16.1 Working capital management - Accounts receivable (1)

Question 1

Credit sales - receivable / problem

Answer 1

• With a credit sale a receivable is created which is an asset in SFP
• The problem with selling on credit is that bus has to wait for their cash

Question 2

Credit policy

Answer 2

• management must establish a credit policy to manage liquidity appropriately
• a credit policy outlines the bus terms and conditions and internal procedures for offering credit to their customers

Question 3

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

Answer 3

• profit improvement from sales obtained by allowing credit
• the cost of credit allowed

Question 4

Receivables balancing act (trade off)

Answer 4

• Liquidity - collecting sales receipts as quickly as possible to reduce the cost of financing the receivables balance
• Profitability - Extending the credit period to customers to encourage additional sales

Question 5

The credit policy will be influenced by

Answer 5

• demand for products
• competitors terms
• risk of irrecoverable debts
• financing costs
• costs of credit control

Question 6

Receivables management has four key aspects:

Answer 6

1. Assessing creditworthiness of customers
2. Setting credit limits
3. Invoicing promptly and collecting overdue debts
4. Monitoring the credit system

Question 7

A firm should assess the creditworthiness of

Answer 7

• All new customers immediately, before offering credit terms
• Existing customers periodically

Question 8

Information for assessing creditworthiness may come from

Answer 8

• bank references
• trade references
• visit to customers premises
• competitors
• published info
• credit reference agencies
• legal sources of credit info
• firms own sales records
• credit scoring
• credit rating (large corps)

Question 9

Factors that may be considered when revising credit limit of existing customer

Answer 9

• Customers past payment history - if usually pays on time than a higher credit limit might be given
• Any new public info about the customer - eg. recent press releases suggest financial difficulty wouldn’t increase credit limit
• A change in the customers credit rating - for larger customers any changes to credit rating would impact the amount of credit offered

Question 10

When setting credit limits there are two limits that need to be set in accordance with risk profile of customer

Answer 10

• the amount of credit available
• the length of time allowed before payment is due

Question 11

Tools that a credit controller can use to help make decisions on credit limit

Answer 11

• Past customer history
• An aged receivables report
• Credit reference agencies
• Ratio analysis

Question 12

Invoicing and collecting overdue debts

Answer 12

• A credit period only begins once an invoice is received, so prompt invoicing is essential
• If debts go overdue, the risk of default increases, therefore a system of follow up procedures is required

Question 13

Invoice follow up procedures:

Answer 13

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

Question 14

Motivating credit control staff using collection targets

Answer 14

• One way to improve performance and increase motivation of credit control staff is by setting collection targets
• A collection target is a target for the amount of payments to collect for TR within a given period
• Targets will only be a motivator if performance is assessed and rewarded when meeting or exceeding targets

Question 15

Credit control collection targets can be set for

Answer 15

• Individual members of the collection team
• The credit control team as a whole

Question 16

Methods for reviewing the position of receivables

Answer 16

• Age analysis
• Ratios
• Statistical data

Should be regularly reviewed as part of managing working capital and corrective action taken when needed

Question 17

Cost of financing receivables calculation

Answer 17

Finance cost = Receivable balance X Interest (overdraft) rate

Receivable balance = Sales X (Receivable days / 365)

Question 18

Early settlement discounts

Answer 18

• cash discounts given to encourage early payment by customers
• the cost of the discount is balanced against the savings the the entity receives from having less capital tied up due to lower receivables balance and a shorter average collection period
• discounts may also reduce number of irrecoverable debts

Question 19

Calculation of annual cost of discount formula

Answer 19

Annual cost of discount = [ 1 + (Discount / Amount left to pay)]{to power of No of periods} - 1

No of periods = 365/52/12 / No of days/weeks/months earlier the money is received

Amount left to pay is the amount net of discount

If the cost of offering the discount exceeds the rate of overdraft interest then the discount should not be offered

Question 20

Calculate annual rate of interest implied in a cash discount

Answer 20

[ 100 / (100 - Discount%]{to power of No of periods} - 1

Question 21

Evaluating a change in credit policy to see if financially justified

Answer 21

• First stage is to identify the change in level of working capital investments as a result of change in policy
• Second stage is to consider the annual costs and benefits of changing the credit policy
• Ie. the saving in finance costs as a result of reduction in level of working capital investment, reduction in gross profit, reduction in irrecoverable debts, extra credit control costs, etc