OVERVIEW
Objective
¾
To consider the factors involved in the granting and accepting of trade credit.CREDIT CONTROL
MANAGEMENT OF ACCOUNTS
PAYABLE INVOICE
DISCOUNTING AND FACTORING ¾ Invoice discounting ¾ Debt factoring
SETTLEMENT DISCOUNTS
¾ Credit as a source of finance ¾ Advantages of trade credit as
a source of finance ¾ Granting credit
¾ Credit periods and settlement discounts ¾ Credit rating
¾ Collection procedures
1
CREDIT CONTROL
1.1
Granting credit
¾
Should credit be granted at all? Consider normal trade practice, but also consider leading a change. Providing credit may stimulate sales.¾
What is the true cost to the business of customer credit? This will be influenced by the risk of bad debts and the cost of financing accounts receivable.1.2
Credit periods and settlement discounts
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Credit periods can be changed to respond to competition but will be largely influenced by trade custom.¾
Settlement discounts – again influenced largely by accepted practice within theindustry. The company must ensure the discounts allowed expense does not exceed the benefit in terms of reduced finance costs.
¾
Having defined the credit periods and settlement discounts, the company must make sure that customers are aware of them by stating the terms: on orders; on invoices; on statements.
¾
The settlement discount policy must be enforced, since some customers will attempt to take the settlement discount whether they pay on time or not.1.3
Credit rating
This is a crucial policy area. The company must balance the risk inherent in granting credit against the necessity to allow enough credit to support the level of business.
Credit limits should be set for all accounts, based upon:
¾
an assessment of the customer’s financial statements;¾
the use of credit rating agencies (e.g. Dun and Bradstreet);¾
contacting credit managers in other firms to exchange information;¾
references from the customer’s bank or accountant, although these may be of limited value;¾
the impression of credit-worthiness gained when visiting customers’ premises and meeting the management;1.4
Collection procedures
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Establish timings for issuing letters of demand, making chasing telephone calls, and the point when further deliveries should stop.¾
Ensure credit controllers liaise with sales management to avoid insensitive collection procedures that may damage customer relations.¾
Consider using a “stop list” i.e. suspending supplies.¾
Decide when outside assistance is needed to collect overdue debts. Lawyers, trade associations and debt collection agencies may be considered.1.5
Charging interest on overdue invoices
Some powerful companies have a reputation for paying their small suppliers very slowly. Therefore in November 1998 the UK government introduced the Late Payment Act.
This legislation allows small suppliers to charge large companies 8% above central bank interest rate on invoices unpaid after 30 days.
2
INVOICE DISCOUNTING AND FACTORING
2.1
Invoice discounting
Definition
Selling selected sales invoices to a third party for a discounted cash sum.
The process is as follows:
¾
A company issues an invoice to a customer and sends a copy to the discounter.¾
The discounter pays the company a percentage of the invoice value e.g. 90%, and takes responsibility for collecting the debt from the customer.¾
The customer pays the discounter.¾
The discounter then pays the company the 10% balance due minus fees. Fees include finance charges (linked to base rate) on the cash advance and often an administration fee of 0.2% - 0.5% of invoice value.¾
The process operates “with recourse”i.e. the company keeps the risk of bad debts. Even so companies will often find that they are only able to discount the invoices ofcustomers with high credit ratings.
2.2
Debt factoring
Definition
A range of services in the area of sales administration and the collection of amounts due from customers
Debt factors may offer three closely integrated elements:
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Accounting and collection – the company is paid by the factor as customers settle their invoices or after an agreed settlement period. The factor will maintain the sales ledger accounting function.¾
Credit control – the factor is responsible for chasing the customers and speeding up the collection of debts.¾
Finance against sales – the factor advances, e.g., 80% of the value of sales immediately on invoicing.Accounting and collection is often carried out together with credit control. The finance that the factor then makes available is only taken if required, as it is typically slightly more expensive than a bank overdraft.
Factoring is becoming increasingly competitive; generally, factors will act for customers with turnover in excess of $100,000 and invoices over $100.
The usual fees are between 0.5%- 2.5% of invoice value, plus a charge for cash advances.
2.2.1
Advantages
9
Administrative savings;9
Provides a flexible source of finance;9
Obtain benefits from the factor’s economies of scale;9
Obtain benefits from the factor’s expertise.2.2.2
Disadvantage
8
Cost;8
Loss of customer contact/goodwill;8
Possible damage to company reputation.2.2.3
Recourse vs. Non-recourse
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Factoring with recourse – bad debts remain the company’s problem.Example 1— Factoring (service basis/admin only)
A plc makes annual credit sales of $2m. Customers take 60 days to pay and bad debts are 1% of sales.
Factoring is being considered. The factor would charge a service fee of 2% of sales per annum, reduce the accounts receivable collection period to 40 days, and it would be a non-recourse agreement. Administration savings of $10,000 per annum would be made.
Required:
Assuming a cost of working capital of 15% per annum, what is the impact on annual profit of the factoring option that is being considered?
Solution
Example 2 — Factoring (with finance)
Tipsy Ltd has annual sales of $500,000 and accounts receivable days of 60. It pays overdraft interest at 17%.
It is approached by a factor who offers:
Immediate finance of 80% of sales at 18% interest A guaranteed collection period of 45 days
$8,000 of administration savings A service fee of 2% of turnover
Required:
Calculate the impact on annual profit of using the factor.
