Working Capital Management Accounts Receivables & Accounts Payables

1. Working Capital ManagementAccounts Receivables&Accounts Payables Samantha Karandagoda

2. Accounts RECEIVABLES

3. Accounts Receivable • Refers to the Money that Still Has to be Collected from the Customers who Bought on Credit • Selling on Credit Helps to Increase Sales Volumes & Profits • Consider the Cost of Allowing Credit

4. Credit Policy • Firms Must have a Clearly Outlined Policy when Selling on Credit • What’s the Maximum Amount of $ or Currency Allowed in Credit • What’s the Duration to Pay • What are the Penalties

5. Credit Policy • Demand for Products • Competitor’s Terms • Risk of Irrecoverable Debts • Cost of Finance • Costs of Credit Control

6. Receivables Management • Assessing Creditworthiness • Settling Credit Limits • Involving Promptly & Collecting Overdue Debts • Monitoring the Credit System

7. Assessing Creditworthiness • Bank Reference • Trade Reference • Competitors • Published Information • Credit Reference/Rating Agencies • Legal Information • Sales Data

8. Setting Credit Limits • Limits are Twofold • Amount of Credit Available • Duration for which the Credit is Allowed • Ideally Firm Should have an Internal Policy • Customers Should be Well Informed

9. Debt Collection • Reminding Letter • Telephone Call • Withholding Supplies • Debt Collectors • Legal Action

10. Illustration • A Firm at the end of March has Following to be Collected from the Customers of each Month: • March: (100% of sales): $ 1,200,000 • Feb: (70% of sales): $ 700,000 • Jan: (30% of sales): $270,000 • Total: $2,170,000

11. Illustration • Convert this to Receivables Days: • March: (100% of 31 Days): 31 Days • Feb: (70% of 28 Days): 20 Days • Jan: (30% of Days): 9 Days • Total: 60 Days

12. Illustration • Trying to Make it 50 Days • Collect More from March Sales • Jan Sales 9 Days + Feb Sales 20 Days = 29 Days • 50 – 29 = 11 • Therefore Collect March Sales Belonging to First 11 Days of March • $1,200,000 x (11/31) = 425,806

13. Monitoring the Receivables Collection • Age Analysis • How many days before of sales paid up by the customer • Ratios • As Calculated in the Previous Lesson • Statistical Data

14. Accounts ReceivablesCalculations • Cost of Financing the Receivables • Finance Cost = Receivable Balance X Interest Rate • Receivable Balance = Sales x Receivable Days 365

15. Cost of SettlementDiscount • Giving Discount Means a Loss in the Total Collection • However, avoids Losses Caused by the Interest Charges

17. Illustration • Sales: $20 Million • Receivables at Year End: $4 Million • Over Draft Interest Rate: 12% • Cash Discount of 2% is Proposed for Settlements within 10 Days

18. Illustration • Discount as a Percentage of the Amount Left to Pay: = 2/98 = 2.04% • Receivables Days are Currently: = (4 / 20)x 365 = 73 • Shortening the Receivable Days from 73 Days to 10 Days is the Target (63 Days Down!) • 63 Days -> 5.794 Periods Per Yr.

19. Illustration • Cost of the Discount = (1+0.0204)5.794-1 = 12.41% But Cost of the OD Is: 12% Therefore, Borrowing from the Bank is Cheaper than Giving Discount to Collect Debt!

20. Factoringthe Receivables • Selling Debts to a 3rd Party at a Discount in Return for Prompt Cash • Services offered by Factor • Debt Collection & Administration • Credit Insurance • Useful for • Small Firms • Faster Growing Firms

21. Advantages • Saves Admin Cost • Reduced Need for Management Control • Useful for Small & Medium Businesses where a Credit Control Department is Not Feasible to Be Set Up

22. Disadvantages • More Costly than an Efficient Internal Credit Control Department • Using a Factor Indicates Lack of Liquidity -> Bad Reputation • Customers May not Wish to Deal with a Factor • Difficult to Reverse • Loss of Control on Credit Decisions

23. Invoice Discounting • A Method of Raising Finance Against the Security of Receivable without Using a Factoring Service • However Some Factoring Companies Carry Out this Service • Customer Doesn’t Know • Confidential

24. AccountsPayables

25. Accounts Payables • Refers to the Payments to be Made to the Suppliers • Have to Be Paid Back on Time • Maintain Supplier Relationship • Avoid Loss of Reputation • Avoid Price Increases in the Future • Considered as a Free Source of Finance but there’s a Discount Foregone!

26. Settlement Discounts • When the Businesses Purchase on Credit, a Period is Given to Pay Back • However if the Payment is Made Earlier, the Supplier Might Give a Settlement Discount

27. Age Analysis of Payables • Similar to Receivables, We Can Analyse How much is Falling Due within the Next 30 days, 60 days & 90 days etc.

28. Question • Entity is Offering a Cash Discount of 2.5% to the Customers if they Pay within 1 month. Usual Credit Period is 3 months. Bank Loan Rate 18% p.a.

29. Answer Discount as a Percentage of Amount to be Paid: 2.5/97.5 = 2.56% Saving: 2 months (since payment comes in 1 month instead of 3 months) = 6 periods (2/12) Calculate the Annualized Cost of Discount (1+0.0256)6 – 1 = 16.38% Loan Rate is 18% Hence it’s worth to give the discount!

30. Question • Allow 1.75% discount for payment within 3 weeks or full payment within 8 weeks? (assume a 50 week year)

31. Answer • Assume a $100 invoice • Discount: 100 x 1.75% = $1.75 • Amount Due After Discount: 100 – 1.75 = 98.25 • Effective interest cost of NOT taking the discount: 1.75/98.25 = 0.0178 (~0.018) • 5 Week Period • Means there are 10 periods/yr

32. Answer • Equivalent Annual Rate for 10 Periods (1 + 0.018)10 – 1 = 0.195 • Rate is 19.5%

33. Working Capital ManagementAccounts Receivables&Accounts Payables Samantha Karandagoda