Chapter 5 - management of working capital - receivables and payables

Question 1

Points to consider before onboarding a customer

Answer 1

1. Credit check using an agency like Experian
2. Ask for trade and bank references
3. Analyse the payment record of existing customers
4. Access the financial statements
5. Review credit limits regularly

Question 2

what is invoice discounting

Answer 2

It is where a company sells an invoice to a third party (usually a bank) for less so that this company gets paid and the bank is waiting on payment from customer

For example bank gives me £9,900 today for an £10,000 invoice

Question 3

what is factoring and what are things to consider

Answer 3

Factoring is paying another company to administer all parts of the receivables ledger

To consider:
1. Fees
2. For higher fee, the factor will advance money to the company before debts have been collected (eg 80% of invoice value)
3. For an even higher fee the factor may accept responsibility for bad debt

Question 4

What is the difference between ‘with recourse factoring’ and ‘non recourse factoring

Answer 4

With recourse is where the company is responsible for the bad debt whereas non recourse is where the factor is responsible for the bad debt

Question 5

What is simple discounting and how to work it out

Answer 5

Simple discounting is where we give a % discount on early payment which may be beneficial if we need the money in faster and it is cheaper than the interest % offered by the bank on overdrafts

To calculate, let’s imagine it currently takes 3 months to receive receipt but for a 4 % discount we can receive it in 1 month.

Therefore per $100 we can either get;

3 months = $100
1 month = $96

Therefore it is like an interest and effectively the interest rate is 4/96 = 0.04167 x 100 = 4.167% over two months (3 months vs 1 month). We then need to calculate the yearly interest to see if worth it. To do this the formula is;

1 + R = 1.04167 (to the power of 6 = 1.2776 and therefore R = 0.2776 or 27.76%

On the question it said that the annual overdraft interest was 20% so therefore it is cheaper to stay in overdraft than give the early discount

Question 6

How to calculate a change in policy

Answer 6

A change in policy is to consider giving discount to bring in cash sooner compared to interest on overdraft but where not all customer take up offer

Let’s imagine a company has sales of £20m pa, the company is considering a 1% discount for payment within 30 days, it is predicted that 60% will take up off with remaining taking 90 days. Current customer credit breakdown is;

30 days - 20%
60 days - 50%
90 days - 30%

The overdraft interest is 15%

We need to compare the cost of the discount vs the saving in interest by the less average receivables at any one time and therefore less interest being paid.

The first part is easy, 1% discount of 20m = $200,000 and 60% take up off so will cost $120,000

To work of the fall in receivables we need to first work out the current average receivables and do that we do averaging

30 x 20% = 6
60 x 50% = 30
90 x 30% = 27

Total up is 63 days on average so each day there is $54,794 of receivables (20m / 365) x 63 days average is $3,452,055

That is how much on average at any one time there is receivables balance.

Now we need to see how much there would be with discount, again work out average

30 x 60% = 18
90 x 40% = 36

Now the average is 54 days, do the same and we can see receivables falls to £2,958,904 therefore dropping by £493,151 of which we would have paid 15% interest on gives a saving of £73,973.

However the £73k saving is less than the £120k cost so therefore not worth it