TOPIC 1 WORKING CAPITAL MANAGEMENT

TOPIC 1

WORKING CAPITAL
MANAGEMENT

ROSMARIA ISMAIL DPA40103 FINANCIAL MANAGEMENT 2
COMMERCE DEPARTMENT
POLITEKNIK MELAKA

1.3 2

RECEIVABLES
CONTROL

1.3 Discuss the receivables control

1.3.1 Explain the role of accounts receivables in the working capital cycle
1.3.2 Explain the need to monitor accounts receivables
1.3.3 Explain accounts receivables control operations and the importance of managing

accounts receivables
1.3.4 Explain the various types and forms of accounts receivables
1.3.5 Explain the various accounts receivables collection method and procedure
1.3.6 Explain the issues involved with early payment and settlement discounts

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INTRODUCTION

For most firms, there would be some sales that would be conducted in cash 4
terms. However, a sizeable portion of sales would tend to be on credit terms.

When this happens, it results in the creation of Account Receivables.

A C C O U N T S R E C E I V A B L E is a balance of money owed by customers
(individuals or corporations) to another entity in exchange for goods or services
that have been delivered or used.

AR is common account used by company accountants to track revenue earned
but not yet collected.

Usually comes in the form of operating lines of credit & are usually due within a
relatively short time period (ranging from a few days to a year).

RECEIVABLES MANAGEMENT

AR represents a significant part of the firm’s current asset investment and need to be
managed effectively. Thus, collecting payments on account in a timely manner is
important to financial efficiency for a business.

Giving credit to customers results in higher costs, in particular higher interest costs and
some bad debts. These costs must be kept under control. To do this, trade receivables
must be properly managed.

Good management of trade receivables involves systems for:

deciding whether to give customers credit, and how much credit to give them

monitoring payments

collecting overdue payments 5

TYPES AND FORMS OF AR

AC COUNTS R ECEIVABLES 6
Amounts that customers owe the company for normal credit purchases.
Since accounts receivable are generally collected within two months of the sale, they are considered a
current asset.

NOTES RECEIVABLES
Amounts owed to the company by customers or others who have signed formal promissory notes in
acknowledgment of their debts.
Promissory notes strengthen a company's legal claim against those who fail to pay as promised.
Notes that are due in one year or less are considered current assets, while notes that are due in more than
one year are considered long-term assets.

OTHER R ECEIVABLES
Interest revenue from notes or other interest-bearing assets is accrued at the end of each accounting
period and placed in an account named interest receivable.
Ex : wage advances, formal loans to employees, or loans to other companies

ROLE OF ACCOUNTS RECEIVABLE IN
THE WORKING CAPITAL CYCLE

1) Billing analyst 7

Liaise with the organization’s sales teams to carry out timely invoicing of customers.
2) Cash applications analyst

Ensure the prompt and accurate allocation of invoice payments to the relevant departments
and functions.
3) Collections and disputes analyst

Collect overdue payments and resolve payment issues highlighted by customers.
4) Credit control analyst

Perform day to day credit management activities and ensure credit information and analyses
are up to date.
5) Accounts receivable manager

Coordinate the team to ensure customer payments are handled efficiently.

FACTORS DETERMINING THE SIZE
OF INVESTMENT IN AR

1) % of credit sales to total sales  nature of the business tends to determine the
blend between credit sales & cash sales.

Example : large grocery store tends to sell exclusively on a cash basis ; whereas

manufacturing firms makes their sales primarily with credit.

2) Level of sales  the more sales, the greater the AR.

(1) and (2) are not within the control of the Financial Manager !

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FACTORS DETERMINING THE SIZE
OF INVESTMENT IN AR

3) Credit and collection policies **(under the control of Finance Manager)

Terms of Quality of Collection
sale customer efforts

Specify the time period Involves Focuses on the
for customers to pay and determining control &
the terms and conditions the type of
customer who elimination of
surrounding the sale qualifies for past-due
For example : discount trade credit
for early repayments or receivables by
late interest charges. and the using ratio
credibility analysis

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THE NEED TO MONITOR ACCOUNTS
RECEIVABLE

AR must be closely monitored because the cash flow from a sale cannot be invested until the

account is collected.

Efficient management of AR would be to collect from debtors as quickly as possible without losing
sales from high-pressure collection techniques.

How to improve collections on receivables?

1) Check the credit status of new customers.

2) Invoice promptly  customers may not pay until company send a bill.

3) Consider offering discounts for early payment of invoices.

4) Prepare an accounts receivable aging schedule every month and monitor past-due

accounts.

5) Put customers who habitually pay late on cash-on-delivery terms.

