Chapter 9

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Chapter 9 – Accounts receivable and

payable management
Chapter agenda
Liquidity Vs
Profitability

Credit policy

Receivables Key ratios

Invoice
discounting

Factoring
Chapter 8

Liquidity Vs
Profitability
Payables

Key ratios
Foreign
receivables &
payables

Introduction – Accounts receivable


When managing accounts receivables, an organisation must strike a balance between
Liquidity and Profitability.

Liquidity – Collecting debtor receipts fast to reduce the cost of financing debtors

Profitability – Extending the credit period encourages customers to buy more

These two aspects are captured in the credit policy of the organisation

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Rukmal Devinda
Credit policy
This sets out credit terms given by an organisation to its customers.

A lenient policy may induce sales at a high cost (Higher discounts, extended credit period)

When setting the credit policy, the following must be considered.

• Demand for products


• Risk of bad debts
• Competitors’ credit policies
• Competitors' terms
• Cost of credit control

There are 4 key purposes of the credit policy

1. Assessing creditworthiness – The organisation must assess all its new customers and
review existing customers periodically. In assessing creditworthiness, they can refer
to bank references, company sales records, references from credit rating agencies
etc.

2. Setting credit limits – The credit limit should be adjusted by referring to the sales and
cash payment history of the customer.

3. Timely invoicing and collection of dues – The credit period starts when the customer
receives the invoice. There needs to be a mechanism to collect the dues promptly.
E.g., Sending reminders, telephone calls to customers etc.

4. Monitoring the credit system – The position of the receivables must be reviewed
through means such as ageing analysis, ratios etc.

Key ratios used in managing receivables


Cost of financing receivables

𝐹𝑖𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡 = 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑥 𝑂𝐷 𝑟𝑎𝑡𝑒 (𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝐼𝑅)

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 = 𝑥 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
365

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Example – Cost of financing

Company XY has sales of $10 million for the previous year, receivables at the year-end were
$2 million, and the cost of financing receivables is covered by an overdraft at the interest
rate of 6% per year.

Calculate the receivables days


Calculate the annual cost of financing receivables.

Early settlement discounts

• Providing cash discounts encourages customers to pay the dues early.

• There is a cost to the company in providing the discount.

• But it acts as a saving to the organisation in terms of reducing the amount of money
tied up in receivables.

!"#$%&'( '%.%1 .-2"%!#


• Annual cost of discount = !1 + $ −1
)*%&'( ,-( (% .)/

!"# %& #' %& ('


• No of periods =
)% %* +,-. %& /001. %& 2%345. 0,&670& 450 2%30- 7. &080790+

• Discount must be provided only when,


𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 < 𝑂𝐷 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

Example – Early settlement discounts

A company is offering a cash discount of 2.5% to receivables if they agree to pay debts
within one month. The usual credit period taken is three months. Assume the OD rate is
18%. Should the discount be offered by the company?

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Invoice discounting
Invoice discounting helps the organisation to improve its cash position.

How ?

This is when an organisation borrows money from a specialist party at an interest rate
against a few selected debtor invoices. Thus, it is like debt factoring. However, in invoice
discounting, the organisation retains control over the sales ledger and customer dealings
stay confidential. This is a major benefit to the organisation.
Therefore, finance cost of invoice discounting is higher than that of factoring.
Administration charges for this service are around 0.5–1 % of a client’s revenue.

Factoring
This is when an organisation sells its debtor invoices to a factoring agent. The factoring
agent collects the debt for a fee. Factoring agents provide the following services. (Factoring
involves outsourcing the credit control department to specialist party)

• Debt collection and administration


• Financing
• Credit insurance

Factoring is specifically useful for small firms, and fast-growing firms because these firms
may lack the capital to set up strong sales & credit systems and debt collection is not a
value-adding activity.

What is recourse and non-recourse in factoring?


Recourse is when a debtor defaults on the dues & company must bear the cost. Non-
recourse is when factoring agent bearing the cost of default

Pros and cons of factoring


Pros Cons
Saves administration cost (Cost of debt Customer may not be willing to deal with a
collection & maintaining sales ledger) factor
Useful for small and fast-growing Use of factoring can attract ill reputation
businesses
Need for management control reduces Difficulty in reverting to an internal credit
controlling system
Improves short term cashflows

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Introduction – Accounts payable
When managing accounts payable, an organisation must strike a balance between liquidity
and profitability.