3
SETTLEMENT DISCOUNTS
In the UK it is common to offer credit customers a discount if they pay within a certain number of days.
To decide if this is a good policy the cost of the discount must be compared to the cost of financing accounts receivable e.g. overdraft rate.
To allow a fair comparison the cost of the discount must be expressed as an annual effective cost.
Example 3
Customers normally take 60 days credit. A quick payment discount of 1.5% is offered for payment within 20 days.
Required:
Calculate the annual effective cost of the discount and conclude whether the discount should be offered if the overdraft rate is 15%.
Solution
Example 4
Dodgy Ltd has sales of $100,000 and accounts receivable days of 60. It pays overdraft interest at 18%.
It is considering a discount of 2% to customers who pay within 10 days. It is estimated that 50% of customers will take the discount.
Required:
Calculate the impact on annual profit of the discount.
4
MANAGEMENT OF TRADE ACCOUNTS PAYABLE
4.1
Credit as a source of finance
¾
Firms can use trade credit as a flexible source of short-term finance. The firm may even decide to pay suppliers late.Trade credit is not, however, without cost. For example:
possible loss of credit status such that the supplier might give low priority to the firm’s future orders, with consequent disruption of activities;
the supplier may raise prices in order to compensate for the finance which he is involuntarily supplying;
¾
the firm may lose any discounts for prompt payment;¾
the annual effective cost of refusing a discount should be calculated. This should be compared to the cost of financing working capital e.g. overdraft rate;¾
if the cost of refusing discount > overdraft rate then the discount should be accepted.Example 5
A supplier offers a 2% discount if the invoice is paid within 10 days of receipt, but offers no discount if the payment is delayed for a further 20 days.
Required:
Calculate the annual effective cost of refusing the discount.
Example 6
A company currently takes 40 days credit from its suppliers, believing this to be “free” finance.
Annual purchases are $100,000 and the company pays overdraft interest at 13%.
Payment within 15 days would attract a 1½ % quick settlement discount.
Required:
Calculate the effect on the profit and loss account of accepting the discount.
Solution
4.2
Advantages of trade credit as a source of finance
9
Convenient and informal.9
Can be used if unable to obtain credit from financial institutions.9
If settlement discount s are taken, it can result in a cheap source of financing − as a period of time is still allowed before payment.Key points
³
Many exam questions on this area require candidates to use working capital management ratios “in reverse” e.g. to re-arrange the formula for accounts receivable days and then use it to move from the sales figure to the estimated level of receivables.³
The other key technique is to calculate the Annual Effective Cost of settlement discounts. Use compound interest, not simple and bring a scientific calculator to the exam.FOCUS
You should now be able to:
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explain the role of accounts receivable in the working capital cycle;¾
explain how the credit-worthiness of customers may be assessed;¾
explain the role of factoring and invoice discounting;EXAMPLE SOLUTIONS
Solution 1 — Factoring (admin. only)
Annual (costs)/
Reduction in financing cost (W)
10,000
Reduction in cost of financing working capital
$ Current average accounts receivable 2,000,000 ×
36560
328,767
Revised average accounts receivable 2,000,000 × 36540
(219,178) _______
One-off cash flow improvement 109,589
Annual saving thereon at 15% 16,438
_______
Solution 2 — Factoring (with finance)
Current accounts receivable
P & L impact:
$ Reduced interest expense (13,973 – 10,973)
Saved admin expense
Solution 3 — Settlement discount
It costs 1.5% to receive 98.5% of accounts receivable 40 days sooner. 40 day interest rate =
Annual effective rate =
40 365
0152 .
1 – 1 = 1.0152 9.125 – 1 = 14.8%
Conclusion: This is below the overdraft rate and therefore the discount should be offered.
Note – the annual effective rate has been calculated above using compound interest to compare to the cost of overdraft where interest is also charged on a compound basis. However the examiner has said that he would also accept the use of simple interest i.e. 1.52% × 9.125 = 13.87%
Solution 4 — Settlement discount
Current accounts Reduced interest expense (16,438 – 9,589) × 18%
Discounts allowed expense 100,000 × 50% × 2% (1,000) 1,233 Increased profit
_____ 233 _____
Note - This solution follows the examiner’s approach as shown in the Pilot Paper and in his book “Corporate Finance Principles and Practice” (Denzil Watson and Antony Head) However there is a strong argument that the new level of accounts receivable should be stated net of discounts allowed i.e.
(100,000 × 50% ×98% ×
Solution 5 — Supplier finance
If a company receives an invoice of $1,000 under the terms in the example, and decides to pay after 30 days it will:
-lose the 2% discount.
-effectively have the use of $980 ($1,000 – $20) for the additional 20 days.
This is an equivalent compound rate of 1 44.6%pa
980 20
1 365/20 − =
+
This should be compared with the cost of financing working capital. Trade credit can
therefore be a very expensive form of financing when a cash discount is offered but refused.
Solution 6 — Discount
Current accounts payable = 100,000 ×
36540 = 10,959 New accounts payable = 100,000 ×
36515 = 4,110
$ Increased interest expense (4,110 – 10,959) × 13%
Discounts received (100,000 × 1½%) 1,500 (890) Increase in profit
