LESSON TEN

WORKING CAPITAL MANAGEMENT

Working capital refers to current assets which include.

a. Cash
b. Debtors
c. Stocks
Net working capital refers to current assets – Current liabilities.
Working capital management refers to the management of current assets (management
of stock, debtors, and cash) with the following critical objectives.
1. To set the optimal level of cash debtors and stocks to be maintained by a firm.
2. To determine the best level of cash debtors and stocks to be maintained by a
firm.
3. To reduce the long-term cost associated with working capital financing.
4. To maintain the liquidity of the firm so that it can be able to meet its financial
obligations as and when they fall due.
Importance of working capital management
a) The amount of capital invested in current assets is normally of a higher proportion
for most firms. This huge investment therefore requires proper management.
b) Relationships with sales, current assets and sales have a direct relationship and the
changes in the level of current assets will directly affect the sales and profitability of
the firm.
c) Liquidity of the firm – Current assets management will gauge on the liquidity of the
firm and its ability to meet the short-term financial obligations.
d) Importance to small firms
Small firms that have limited access to the capital markets need proper management
of their current assets and liabilities so that the credit associated with the current
liabilities is used to finance the current assets.
e) Time devoted to working capital management.
A large proportion of the finance manager’s time is devoted to the management of
current assets so that the firm can reap maximum benefits from these assets.
f) Vulnerability of current assets
Current assets are highly volatile and easily misappropriated by the employees of
the firm, hence proper management.

Factors influencing the working capital needs of a firm.

There are various determinants of working capital needs of a firm which includes.

a. The size of the firm

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 The larger the firm and scale of its operations the larger the working capital
required.

b. Growth and expansion activities

Newly established firms with profitable investment opportunities require a high
level of working capital to invest in current assets to support the enlarged scale of
operations.

c. The nature and the type of the business

Trading firms such as supermarkets require low investment in fixed assets but a
high level of stock while a transport company will need high level in fixed assets
i.e., vehicles.

d. Manufacturing cycle of the firm

The longer it takes to buy raw materials and convert them into finished goods the
higher the working capital needs due to large capital field up in raw materials.
In some cases, manufacturing firms ask for advance payment from customers to
resolve the liquidity problem.
e. Price level changes (Inflation)
If future prices are expected to rise a firm will require high levels of working
capital by buying a high level of stock where prices are low and sell them when
prices are high, therefore making holding gains.

f. The firm’s credit policy

A firm which offers a short credit period to its customers will ensure prompt
collection. The working capital needs will therefore be low, unlike firms with
longer credit periods.

g. Business fluctuations
Some firms experience erratic fluctuations in the demand for their products, low
demand is high the level of working capital is also high e.g., textile firms may
experience high demand during the month of December; umbrella making firms
will experience high demand in April and May.

Dangers of excessive working capital

1. It results in unnecessary accumulation of investment i.e., investors therefore have
high chances of inventory mishandling, wastage, theft and losses.
2. It’s an indication of a defective credit policy, poor stock management and cash
management by a firm, e.g., a high level of debtors may have a high level of bad
debts.

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3. Excessive working capital will lead to liquidity problems due to the huge amount of
cash tied up in current assets.
4. It will lead to managerial compliancy/laxity which degenerates into managerial
inefficiency.
5. Lost profitability i.e., cost investment income due to the cash field up in debtors and
stocks.

Dangers of inadequate working capital

1. It stagnates the growth of the firm i.e., there is no adequate cash to undertake
profitable projects.
2. Failure to meet short-term maturing financial obligations due to liquidity
problems.
3. Underutilization of fixed assets
Without raw materials production can’t take place and fixed assets will have idle
capability.
4. Inability to achieve profit targets.
This is because the firm can’t implement its operating plans without working
capital.
5. Imposition of tight credit policies by suppliers.
In case the firm cannot meet its short-term obligations, the suppliers will tighten
the credit policies.

Approaches/methods of financing working capital.