6) Hire a collection agency to pursue delinquent accounts. 10

THE PROCESS OF CREDIT SELECTION

Involves the application of techniques for determining the customers that should receive
credit, by first evaluating their creditworthiness and then comparing it with the minimum
requirements for extending credit.
Several costs are associated with extending credit to less creditworthy customers.
The decline in customer quality will result in an increase in the costs of investigation,
collection and default.
Some of the techniques are :

1 ) C R E D I T S C O R I N G  customers who purchase in high volume but small monetary
amounts. It involves the use of statistically derived weights representing key financial &
credit characteristics that will measure a customer overall credit strength. The decision
to accept or reject a particular applicant will be dependent on the score.

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THE PROCESS OF CREDIT SELECTION

2 ) F I V E C ’ s O F C R E D I T  Customers who purchase in large monetary amounts may be
selected based on the following criteria :

CHARACTER reliability in payments

CAPITAL the customer’s debt to equity ratio 12
CAPACITY
COLLATERAL the cash flow available for
CONDITIONS repayment

the assets available for securing
the debt

prevailing economic & industry
conditions

AR COLLECTION
METHOD & PROCEDURE

Include how a firm should pursue its collection on
customer delinquent accounts & whether to
change the firm’s credit policy.

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DELINQUENT CREDIT ACCOUNTS

Steps in the collection process :

Letter or statement of account
Telephone call
Personal visits to customers’ premises
Collection agencies

Legal proceedings

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CHANGING CREDIT POLICY

Early payment and settlement discounts

CREDIT TERMS
CASH DISCOUNT

CREDIT POLICY

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CREDIT TERMS

C R E D I T T E R M S  Terms of sale that is laid out by a firm, for credit to be 16
extended to customers.

The terms of sale identify the possible discount for early payment, the discount
period and the total credit period.

Usually stated as a / b net c meaning that the customer can deduct “a” %

(the discount) if the discount is paid within “b” days (the discount period); if not,
the account must be paid within “c” days (the total credit period).

For example  terms of 3 / 10 net 45 indicate that a 3% discount is obtained if the
account is paid within 10 days; if not it must be paid within 45 days.

Failure to take up this discount is a cost to the customer.

CREDIT TERMS

Represented by the formula :

EFFECTIVE COST OF CREDIT = [ a / (1 – a) ] x [ 360 / (c – b) ] x 100%

(cost of release the discount)

For example : 3 / 10 net 45
Solution :

ECOC = [ 0.03 / (1 – 0.03)] x [360 / (45 – 10)] x 100%
= 31.81%

If the customer pays on the Day 45, the customer bears the annual cost
of 31.81% as he requires 35 additional days to make payment.

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CASH DISCOUNT

Acts as an incentive for the customer to pay earlier rather than later.
The discount decreases the firm’s investment in AR although it also
decreases profit.
A cash discount also helps in reduction of bad debts and may increase
sales volume.
Firms offering a cash discount should perform a cost benefit analysis to
determine whether extending a cash discount is profitable

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CASH DISCOUNT EXAMPLE

Youn Sdn Bhd is considering changing its credit terms from net 30 to 2/10 net 30. The
current Average Collection period (ACP) is 40 days, which includes receiving, processing and
collecting payments once the invoices are mailed. The firm expects the change to result in
an ACP of 25 days.
Current sales of Youn’s product is 1,100 units at a price of RM3,000 each. The variable cost
per unit is RM2,300.
The firm expects 80% of its customers to take the 2% discount, resulting in an increase in
sales of 50 units. The bad debt % is expected to remain the same. The opportunity cost of
funds invested in AR is 14%. Assume a 360-day per annum.

Should Youn Sdn Bhd offer the proposed cash discount? Provide an analysis.

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CREDIT STANDARDS & POLICY

Credit standard for customer selection may change from time to time.

The of these standards  by increasing AR will lead to a higher

sales volume which in turn increases profitability. However, it will also increase
debt collection efforts & chances of bad debts.

If credit standards were  it will lead to lower sales volume &

lower profitability. However, the chances of bad debts are also lower.

Additional cost also occurs when customers take the cash discount.

Firms need to determine the appropriate time & conditions for implementing
changes to credit policy.

Use Marginal Analysis. 20

CREDIT STANDARDS & POLICY EXAMPLE

Cobay Inc. Is considering credit policy changes in an effort to increase sales. Below is the information about the firm’s
policy before and after the change.

C URRENT P OLICY P ROPOSED P OLICY
(1/10 net 30) (2/10 net 45)

Total sales = RM3 million Credit sales expected to increase by 20% from current credit sales

50% of customers take the discount 60% of customers take the discount

35% of customers pay on Day 30 30% of customers pay on Day 45
15% of customers pay on Day 40 10% of customers pay on Day 60
Bad debt = RM50,000 Bad debt = RM55,000

Inventory level = RM100,000 Inventory level = RM120,000

A dditional in formation :

▰ 1/3 of total sales are credit sales.
▰ Variable costs are 75% and the required rate of return before tax is 10%.

Should the recommended credit policy changes be implemented? Provide an analysis. 21

THANKS!

Any questions?

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