15) receivables and payables

Question 1

The optimum level of trade credit extended represents a balance between two factors: ?

Answer 1

The optimum level of trade credit extended represents a balance between two factors:

profit improvement from sales obtained by allowing credit which encourages additional sales

the cost of credit allowed.

Question 2

What is a credit policy influenced by?

Answer 2

demand for products 
 competitors' terms       
risk of irrecoverable debts 
 financing costs       
costs of credit control.

Question 3

What are the aspects of a credit policy?

Answer 3

(1) Assess creditworthiness.
(2) Credit limits.
(3) Invoice promptly and collect overdue debts.
(4) Monitor the credit system.

Question 4

Where does information for assessing creditworthiness come from?

Answer 4

 bank references (you’ll need to get customers’ permission in order to achieve this)

 Credit checks from agencies such as Dun and Bradstreet

 analyzing financial statements to assess liquidity (companies House)- look at levels of cash, working capital cycle, inventory days/payable/receivable days. Also looking at their Long term commitments.

       trade       references       
       competitors       
       published       information       
      credit reference agencies 
       company sales records 
       credit       scoring

Question 5

What are bank references in assessing creditworthiness come from?

Answer 5

A customer’s permission must be sought. These tend to be fairly standardised in the UK, and so are not perhaps as helpful as they could be.

Question 6

What are Trade references –in assessing creditworthiness come from?

Answer 6

Suppliers already giving credit to the customer can give useful information about how good the customer is at paying bills on time. There is a danger that the customer will only nominate those suppliers that are being paid on time.

Question 7

What are Competitors in assessing creditworthiness come from?

Answer 7

in some industries such as insurance, competitors share information on customers, including creditworthiness.

Question 8

What are Published information in assessing creditworthiness come from?

Answer 8

– The customer’s own annual accounts and reports will give some idea of the general financial position of the company and its liquidity.

Question 9

What are Credit reference agencies –in assessing creditworthiness come from?

Answer 9

Agencies such as Dun & Bradstreet publish general financial details of many companies, together with a credit rating. They will also produce a special report on a company if requested. The information is provided for a fee.

Question 10

What are Company’s own sales records –in assessing creditworthiness come from?

Answer 10

For an existing customer, the sales ledgers will show how prompt a payer the company is, although they cannot show the ability of the customer to pay.

Question 11

What are Credit scoring –in assessing creditworthiness come from?

Answer 11

Indicators such as family circumstances, home ownership, occupation and age can be used to predict likely creditworthiness. This is useful when extending credit to the public where little other information is available. A variety of software packages is available which can assist with credit scoring.

Question 12

What is credit limit?

Answer 12

Credit limits should be set to reflect both the:

amount of credit available
length of time allowed before payment is due.

The ledger account should be monitored to take account of orders in the pipeline as well as invoiced sales, before further credit is given, to ensure that limits are not breached.

Question 13

What are the techniques for ‘chaasing’ overdue debts?

Answer 13

• Reminder letter
• Telephone calls
• Witholding supplies
• Debt collectors
• Legal action

Question 14

What is monitoring the system and the methods?

Answer 14

The position of receivables should be regularly reviewed as part of managing overall working capital and corrective action taken when needed.

Methods include:

 age analysis of outstanding debt
 ratios compared with the previous period/target, to indicate trends in credit levels and the incidence of overdue and irrecoverable debts.

 statistical data to identify causes of default and the incidence of irrecoverable debts among different classes of customer and types of trade

Question 15

What is the formula for annual compound cost of discount formula?

Answer 15

= [ 1+ (discount/(1-discount)^period] - 1

Number of periods= Year or week or months / ‘’ earlier the money is received

Question 16

What are the steps to calculating whether to take a discount or not?

Answer 16

Compare the cost of the discount with the benefit.

Question 17

What is the cost of the discount?

Answer 17

Sales revenue x the % predicted to pay early x discount rate

Question 18

What are the steps in deciding whether to take a discount or not?

