5. Management of Working Capital - Receivables & Payables

How can companies reduce the level of working capital?

By managing receivables & payables more efficiently

Explain trade receivables

• The reason for the existence of receivables is that the business is prepared to sell to customers on credit

• The higher the receivables, the more cost there is for the company - both in terms of the interest cost and in terms of greater risk of losses through bad debts

• An easy solution would be to stop selling on credit and to insist on immediate cash payment, but thus would risk the losing of customers to competitors that offer credit

• There is no best level of receivables - it depends very much on the type of business and the credit terms offered by competitors - but it is in the interest of all companies to keep the level as low as possible

What are points to consider as part of efficient management of receivables?

• Credit checks & credit limits:

  • before granting credit, customers should be assessed as to their ability to pay, and credit limits set for all accounts

    • use credit rating agencies

    • ask for trade and bank references

    • analyse payment record of existing customers

    • assess the financial statements of large customers

    • review credit limits

• Credit terms & settlement discounts:

  • These will be greatly influenced by competition and trade custom

  • The company must quantify the cost of any settlement discounts and decide whether the benefits outweigh the cost

  • Ensure that customers are aware of the terms and settlement discounts by printing them on orders, invoices and statements

  • Ensure that any discount policy is enforced - most customers will attempt to take the discount as a matter of course, whether or not they have paid in time

• Collection procedures:

  • Set clearly defined procedures to be followed

    • Set timings for issuing demand letters, making chasing phone calls, and stopping deliveries

  • Decide when outside assistance is needed

    • E.g. the use of collection agencies or lawyers

  • Compare the cost of taking direct legal action with that of using outside help

• Charge interest on overdue invoices

  • Clearly outline the time deadline and interest to be charged on overdue invoices

What is invoice discounting

The selling of an invoice to a third party, usually a bank, for a lower discounted amount

This way the supplier gets cash immediately and it is the bank who has to wait for payment

What is factoring?

Paying another company to administer all or part of the receivables ledger

Depending on the fee paid to the factor, different facilities may be bought

What are the levels of factoring?

Basic level: Paying the factor or handle all the administration, such as:

• maintaining the sales ledger

• collecting the debts

For a higher fee: The factor will advance money to the company before the debts have been collected

For a higher fee still: non-recourse factoring

What is non-recourse factoring?

When the factor accepts responsibility for any bad debts

The company is effectively insured against bad debts

What is with-recourse factoring?

Normal factoring where the company keeps responsibility for any bad debts

Exam techniques on receivables management:

• Two techniques to be aware of:

  • Is it worthwhile offering a simple settlement discount?

  • Is it worthwhile to make a change in collection policy?

    • By using discounts

    • By using a factor

How can trade payables be used as a source of short-term finance?

If a company delays payment by a further month then they now have a further month’s use of that cash

What are the dangers of delaying payment of payables?

• Company may lose its credit status with the supplier and could result in supplies being stopped

• Company could lose the benefit of any settlement discount offered by the supplier for early payment