To determine the working capital financing techniques to adopt assets of the firm can be
classified into 3: -
i. Permanent working capital
This is the minimum capital (working) required by a firm per day to meet the
daily demands. It’s the minimum operating current assets.
The permanent working capital should be financed with long-term borrowing.
ii. Temporary/seasonal working capital
Any amount of working capital more than permanent working capital is
called the seasonal working capital. It will fluctuate daily, therefore it’s not
constant.
Temporary/seasonal working capital should be financed with short-term
borrowing.
iii. Fixed assets
These are long-term assets of the firm which should be financed with long-
term borrowing.

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Illustration
The following total working capital needs relate to ABC for the week that has just
passed.

Day M Y W Y F S
T.W.C 42000 40,000 47,000 43,000 50,000 45,000

Required: Prepare a schedule showing the permanent and seasonal working capital of
the firm during the week.

The various methods available in financing the working capital are: -

i. Aggressive Approach
This is where a firm utilizes more short-term funds than long term funds. In this
case a huge proportion of permanent current assets are financed with short-term
funds. In extreme cases, the firm may use short-term funds to finance a small
portion of fixed assets. This method is used by risk seekers and can be presented
as follows: -

Seasonal/temporary
working capital Short term funds

Assets

Permanent working
Capital
Long term funds
Fixed Assets

Advantages of Aggressive Approach

a. It’s popular with small firms which do not access to the capital markets from
long term borrowing.

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 b. There is increased profitability of the firm since the cost of short-term funds are
lower than the cost of long-term funds is lower than the cost of long-term funds.

Disadvantages
a. It results in overutilization of short-term funds.
b. Its unfavorable if short term interest rates are erratic (fluctuates)

ii. Conservative policy approach

This is used by risk-averse firms who want to avoid liquidity problems. They
therefore depend on long-term funds to finance the permanent current
assets/working capital, the fixed assets and a portion of the temporary working
capital which should be financed with short-term borrowings.
In this case therefore, the firm utilizes more long-term borrowing than short term
borrowing.

Seasonal/temporary
Short term funds/borrowing

Assets

Permanent working
Capital
Long term funds / borrowing

Fixed Assets

Advantages
1. The short-term sources of funds of the firm are conserved.
2. Financial obligations (short term) mature after a long period because of long term
financing; therefore, the liquidity problem is resolved.
3. The firm can adequately meet its short-term obligations without technical
insolvency.

Disadvantages
1. High costs of borrowing since long term funds are expensive.
2. High level of gearing, therefore, increase financial risk due to high debts capital.
3. Reduced profit potential associated with utilization of short-term funds.
iii. Matching/Hedging Approach

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 This is where a firm adopts a financing policy which involves matching of the
expected life of the asset with the expected maturity period of the source of funds
used to finance the assets e.g. an asset with five years economic life is financed
with a 5-year loan.
Under these methods temporary working capital is financed with short-term funds
while permanent working capital and fixed assets are strictly financed with long
term funds.

This can be illustrated as follows: -

Seasonal
Short term funds /borrowing

Assets

Permanent

Long term funds/ borrowing

Fixed Assets

This is a risk neutral approach between aggressive and conservative policy.

Overcapitalization
This is over investment in current assets. It involves holding excessive working capital
such that there is a high level of capital field up in the working capital items.
Cash is not readily available because it’s tied up in stock and debtors.
The firm is likely to have a low return on investment.
The symptom of over capitalization includes: -
i. High liquidity ratio (current and acid test ratios) with the ratios being more than 2
and 1 respectively.
ii. A low sale and working capital ratio due to the high level of current assets.
iii. Longer turnover periods for stock and debtors I,e stock holding period and debtors
collection period.
iv. Short credit period granted by the suppliers because of the inability to meet short-
term financial obligations due to high capital tied up in the current assets.