Answer 18

(1) Calculate the current level of average receivables & receivables days
(2) Calculate the cost of financing this
(3) Calculate the new level of average receivables (Separated into the % who take the discount and those who don’t then totalling to find new average receivables figure)
(4) Calculate the cost of financing this new average receivables figure with the discount with the overdraft
(5) Compare the old cost without discount with the new cost with to determine the benefit
(6) Compare the cost and benefit i.e. cost of offering the discount and the benefit it brings- netting it off essentially .

Question 19

What is invoice discounting

Answer 19

Invoice discounting is a method of raising finance against the security of receivables. Individual invoices are sold at a discount to their face value. This provides a company with a cash advance simiar to debt factoring.

Question 20

How does a debt factoring company provide invoice discounting service?

Answer 20

Selected invoices are used as security against which the company may borrow funds (like a house being used as security for a mortgage).
This is a temporary source of finance, as the receivables invoices are only temporary, repayable when the debt is cleared.

Question 21

What are the advantages of invoice discounting?

Answer 21

It’s a confidential service and the customer does not need to know about it.

Question 22

What is the formula for service fee for invoice discounting?

Answer 22

% x by the total value of the invoice/sale

Question 23

What is factoring?

Answer 23

Factoring is the outsourcing of the credit control department to a third party.

Question 24

What is debt factoring?

Answer 24

The debts of the company are effectively sold to a factor (normally owned by a bank). The factor takes on the responsibility of collecting the debt for a fee.

Question 25

What kind of services do debt factoring companies do?

Answer 25

The company can choose some or all of the following three services offered by the factor:

(1) debt collection and administration – (takes over sales ledger i.e. invoicing, sales accounting & debt collection service

(2) financing
(3) credit insurance - recourse (the company bears the cost of bad debts) or non-recourse (the factor bears the cost of bad debts; they guarantee to recover debts)

Question 26

..Which type of firms are debt factoring useful to and why?

Answer 26

• Small &medium sized firms as they can’t afford sophisticated accounting systems
• fast growing firms- these have substantial and growing investment in inventory & receivables which can be turned into cash by factoring the debts. Factoring debts can be more flexible source of financing working capital than an overdraft/ank loan

Question 27

What is non-recourse, explain in detail

Answer 27

When factoring is without recourse or ‘non-recourse’, the factor provides protection for the client against irrecoverable debts.

The factor has no ‘comeback’ or recourse to the client if a customer defaults. When a customer of the client fails to pay a debt, the factor bears the loss and the client receives the money from the debt.

Question 28

What is recourse, explain in detail

Answer 28

When the service is with recourse (‘recourse factoring’), the client must bear the loss from any irrecoverable debt, and so has to reimburse the factor for any money it has already received for the debt.

Credit protection is provided only when the service is non-recourse and this is obviously more costly.

Question 29

When is credit protection provided?

Answer 29

Credit protection is provided only when the service is non-recourse and this is obviously more costly.

Question 30

What are the steps in admin and debt collection in debt factoring?

Answer 30

1) Company sells goods to customer
2) Company sells the debt to the factor
3) Customer pays the factor after 30 days
4) Factor pays the company less the admin fee

Question 31

What are the steps in admin and debt collection including financing in debt factoring?

Answer 31

1) Company sells goods to customer
2) Company sells the debt to the factor
3) Up to 80% of the debt is paid to the company in advance
4) TheCustomer pays the factor after 30 days
5) The Factor pays the company the balance less the admin fee and finance fee

Question 32

What are the advantages of debt factoring?

Answer 32

(1) Saving in administration costs.
(2) Reduction in the need for management control so frees up mgnt time
(3) Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume growth.

4) Do not incur costs of sales ledger department
5) The business gets finance linked to it’s volume of sales
6) Growth can be financed through sales
7) Optimum inventory levels can be maintained
8) suppliers are paid promptly
9) A business can use the factor’s credit control system to assess the creditworthiness of both new and existing customers.

10)Non-recourse factoring is a convenient way of obtaining insurance against irrecoverable debts.

Question 33

What are the dis-advantages of debt factoring?

