EXECUTIVE SUMMARY
Effective working capital management is crucial for manufacturing, trading, and distribution companies due to its significant impact on profitability and liquidity Accounts receivable, a key component of working capital, influence a firm's operating results and serve as a vital source of external financing By strategically managing accounts receivable, managers can enhance revenue, profits, and customer relationships However, excessively high receivables can negatively affect company performance, making it essential to maintain them at optimal levels for better financial health.
This thesis addresses the challenges of inefficient receivable management at THM, which negatively impacts the cash conversion cycle and working capital management, ultimately affecting the company's profitability The study identifies the key factors contributing to this inefficiency and its financial repercussions By thoroughly analyzing the underlying issues, the thesis proposes actionable alternatives and best practices to enhance the efficiency of the company's receivables management.
PROBLEM IDENTIFICATION
Company Background
THM Trading and Construction Limited Company is a primary agency for Akzo Nobel in Vietnam, specializing in the distribution of high-quality painting products to construction projects and secondary agencies across the country.
Founded in 1996, THM began as a retail store specializing in construction materials such as bricks, iron, steel, and paint Over the years, THM has experienced significant and steady growth In 2002, the company evolved from a retail store into THM Trading and Construction Limited Company, shifting its primary focus to painting products.
The company has established a comprehensive supply chain that spans nearly all provinces in Southern Vietnam, consistently achieving the highest revenue in the region for several years Notably, in 2011, it attained the top revenue in both project and agency segments across the entire Vietnamese market Here is some essential information about the company.
Company name: Công ty trách nhiệm hữu hạn thương mại và xây dựng Thế Hệ Mới
English name: The He Moi trading and construction limited company (THMC)
Office: 299 Tan Ky Tan Quy Street, Tan Son Nhi Ward, Tan Phu District, HCMC
Warehouse: 259 Tan Ky Tan Quy Street, Tan Son Nhi Ward, Tan Phu District,
Company structure: 1 general director, 1 chef accountant, 1 warehouse manager, 1 sale leader and 20 staffs.
Situational analysis
Before interviewing THM's members, we review the company's annual reports to understand its financial situation A quick examination of these documents highlights a significant decline in total revenue and profits over the past four years, with the company experiencing losses in both 2013 and 2014.
Table 2.1 Revenue and profit after tax of THM
In 2011, the return rates of THMC were very high in comparison to the rates of construction materials industry Especially, return on equity (ROE) was over 45%
However, in the next 3 years, ROA and ROE of the firm was decreased dramatically
In 2014, although the industry ROA and ROE ratio recovered and increased to 3% and 10%, respectively, THM’s ratios continued falling
When comparing suppliers of Akzo Nobel products, data reveals that THM has underperformed relative to Nam Phong Company Notably, from 2012 to 2014, Nam Phong experienced a significant increase in return rates, highlighting its strong market performance.
Recent comparisons between THM and industry standards, as well as with Nam Phong, highlight significant inefficiencies in THM's operations over the past four years The following figures will provide detailed insights into these performance issues.
Figure 2.1 Return on assets of THM, Nam Phong and the industry
Figure 2.2 Return on equity of THM, Nam Phong and the industry
Interviews with THM members highlight several factors impacting the company's performance, with accounts receivable emerging as a significant challenge in recent years Mrs Nguyet, the director of THM, emphasizes the critical nature of this issue.
“there is too much capital tied up in the account receivables”
Between 2011 and 2014, accounts receivable experienced significant declines; however, this was primarily attributed to a substantial drop in revenue rather than effective management The rate of decrease in accounts receivable was slower than that of sales, suggesting more lenient credit terms (Cheng & Pike, 2003) Over this four-year period, sales plummeted by over 68%, while accounts receivable fell by less than half.
The level of accounts receivable is significantly influenced by the volume of credit sales, as highlighted by Subramanyam and Wild (2009) The accompanying table illustrates the relationship between credit sales and the corresponding percentage of accounts receivable.