Over Trading

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 This is where a business tries to do so much too fast with very little long-term capital.
The firm normally attempts to support a large volume of sales/trade with very little
supporting capital resource. Overtrading can lead to liquidity problems and it
symptoms include: -
i. A rapid increase in sales/turnover
ii. Dramatic demand in liquidity ratios with decrease in current and quick ratios and
negative working capital.
iii. A small increase in the owner’s capital but a rapid increase in gearing due to
persistent need for bank overdraft and short-term loans to finance the rapid
increase in sales.
iv. Decrease in equity to total assets ratio while total debt capital to total asset ratio
increase.
v. Longer period of creditor’s payments and failure to meet short term financial
obligations and when fall due for payment.

Determination of net working capital needs of a firm

For a manufacturing enterprise, there is normally a lot of tied up capital in
i. Raw materials
ii. Work in progress
iii. Finished goods.
iv. Debtors
The tied-up capital will mean that the firm must borrow to meet the cash shortfall
occasioned by the tied-up capital in the above items.
The tied-up capital will mean that the firm must borrow to meet the cash ghost fall
occasioned by the tied-up capital in the above items.
The tied-up capital nevertheless can be reduced through short term financing associated
with
i. Trade creditors
ii. Accrued overhead expenses.
iii. Accrued wages
Any tied up capital that cannot be offset or reduced by short-term borrowing will be the
net working capital requirement.

N.W.C requirement = Current assets – Current liabilities

- Finished - Accrued off
- Goods - Accrued labour
- W. I. P - Creditors for materials.

Illustration

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ABC Ltd has annual credit sales of 70,000. The cost of production of various
components expressed as a % of annual credit sales are as follows: -
Direct materials 30% Therefore 30% = profit
Direct labor 25%
Overheads 15%
70%

Additional Information
1. Direct materials stay in the warehouse for 60 days before they are processed, while
W.I.P takes 30 days to convert into finished goods.
At the same time as determining to work in capital requirement W.I.P is usually 70%
complete.
2. Finished goods remain in the warehouse for 15 days before they are sold and once
sold on credit, the debtor take 45 days to pay.
3. The firm pays its suppliers of raw materials after 30 days while direct wages are
paid after 15 days.
4. Overhead expenses are usually paid after 30 days.
5. The firm can secure a bank overdraft of 1.3 million to meet its working capital
requirement.

Required: Assuming 360 days per annum, determine the net working capital
requirement.

Concept of working capital/cash operating cycle

The working capital cycle refers to the time that elapses between the payment of raw
materials (cash outflows) and the concept of cash flow the sale of goods and credit (cash
inflow).
The time that elapses between the purchases of raw materials on credit and the
subsequent payment is called creditor’s payment period.
Creditors payment period = Average creditors x 365 days
Credit purchases
The time that elapses between the purchase of raw materials and conversion of the same
into finished goods is called the raw materials conversion period.

= Average stock of raw materials x 365 days

Cost of sales
It’s simply the stock holding period where stock is held in the form of raw materials.
The period that elapses between the sale of finished goods and credit and receipt of cash
from the debtor is called the debtor’s collection period.
A lengthy working capital period is an indication of a poor capital management policy.
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A firm can improve or reduce its working capital cycle and therefore improving its
liquidity by
1. Shortening the debtor’s collection period
2. Fluctuating for a long credit period with the suppliers.
3. Shortening the raw materials conversion period
4. Efficient management of stock so that little capital is fed up with raw materials and
in working progress.
The cash opening cycle turnover refers to the number of times in a year (Frequency
that working capital can occur).
Working capital life = 365 days
Cycle turnover Working capital cycle

MANAGEMENT OF INVENTORY
In a manufacturing concern inventory (ies) consist of 3 components: -
1. Raw material
2. Work in progress
3. Finished goods.
The holding of excessive stocks will lead to tied up capital in stocks while the holding of
inadequate stock may lead to stock out – out costs e.g., lost profitability and goodwill
from customers.
To set the optimal amount of stock to hold and order the E.O.Q model will be used.
(Economic order quantity)
This model operates under the following assumptions: -
i. The annual demand of raw materials and the subsequent usage is known and is
constant.
ii. There is no quantity discount associated with bulk purchases.
iii. There is no stock – out – cost i.e., every time the firm runs out of stock there is
instantaneous replacement without lead time.
iv. The ordering cost per order is known and will be constant throughout the year.
Ordering cost may consist of telephone charges, transport charges to the
warehouse, insurance on transits, handling cost of the goods etc.
v. The holding/carrying cost per unit is known and it remains constant. The holding
cost may consist of security expenses, insurance of stock in the warehouse, rent
charges etc.