Answer 33

(1) Likely to be costlier than an efficiently run internal credit control department.
(2) Factoring has a bad reputation associated with failing companies; using a factor may suggest your company has money worries.
(3) Customers may not wish to deal with a factor and ruin relationships
(4) Once you start factoring it is difficult to revert easily to an internal credit control system.
(5) The company may give up the opportunity to decide to whom credit may be given (non-recourse factoring).

Question 34

What are some additional risks that come with overseas receivables and payables?

Answer 34

export credit risk

Foregin exchange transaction exposure

Question 35

What are some of the Possible causes of loss from export credit risk?

Answer 35

▪ Illiquidity or insolvency of the customer
▪ bankruptcy of bank in the remittance chain
▪ poorly specified remittance channel
▪ inconvertibility of the customer’s currency- can be due to unplanned lack of FX in the customers central bank or deliberate exchange controls
▪ Political risks- change in regime, civil war, blockage

Question 36

how can exporters protect themselves against export credit risk?

Answer 36

▪ use banks in both countries to act as collecting channel for the remittance and to control the shipping documents so they’re only released against payment/acceptance of negotiable instruments ( bills of exchange or promissory notes)

▪ commit to customers bank through an international letter of credit

▪ Require ILC to be confirmed (guaranteed) by a first class bank in the exporters country to make it a confirmedILC

▪ Obtain support from 3rd parties e.g. get a guarantee of payment from local bank/ letter from finance ministry or central bank confirming availability of foreign currency

▪ take out export credit cover

▪ Use intermediary such as a confirming, export finance, factoring or foreiting house to handle the problems on their behalf OR by giving no credit OR selling only through agents who accept the credit risk and are themselves financially strong

Question 37

What are some of the ways of managing foreign accounts receivable? I.e. list them

Answer 37

Payment in advance
Forfaiting
letter of credit
reducing investment in forein accounts receivable
Countertrading
Export credit insurance
Export factoring
Other considerations
Bills of exchange
General policies for foreign accounts receivable

Question 38

What is forfaiting

Answer 38

It’s basically the same as invoice discounting

This is where a company purchases a foreign account receivable at a discount to the face value. The company purchasing the foreign account receivable is called a forfeiter. The forfeiter takes on all of the credit risk from the transaction (a non-recourse arrangement) and so a company using the forfeiter has removed the risk of a bad debt arising.

The purchased receivables become a form of debt instrument such as bills of exchange which can be sold on the money market

Question 39

What are the disadvantages of forfaiting?

Answer 39

The cost is relatively high because of the transfer of the bad debt risk to the forfeiter. Forfaiting is usually available for large receivable amounts (over $250,000) and also is only for major convertible currencies. It is usually only available for medium-term or longer transactions.

Question 40

what is export credit insurance?

Answer 40

It’s basically credit insurance.

It is possible to purchase export insurance from a specialist company.

Export credit insurance usually insures the seller against commercial risks, such as insolvency of the purchaser or slow payment, and also insures against certain political risks, for example war, riots, and revolution, which could result in non-payment. It can also protect against currency inconvertibility and changes in import or export regulations.

Question 41

what are the disadvantages of export credit insurance?

Answer 41

the cost of the insurance can be very high and the insurance typically does not cover 100% of the amounts outstanding.

Question 42

what is export factoring?

Answer 42

An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be more costly than export credit insurance and it may not be available for all countries, particularly developing countries.

Question 43

what is letter of credit?

Answer 43

This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free method of securing payment for goods or services.

When the goods are received by a buyer and the buyer confirms that the condition of the goods is satisfactory, the buyer’s bank will make credit available to the seller.

The credit available will cover the full amount owing. This is confirmed in a letter sent by the buyer’s bank to the seller (a banker’s acceptance). The seller can either hold the banker’s acceptance until maturity or sell it on the money markets at a discounted value.

Question 44

What are the steps in arranging a letter of credit?

Answer 44

 Both parties set the terms for the sale of goods or services

 The purchaser (importer) requests their bank to issue a letter of credit in favour of the seller (exporter)

 The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions specified in the letter have been complied with. Typically, the conditions relate to presenting shipping documentation and dispatching the goods before a certain date

 The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank

 The bank then issues a banker’s acceptance

 The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted value

Question 45

What are the disadvantages of letter of credit?