Table 2.2 Percentage of accounts receivable on credit sales
During 4 years, although the volume of sales on credit decrease sharply, the percentage of accounts receivable on total sales on credit climbed up from 23% and remain at a significant high level of 47% in 2014 The decrease speed of accounts receivable is also slower than credit sales
Based on data from financial reports, accounts receivable ratios are computed and indicated in the following table
Table 2.3 Receivables’ ratios of THMC
Over 4 years, both two accounts receivable ratios tended to deteriorate Receivables turnover ratio decreased substantially from 4.32 to 2.1 and the number of days sales outstanding increased to over 5 months in 2014 The meaning of receivables turnover ratio is measure the number of times accounts receivable were collected during the year and how efficiently a company uses the working capital (Subramanyam & Wild, 2011) The decrease in account receivable turnover shows that the company was not successful in managing the account and it took more time to turn account receivable into cash This is a signal of the fact that the company is having difficulties in collecting sales made on credit The number confirms the perspective of Ms Nhi, who works in Finance – accounting department She said that “the speed of collecting receivables in THM kept declining”; “customers delayed their debts for longer time” and it makes “an amount of working capital locked up in this account for long time” In other words, there were more delinquent customers and also the costs of holding receivables for a longer period of time
The figures below indicate the ratio comparison of THM with Nam Phong and industry
Figure 2.4 Receivable turnover ratio of THM, Nam Phong and the industry
Figure 2.5 Days sales outstanding of THM, Nam Phong and the industry
THM's financial ratios are significantly lower than those of its competitor, Nam Phong, and the industry average, indicating poor accounts receivable management This discrepancy suggests that THM struggles to collect outstanding payments, resulting in customers retaining a substantial amount of working capital for extended periods Consequently, THM's liquidity related to accounts receivable is low, and the speed at which these receivables are converted into cash is inadequate.
In a recent interview, Miss Nhi from the financial and accounting department disclosed that numerous customers have delayed their payments for extended periods, ranging from 4 to 6 months, and in some cases, up to a year, with some even defaulting on their payments An analysis of the accounts receivable ledgers at the end of 2014 reveals that THM's accounts receivable can be categorized into six distinct levels, as illustrated in the accompanying pie chart showcasing the percentage distribution of each element within the accounts receivable for that year.
Figure 2.6 Aging of THM’s accounts receivable in 2014
The analysis of accounting documents reveals that the majority of total receivables at the end of 2014 were concentrated in accounts overdue by 1.5 to 4.5 months, with 82% of accounts receivable classified as overdue Notably, 8% of debts were over two years old and deemed uncollectable Despite offering a 45-day credit period to customers, only 18% of receivables were within maturity, highlighting significant inefficiencies in THM's accounts receivable management.
1 year - 2 years over 2 year - consider as default
From the symptom of “high accounts receivable”, literature as well as the evidence from the in-depth interview, there are some tentative problems that the company is facing.
The first tentative problem: Trade credit policy
Ineffective accounts receivable management at THM is largely attributed to its lenient trade credit policy, which serves as an interest-free loan alternative for customers compared to traditional financing options (Cheng & Pike, 2003) A comprehensive credit policy, as suggested by Brigham and Ehrhardt (2013), should encompass credit standards, credit periods, early payment discounts, and collection strategies The slower decrease of accounts receivable relative to sales indicates that THM's credit policy may be too relaxed, leading to increased sales and customer attraction However, this approach also incurs higher costs and risks of default due to the substantial trade credit extended (Garcia-Ternuel and Martinez-Solano, 2008).
Mrs Nguyet states that THM primarily serves construction contractors, resulting in significant and diverse purchasing contracts Consequently, THM assigns varying credit sales amounts to different customers without a formal credit standard or financial capacity assessment Instead, the credit limit is determined based on the design plans provided by customers, typically around 10% of the total projected expenditure on painting products THM halts supplies to customers with overdue debts or those exceeding their credit limit While this lenient credit policy may attract customers, it also risks increasing payment delinquencies due to the financial instability of some clients.
Ms Nhi stated that THM offers a uniform credit period of 45 days for all customers, regardless of contract size Once all products outlined in the contract are delivered, customers are granted 45 days to complete payment This policy reflects a rigid credit period that aligns with the product pricing (Cheng & Pike).
In 2003, it was noted that the longer customers delay their payments, the lower the product price becomes Customers with the ability to pay off their debts quickly often tend to wait until the last day of the credit period Allowing all customers extended payment terms poses risks, as a customer's financial situation may change during that time, particularly for those with significant credit sales who may struggle to meet their obligations (Teng & Lou, 2012).
Ms Nhi highlighted that the company boosts cash revenue by providing a 2% discount for immediate payment purchases, while no discounts are offered for early payments on credit sales This strategy not only appeals to customers seeking price reductions but also incentivizes them to settle their bills sooner In contrast, the absence of discounts for credit sales fails to encourage early repayment, leading customers to postpone payments until the end of the credit period.
In reality, THM has poor collection efforts When there is a mature debt, the company
Mrs Nguyet noted that the company often calls customers and sends payment request letters, yet debts are frequently paid only partially and below expectations She explained that these methods do not exert enough pressure to ensure immediate repayment, leading to delays in receivables Although the company's purchasing contracts outline legal collection policies and penalty interest rates for late payments, these measures are rarely enforced Mrs Nguyet believes that applying such policies could negatively impact customer relationships and satisfaction, which is why they are only implemented for customers who are unwilling to pay or those who have excessively delayed payments.
The lenient in collection policy encourages customers to delay their payment which makes long days sales outstanding.