There are 2 types of costs associated with the E.O.Q model.

i. Holding cost = ½ Qch
ii. Ordering cost D/Q Co.

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Where: Q = Economic Order Quantity
Ch = Holding cost per unit
Co = Ordering cost per order
D= Annual demand

Illustration
Pascal Ltd requires 432.7 units of raw materials per week to convert into finished goods.
Every time the company places an order it in curb sh.60, the holding cost per unit per
annum is sh.30 and the buying price per unit of the raw materials is Sh.25.
Required: How many units should the company order each time to minimize ordering
and holding costs
How many orders should the firm place per annum?
What is the frequency of placing the orders?
- Determine the total cost of maintaining the stock and the average stock to maintain.
- Suppose the firm has a lead time of 10 days, what should be the re-order level?
- Suppose the company requires safety units of 50 units, determine the holding costs
and orderly costs.
- Supposed the firm is granted a 1% discount on the purchase price so that every time
it places an order, it orders 450 units to evaluate whether to accept or reject the
discount.
A JIT (just in time) purchasing system refers to an inventory management system where
raw materials are only purchased when they are needed for production. Under this
system, the company or the firm do not maintain a stock or raw materials. The objective
of the system includes: -
i. To eliminate inventory storage cost
ii. To eliminate raw material wastage due to obsolescence theft and pilferage.
iii. To eliminate other inventory handling costs e.g., insurance of inventory
stock, costs of maintaining a storekeeper etc.

MANAGEMENT OF CASH AND OTHER SHORT TERM MARKETABLE

SECURITIES
Cash held in the most liquid form is a non-earning asset.
This is because cash in hand cannot generate interest; however, the firm requires
holding an optimal cash balance since excessive cash means foregone interest income.

Inadequate cash will also mean that the firm cannot meet its short-term maturing
financial obligations as and when they fall due. Any idle cash held by the firm should
be converted into an earning term so that it can generate interest income. This is

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 achieved though buying short term marketable securities or investing the idle cash in
short term lending.

The various types of short-term investments/marketable securities include: -

i. Treasury bills
These are short term financial instruments issued by the government to borrow short
term loans from the market.
They are riskless investments, therefore the interest rate in turn is called the risk-free
rate.
They are normally issued at a discount and mature at par i.e if the par value is Sh.1000,
the issue price may be sh.900 and the sh.700 difference is the interest income. They
normally have a maturity period of 91 & 182 days.

ii. Commercial Paper

A firm can invest surplus cash by buying commercial paper (lending to another
firm). A commercial paper is a short term unsecured financial instrument issued by
a financially strong and sound firm in the market.
They are issued at a discount to raise short term funds by the issuer.
Commercial papers offer the following advantages to the borrower.
a. There is no security or collateral required, only a guarantor.
b. A firm which successfully issues commercial paper improves its credit standing
and can therefore attract other sources of short-term finance.
c. Flexibility – A commercial paper has varying maturity period ranging from 30, 90,
120, a80 and 270 days.
d.Cost – The interest rate on a commercial paper is lower compared to a bank loan
facility.
e. Administrative procedures – The issue of a commercial paper has less procedure
compared to bank overdraft and short-term firms, because of the regulations
imposed by the capital market authority. For a firm to issue a commercial paper,
the restrictions imposed are: -
i. A firm must have a capital of at least 50 million.
ii. The firm’s gearing level must not be 740%
iii. The firm must have made a profit in 2 out of the last 3 years.
iv. The firm must be liquid and have a long history of paying dividends.
v. Investing the idle cash in short term deposits.
This involves opening a fixed account where the cash is deposited and
cannot be withdrawn before the expiry of a given period.
Interest is normally earned on cash deposits.
vi. Reduction of the bank overdraft of the firm
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 The idle cash can be used to pay off existing bank overdraft or short-term
loans, therefore saving the company interest charges.
vii. Promissory notes
These are forms of short lending where the borrower issues a promissory
note to the effect promising that he will pay periodic interest and the
principal at maturity.