Answer 45

letters of credit take up a significant amount of time and therefore are slow to arrange and must be in place before the sale occurs.

Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank. Letters of credit are costly to customers and also restrict their flexibility: if they are short of cash when the payment to the bank is due, the commitment under the letter of credit means that the payment must be made.

Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only occurs if the seller presents exactly the documents stated in the conditions. This means that letters of credit provide protection to both the purchaser and the seller. However, the seller will not be able to claim payment if, for example, goods have been sent by air but the letter of credit stated that shipping documents were required.

Question 46

What is counter trading?

Answer 46

basically bartering

In a countertrade arrangement goods or services are exchanged for other goods or services instead of for cash. This is very useful if a company exports to a foreign market where currency is not readily convertible (facilitates conservation of fx) or where currency values are volatile.

Question 47

What is counter trading disadvantages?

Answer 47

The main disadvantages are finding suitable goods or services that are acceptable for goods or services exported and agreeing an ‘exchange rate’ for the goods or services; complex negotiations

Question 48

What are bills of exchange?

Answer 48

A bill of exchange is a document signed by the buyer of goods which guarantees to pay the seller of goods a certain amount on a certain future date. The seller of the goods can either hold the bill until maturity or discount the bill on the money markets in order to receive immediate payment.

Question 49

What is the financing cost of receivables formula

Answer 49

Average receivables x Interest rate

Question 50

what is average receivables

Answer 50

Rearranged from Trade Receivable days formula (Receivable/ Credit Sales) x 365

(Receivable days / 365 Days) x Credit Sales

Question 51

what are the costs and benefits that must be taken into account when giving early settlement discount?

Answer 51

benefits

reduction in financing cost of receivable
any additional contribitution from increased sales

Costs

Cost of discount = Sales x % taking discount x % Discount

Question 52

what are the costs and benefits that must be taken into account when considering a facor

Answer 52

benefits

reduced internal admin costs
reduced irrecoverable debts
reduced financing cost of receivables

Costs

cost of the factor’s admin and financing fees

Question 53

what is credit analysis

Answer 53

Offering credit to customers exposes a company to the risk of bad debts and this should be minimized through credit analysis or assessing creditworthiness. This can be done through collecting and analyzing information about potential credit customers.

Relevant information includes bank references, trade references, reports from credit reference agencies, records of previous transactions with potential customers, annual reports, and so on. A company might set up its own credit scoring system in order to assess the creditworthiness of potential customers.

Where the expected volume of trade justifies it, a visit to a company can be made to gain a better understanding of its business and prospect

Question 54

what is credit control

Answer 54

The accounts of customers who have been granted credit must be monitored regularly to ensure that agreed trade terms are being followed and that accounts are not getting into arrears.

An important monitoring device here is an aged trade receivables analysis, identifying accounts and amounts in arrears, and the extent to which amounts are overdue.

A credit utilisation report can assist management in understanding the extent to which credit is being used, identifying customers who may benefit from increased credit, and assessing the extent and nature of a company’s exposure to trade receivables

Question 55

What is one way of motivating customers to pay early

Answer 55

early settlement discount

Question 56

discuss reasons for why a company may benefit from services offered by factoring company

Answer 56

• Economies of specialisation
• Scale economies
• Free up management time
• Bad debts insurance
• Accelerate cash flow
• Finance through growth

Question 57

what is economies of specilisation

Answer 57

Factors specialise in trade receivables management and therefore can offer ‘economies of specialisation’. They are experts at getting customers to pay promptly and may be able to achieve payment periods and bad debt levels which clients could not achieve themselves.

The factor may be able to persuade the large multinational companies which Oscar Co supplies to pay on time

Question 58

what is scale economies

Answer 58

In addition, because of the scale of their operations, factors are often able to do this more cheaply than clients such as Oscar Co could do on their own. Factor fees, even after allowing for the factor’s profit margin, can be less than the clients’ own receivables administration cost.