Liquidity – By delaying payments to suppliers, the liquid position of the business can be
improved.

Profitability – By delaying payments profitability can be improved. This can result in

• Cash only supplies


• Loss of reputation
• Increase in prices and loss of trade discounts
• Supplier refusing to supply
• Loss of early settlement discounts

all of which may affect the profitability position of the business in the long term.

Early settlement of accounts payable


Due to delayed payments, early settlement discounts offered by suppliers are lost.

When making early payments to suppliers

• Working capital funding cost increases (Lower payables lead to larger working capital
requirement. As a result, OD interest charge may increase)

• The benefit is that less cash is paid to the supplier

To determine whether paying early is beneficial, the business must calculate the annual
benefit of the discount.

+7.8%:34 3%.%* ;0&7%+.


• Annual benefit of discount = 31 + ,2%:34 604 4% ;,-6 −1

!"# %& #' %& ('


• No of periods = 3% %* +,-. %& /001. %& 2%345. 0,&670& 450 2%30- 7. &080790+

Example – Early settlement discount

2% discount for a payment within three weeks has been offered by a supplier. Alternatively,
full payment must be made within eight weeks of the invoice date. Assume the invoice
value is $100. Assume there are 50 weeks in a year. Calculate the annual cost of the
discount.

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Example II – Early settlement discount

One supplier has offered a discount to Box Co of 3% on an invoice for $10,000 if payment is
made within one month. Payments are typically made in 3 months. If the company’s
overdraft rate is 10% per year, is it financially worthwhile for them to accept the discount
and pay early?

Managing foreign debtors and creditors


Businesses may often engage in foreign trade which will inevitably result in foreign debtors
and creditors arising.

• When a business buys goods/materials from foreign suppliers, the business will need
to have foreign currency or convert local currency to foreign currency to pay the
supplier

• When a business sells goods to foreign customers, the business will need to convert
foreign currency to local currency

This exposes businesses to several additional risks

Risks of foreign trade


These can be categorised under 2 broad headings.

1. Export credit risk – This can arise due to illiquidity or insolvency of the foreign
customer, political risks of the customer’s country (war, change of political parties),
inconvertibility of the customer’s currency due to exchange controls, poor
remittance channels

2. Foreign exchange exposure risk – Due to fluctuations in the forex rates between the
date of the transaction and the date of settlement losses/gains may arise. (Discussed
in a latter chapter)

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Reducing export credit risk
• Transacting through a guaranteed international letter of credit (ILC)
• Undertaking export credit insurance covers
• Use of an expert party such as a factoring agent to handle issues
• Making banks responsible for collecting remittances and controlling shipping
documents

Reducing foreign exchange exposure risk will be discussed in a latter chapter

How to manage foreign debtors and creditors


Reducing investments in foreign debtors by requiring foreign customers to pay in full or
part in advance for supplying goods. (This can have negative impacts on the business)

Selling foreign accounts receivables to a forfaiter - Forfaiter buys the receivables at a


discount from the business. Forfaiter also undertakes the credit risk of the transactions
without recourse. As a result, use of forfaiters is attractive for businesses. But it is costly.
Once the receivables are purchased, they become tradeable in money markets

Countertrading – Goods and services are exchanged for other goods and services rather
than cash.

Export credit insurance – Risk of non-payment by a foreign debtor is covered with this
insurance.

Export factoring - Same logic applied as explained under factoring above.

Issue of LCs – This is one of the most widely used method of managing foreign debtors.

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What are LCs?
In its simplest LC is a letter issued by the buyer’s bank to the seller’s bank guaranteeing the
payment to the seller. If the buyer is unable to make a payment on the purchase, the bank
will be required to cover the full or remaining amount of the purchase.

Steps in arranging a LC

• Buyer and seller set the terms for the sale of goods or services.

• The buyer/importer requests their bank to issue a letter of credit in favour of the
seller/exporter.

• The goods are dispatched to the customer and the shipping documentation is sent to
the purchaser’s bank guaranteeing payment to the seller once the conditions
specified in the letter have been complied with.

• Upon the receipt of LC, the seller’s bank issues a banker’s acceptance to the seller.

• The seller has the option to hold the banker’s acceptance until the payment date or
sell it on the money market at a discounted value.

Demerits of LCs

Takes up a significant amount of time to set up the LC

Customers need to have a good credit history to obtain a LC

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