Sources of short-term funds

A firm can secure short term finances from the following sources: -
1. Issuing a commercial paper
2. Getting credit facilities from suppliers where it is granted longer credit periods
during periods of cash deficits.
3. Bank overdraft
This is where the firm can approach its banker to overdraw from the account. The
bank will charge interest which is usually negotiated with the customer. No
security/raw material is required by the bank since the overdraft facility is only
granted to the customers of the bank.
4. Short term loans
A borrower may approach a financial institution for a short-term borrowing. The
borrower does not need to be a customer of the bank. Interest charges are fixed, and
the lender may require security for the short-term loan.
5. Factoring and pledging
6. Establishing a line of credit
A borrower may enter a formal arrangement with the bank where the bank operates
a short-term loans account with the borrower.
The borrower does not have to take the entire loan from the bank but will keep on
withdrawing from the loan account at different intervals. The borrower will
withdraw any amounts from the loan account if the total drawings do not exceed the
agreed loan amount. Every time the borrower withdraws an amount form the loan;
it is said to be taking down the line of credit.

CASH MANAGEMENT MODELS

To determine the optimal cash balance to maintain so that a firm does not have deficit
or surplus cash, the two models used include the: -
 Baumol model
 Miller – Orr model

Baumol model

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 This is the application of the EOQ stock management model in cash management. The
Baumol model applies the same principles as the EOQ model. It operates under the
following assumptions.
1. The annual cash requirement is known and will remain constant.
2. The cash in and out flow occurs at regular time intervals.
3. The transfer or conversion cost is known and remains constant.
4. The conversion cost relates to the transaction cost of buying and selling short-term
marketable securities in case of a cash surplus or deficit.
5. The opportunity/holding cost is known and remains constant.
This refers to the foregone interest income due to holding cash in a non-earning
from.
6. There is no cost associated with being short of cash, i.e a short-term marketable
security can be converted into cash immediately.

The Baumol model identifies 2 types of cost associated with cash management.
i. Conversion/transfer cost
=Tb b = Conversion cost per conversion
C T = Annual cash requirement
C = Optimal cash balance
ii. Opportunity cost = ½ CI I = Interest rate on marketable securities p.a
½ c = Average cash balance
T/C = Number of conversions/Transfers p.a
The two costs are normally equal, therefore conversion cost = Opportunity cost.
Example: K Ltd requires Sh.40,000 per month to meet its operating needs. Every time
the firm has surplus cash it incurs sh.20 in buying marketable securities. The interest
rate on these securities is 12% p.a required: -
i. Determine the optimal cash balance to hold.
ii. How many conversions transfers should the firm make p.a
What is the frequency of cash transfer?
iii. Determine the total cost associated with the management of the cash for the firm.
iv. What is the average cash balance?

Miller Orr model

The Baumol model is a determined which assumes certainty of valuables on the
parameters. Miller Orr model on the other hand is a stochastic model which assumes
uncertainty. The model identifies 3 types/levels of cash limit within which the cash
balance fluctuates. These are: -
i. Upper limit (H)
ii. Optimal cash balance (Z)
iii. Lower limit (L)
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The firm will always attempt to operate at the optimal= cash balance (Z). However, cash
balances may be allowed to accumulate but only up to the upper limit (H). If it reaches
the upper limit (H), the firm has surplus cash which should be invested in buying short-
term securities amounting to (H-Z).
Immediately after the purchase of these securities of these securities, the cash balance
will revert to 2 (return point). This balance may again fluctuate from 2 to the lower
limit (L) in which case the firm has a cash deficit and must sell short term securities
amounting to Z – L to reverse P Z. This can be presented graphically as follows.
Graph
According to the miller – Orr model the optimal cash balance 2 is influenced by 3
factors: -
i. Variance of daily cash flows (∂2)
ii. Daily interest rate in short term marketable securities (r/365)
iii. Conversion or transfer cost (b)
The optimal cash balance Z
= 3√ 3b ∂2 + L
4i
Where b = Transfer/Conversion cost
∂2 = Variance of daily cash flows
i = Daily interest rate in short term marketable securities
L = Lower limit
N/B = the lower limit is arbitrary set by the management.

