Working Capital, Credit and Accounts

Receivable Management

Cash Flow Cycle of a Business

Purchase of
Materials

Payment for
Materials

Sale of
Product

Collect A/R

Days Inventory
Days
Receivables

Days Payables

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

Days' Receivables

Accounts Receivable
365 Days
Annual Sales

Days' Payables

Accounts Payable
365 Days
Cost of Goods Sold

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

er
er
ed
ed

Credit Policy and Collections

Order
Order
Received
Received

Sale
Sale

Cash
Cash
Received
Received
Accounts
Collection
Accounts
Collection
<<Inventory
Inventory>> << Receivable
Receivable >> << Float
Float >>

Accounts
Accounts

Disbursement
Disbursement
<< Payable
<< Float
Payable >>
Float
Invoice
Payment
Invoice
Payment
Received
Sent
Received
Sent

Time
Time
>>

Cash
Cash
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

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

1+(Cost of Cap. X Coll. Days)
If NPV > 0 then Extend Credit

- Variable
Costs

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

The Five Cs of Credit

Character
Capacity
Capital
Collateral
Conditions

Cost of Trade Credit

From a sellers viewpoint, the cost of the discount
must be weighted against the benefit of receiving
early payment.
From buyers 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

--------------------------------(1 Early Payment Discount)

365

--------------------------------(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:
Cost of Trade Credit =

Early Pmt Discount

365

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:
Avg. Daily Credit Sales =
DSO =

Sales During Period

$425,000
=
= $4,722.22
Number of Days in Period
90
Outstanding A/R
$350,000
=
= 74.11 Days
Avg. Daily Credit Sales $4,722.22

If the companys 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

$1,750,000

70%

31 60 days

$375,000

15%

61 90 days

$250,000

10%

91 + days

$125,000

5%

$2,500,000

100%

0 30 days

Total

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

Month Sales

Sales

Remaining A/R
from Month Sales
at End of March

Remaining A/R
as a % of
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
companys overall cost of capital

Cash Application
Cash application is the process of matching
and applying a customers 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