 55%
March $400,000 $380,000 95%
April $500,000
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 March
sales + 35% of February sales + 20% of January 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 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)