Illustration
The management of MIS always requires a lower cash limit of Sh.8,000. Every time the
company buys or sells short-term marketable securities.
It incurs sh.50; the daily standard duration of cash flow is sh.2000 and the interest rate
on short term marketable securities is 9% p.a.
Required: Using the Miller Orr model to determine: -
i. The optimal cash balance (2)
ii. Upper limit (H)
iii. Average cash balance
iv. Spread
v. The decision criteria to be used by the firm.

Factors to consider in buying short-term marketable securities.

1. Return i.e., the amount of interest income that is expected from the security.
2. Liquidity and marketability i.e., how easy it is to convert the short-term security into
cash without loss of value.
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 3. Default risk – This is the possibility that the issuer or the borrower may fail to honor
his obligation of paying interest income and the principal amount at maturity.
4. Event risk i.e., what kind of events may occur that will affect the borrower’s ability
to honor his obligation.
5. Interest rate variability i.e., to what extent will the interest rate fluctuate during the
investment period.
6. Maturity – If the cash surplus is expected for a given duration e.g., 3 months then
the company can only buy a 3-month short term marketable security.

MANAGEMENT OF DEBTORS/ACCOUNTS RECEIVABLE

The management of debtors is affected through the formulation of sound credit policies.
Debtors cause because of credit sales and the amount of debtors at any point in time is
influenced by: -
i. The credit period granted to the debtors.
ii. The amount of credit sales
Debtors = Credit period x Annual Credit sales
365 days

The credit policy of the firm consists of the following valuables.

i. Credit period
This refers to the period within which debtors are expected to pay their dues to the
firm. It’s the average debtor’s collection period.
ii. Discount
This refers to the rebate granted on the selling price to encourage customers to settle
their dues to the firm before the maturity period e.g., a credit term of 2/10 net 30
days means a customer will get a 2% discount if payment is made within 10 days
(discount period), otherwise the customer should pay within 30 days constant a
discount from the 11th days.
iii. Credit standard
This refers to the acceptable creditworthiness of the customer for the customer to be
granted audit. Credit standards will influence the amount of bad debts acceptable to
the firm.
iv. Collection policy
The firm should set a policy on how to collect overdue debts when the credit period
elapses.
v. Profitability
The firm should carry out a cost-benefit analysis of selling in cash or on credit.

Steps in credit management

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 There are five basic steps or stages which ensure effective credit management. This
includes: -
i. Collection credit information
The firm will gather credit information about the credit applicant from various
sources which include: -
a. Bank references
b. Trade references
c. Credit rating agencies
d.Published financial statements of the credit applicants etc.
ii. Credit Investigation
After gathering credit information, the firm must carry out further investigations of
the credit applicant, such as investigation based on the following issues: -
a) The nature of the business of the credit applicant
b) The type of management of the credit applicant
c) Analysis of the financial statement of the credit applicants to establish the
liquidity position.
iii. Credit Analysis
With the available information and investigations, a cost-benefit analysis is carried
out to determine whether it’s worth extending the credit facilities to the customer.
Credit analysis is largely premised or the 5 is of credit i.e., Character, collateral,
capital, conditions, and capacity.
Character i.e., what is the willingness of the applicant to pay and his personal
integrity. This is the most important account of credit.
Collateral i.e., what security is the capital base of the credit applicant and its gearing
level.
Capacity i.e., what is the ability of the applicant business to generate enough cash
and profits to meet the obligations associated with the loan.
Condition i.e., what is the economic condition and how will it affect the applicant’s
ability to pay the loan e.g., during inflation firms normally make low profits due to
the high cost of input.
iv. Credit limit
This involves setting.
a. The amount of credit facility
b. The credit periods.
These two factors will normally influence the probability of bad debts and the amount
of capital tied up in debtors.
v. Collection policy/procedures
A firm should have a clear-cut policy on how to collect the money due from debtors.
The following steps should always be followed when collecting overdue debts.
a. Send a reminder letter to the debtor/statement of account.
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 b. Send progressive tough worded reminder letters.
c. Call the debtor and remind his/her of his/her financial obligations.
d.Make a personal visit to the debtor’s premises and possibly re-negotiate on the
repayment of the money owed.
e. Take legal action.