Question 59

what is freeing up management time

Answer 59

Factoring can free up management time and allow them to focus on more important tasks. This could be a major benefit for Oscar Co, where directors are currently spending a large amount of time attempting to persuade customers to pay on time

Question 60

what is bad debts insurnace

Answer 60

The insurance against bad debts shields clients from non-payment by customers; although this comes at a cost, it can be particularly attractive to small companies who may not be able to stand the financial shock of a large bad debt.

This could well be the case for Oscar Co. As a small company which supplies much larger car manufacturing companies, it is particularly exposed to default by customers. On the other hand, it could be argued that large multinational companies are financially secure and default is unlikely, rendering bad debt insurance unnecessary

Question 61

what is accelerate cash flow

Answer 61

Factor finance can be useful to companies who have exhausted other sources of finance. This could be useful to Oscar Co if it cannot negotiate an increase in its overdraft limit

Question 62

what is finance through growth

Answer 62

Although factor finance is generally more expensive than a bank overdraft, the funding level is linked to the company’s volume of sales. This can help to finance expansion and protects the company against overtrading. In a rapid growth company such as Oscar Co, this could be a major advantage of factor finance

Question 63

discuss factors which determine the level of a company’s investment in working capital

Answer 63

• The nature of the industry and the length of the working capital cycle

Some businesses have long production processes which inevitably lead to long working capital cycles and large investments in working capital. Housebuilding, for example, requires the building company to acquire land, gain government permission to build, build houses and when complete, sell them to customers. This process can often take more than a year and require large investment in work-in-progress and therefore in working capital.

Other industries, such as supermarkets, buy goods on long credit terms, have rapid inventory turnover and sell to customers for cash. They often receive payment from customers before they need to pay suppliers and therefore have little (or negative) investment in working capital

• Working capital investment policy

Some companies take a conservative approach to working capital investment, offering long periods of credit to customers (to promote sales), carrying high levels of inventory (to protect against stock-outs), and paying suppliers promptly (to maintain good relationships).

This approach offers many benefits, but it necessitates a large investment in working capital. Others take a more aggressive approach offering minimal credit, carrying low levels of inventory and delaying payments to suppliers. This will result in a low level of working capital investment.

• Terms of trade

These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, and any penalties for late payment. A company whose terms of trade are more generous than another company in the same industry sector will therefore need a comparatively higher investment in current assets

• Efficiency of management and terms of trade

If management of the components of working capital is neglected, then investment in working capital can increase. For example, a failure to apply credit control procedures such as warning letters or stop lists can result in high levels of accounts receivable.

Failure to control inventory by using the EOQ model, or JIT inventory management principles, can lead to high levels of inventor

Question 64

Discuss whether a change in dividend policy will affect the share price of DD Co

Answer 64

Dividend policy and the share price

Dividends as a signal to investors

The ultimate objective in any financial management decisions is to maximise shareholders’ wealth. If shareholder wealth is increased, it can be expected that the share price will rise. Shareholder wealth and therefore the share price should largely be determined by the cash flows arising from the investment decisions taken by management Shareholders will look at a number of factors when analysing investments and not just dividends. They will be particularly interested in the business and financial risk of the company and will not necessarily be impressed with a large increase in dividends.

The dividend declared can be interpreted as a signal from directors to shareholders about the strength of underlying project cash flows. Investors usually expect a consistent dividend policy from the company, with stable dividends each year or, even better, steady dividend growth.

Modigliani and Miller

Modigliani and Miller (MM) proposed that in a tax-free world, shareholders are indifferent between dividends and capital gains, and the value of a company is determined solely by the earning power’ of its assets and investments.

MM argued that if a company with investment opportunities decides to pay a dividend, so that retained earnings are insufficient to finance all its investments, the shortfall in funds will be made up by obtaining additional funds from outside sources. If a company pursues a consistent dividend policy, ‘each corporation would tend to attract to itself a clientele consisting of those preferring its particular payout ratio, but one clientele would be entirely as good as another in terms of the valuation it would imply for the firm’.

Conclusion

Capital markets are only semi-strong efficient, not perfect, so the signalling power of a dividend and the existence of clienteles can be important. This implies that a change in dividend policy could affect DD Co’s share price.