TYPES OF CREDIT POLICIES

The management of debtors of a firm can have any of the following types of credit
policies: -
i. Liberal/loose credit policy
This is where the firm sells to many customers on credit to increase its sales and
consequently its profits. The benefit of this policy is increased sales and therefore
increased contribution margin. However, the cost of this policy includes: -
a) Increase in bad debts.
b) The discount is granted to customers to encourage prompt payment.
c) Increase in credit analysis and administration costs.
d) Increase in debt collection cost.
e) High tied up capital in debtors and therefore foregone profits.
Forgone profits = Return on investment x increase in debtors.

ii) Tight/stringent credit policy/conservative

This is where a firm sells on a highly selective basis only to customers with proven
creditworthiness. The firm usually sells during short credit periods, therefore
customers who cannot pay within such credit periods are looked out. The firm
therefore loses sales and subsequently profitability. The benefits of this policy are: -
a) Decrease in bad debts.
b) Decrease in credit administration and analysis cost.
c) Decrease in debt collection cost.
d) Decrease in the amount of capital tied up in the debtors, therefore extra profits.

Extra profits = Decrease Debtors x Return on investment

The costs of this policy however include: -

a) Reduction in sales, therefore, decrease in profitability.
b) The cost of any discount that may be granted to the customers.
In summary, credit analysis involves incremental analysis of costs and benefits
associated with the change of a credit policy.
Example
Santiago Ltd currently has annual sales of 240,000,000 and its credit terms are not 30
days. The finance manager is considering changing the credit policy to a new credit
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term of 2/10 net 45. This will lead to an increase in annual credit sales of 25%. The
firm’s valuable cost ratio is 85%. Due to the demand in the credit policy, bad debts will
increase from 1% of annual credit sales to 1.75%.
It’s anticipated that 40% of the customers (old and new) will take advantage of the
discounts and pay within 10 days. Due to the increase in debtors, the firm will need to
employ a new credit administration who will be paid sh.330,000 p.a. The return on
investment is 12%. The amount of stock is always equal to 10% of the annual credit
sales. Assume 360 days in a year should the credit policy be changed.

FACTORING AND PLEDGING

These are methods of financing the cash shortfall associated with money tied up in
debtors.
Factoring – This involves the sale of debtors to a 3 rd party called the factor; it’s a method
of converting an illiquid asset (debtors) into a liquid asset (cash).
Factoring arrangement involves 3 practices as follows: -
a) The factor who acts as the tender
b) The seller of goods on credit acts as the borrower.
c) The debtor who is the buyer of goods on credit.

Factoring arrangements have the following procedures: -

a) The seller receives an order from a debtor.
b) The factor and seller enter into a binding agreement or contract setting out the terms
and conditions of the factoring arrangement also covering the obligations of each
party.
c) When the seller receives an order from the debtors, he will send direct to the factor
who carries out credit analysis of the debtor i.e., the factor can either approve the
credit sale or not. If he approves according to the credit worthiness of the debtor, he
will send a credit approval slip to the seller authorizing the credit sale. The goods
are accompanied by a note advising the debtor to pay directly to the factory on the
elapse of the credit period.
d) In the meantime, the factor will give money to the seller equal to the amount of
debtors bought by the factors, but net of costs associated with factoring i.e., the
service fee or commission, interest changes paid to the factor to compensate for the
time value of money.

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