The second tentative problem: Ineffective coordination
Ms Nhi from the finance and accounting department highlighted a significant conflict with the sales department, noting that sales personnel often neglect customer creditworthiness when selling products, leading to an accumulation of bad debt that her department must address Mr Hai added that in THMC, salesmen primarily earn commissions based on their monthly sales, which incentivizes them to maximize product sales without considering the financial implications This misalignment in communication and priorities between the sales and finance departments contributes to ineffective accounts receivable management.
Burez and Vandenpoel (2008) highlight that the credit and finance department prioritizes assessing customer creditworthiness before offering credit contracts to avoid tying up working capital in overdue debts Conversely, the sales department focuses on maximizing total revenue, regardless of customer creditworthiness This conflict has been evident at THMC over the past four years, where a significant drop in total revenue has intensified pressure on the sales team In their efforts to boost sales, salespeople have signed more contracts and sold more products without thoroughly evaluating customer credit information, leading to increased delinquency and bad debts for the finance department to manage.
The sales department must adhere to a trade credit policy when acquiring customers, as highlighted by Burez and Vandenpoel (2008) However, due to the company's ineffective credit policy, sales personnel tend to prioritize revenue growth over adherence to these guidelines While this focus may help the sales department achieve its targets, it simultaneously increases risks and costs, leading to a decline in the accounts receivable ratio over time.
The third tentative problem: External effects
According to Mrs Nguyet, since the beginning of 2012, “Akzo Nobel Vietnam oriented
THM as the specialized project distributer Thus, they required THM to stop supply for
Due to a strategic shift towards construction projects, 2nd level agencies are expected to experience a significant decline in revenue and profit over the next three years This focus on a narrower market segment began in 2012, leading the company to concentrate exclusively on the construction industry.
Ms Nhi stated that THM ceased supplying to second agencies, leading to customers' unwillingness to pay for prior orders, which resulted in a significant increase in doubtful debts from accounts receivable.
Level of accounts receivable is also affected by the economic situation (García-Teruel
Under challenging economic conditions, companies face a decline in their ability to generate cash from operations, leading to a deterioration in the financial position of debtors after credit is extended As a result, many customers struggle to make timely payments, causing an increase in the company's days receivable Additionally, the construction sector experiences heightened risks in sales, as cash flows are heavily influenced by market and economic factors According to Mrs Nguyet, clients often delay payments until after they have sold their properties.
The real core problem: Trace credit policy
The analysis of literature reviews and interview findings reveals that the primary issue contributing to inefficiencies in accounts receivable is the trade credit policy This policy serves as a framework for companies to determine whether to extend or deny credit to customers, significantly impacting accounts receivable management.
2015) Thus, an ineffective policy brings many mistakes in making decision in granting credit
The lack of a standardized trade credit policy has led to inconsistencies among departments in granting and managing trade credit Additionally, external factors beyond the company's control further complicate receivables management Consequently, establishing a clear and cohesive trade credit policy is crucial for effective receivables management.
Figure 2.7 Factors cause the inefficiency in accounts receivable
Policy change of Akzo Nobel
SOLUTIONS
Alternative 1 - Change trade credit policy
A trade credit policy serves as a crucial guideline for companies in determining whether to grant or deny credit to customers, directly impacting accounts receivable management (Gupta & Gupta, 2015) Changes in credit policy can significantly influence the volume of credit sales tied up in receivables (Omolumo, 2003) In the case of THM, the primary challenge in managing accounts receivable arises from a lenient and ambiguous trade credit policy To address this, revising the credit policy is essential A clear and efficient credit policy can help limit bad debt costs and enhance cash flow (Ojeka, 2011) It fosters consistent cooperation across departments, mitigating biases in credit offerings and ensuring fairness among customers This consistency not only streamlines decision-making based on established credit standards but also strengthens customer relations Ultimately, implementing a well-defined credit policy can enhance the efficiency of accounts receivable management and benefit the organization as a whole According to Brigham and Ehrhardt (2013), an effective credit policy should encompass credit standards, credit periods, early payment discounts, and collection procedures.
Establishing credit standards is essential for companies to categorize customers and determine appropriate credit limits and terms A lenient credit policy can entice more buyers, leading to increased sales; however, it also escalates investment in receivables and associated costs Conversely, stringent credit standards can minimize accounts receivable investment and mitigate risks of bad debt losses, ultimately saving costs, but this may negatively impact sales and profitability.
Establishing clear and effective credit standards is crucial for THMC, as it enables the company to classify customers and set appropriate credit limits The decision to grant trade credit should be based on the customer’s creditworthiness and financial capacity (Mian & Smith, 1992).
Setting credit terms effectively involves defining the discount percentage for early payment, the qualifying days for this discount, and the overall credit period Companies can differentiate their selling prices by offering a credit period or providing a discount for early payment, which acts as a price reduction (Brennan, Maksimovic & Zechner, 1998) By granting discounts, sellers can encourage customers to settle their debts before the credit period expires, benefiting both parties—buyers gain from reduced costs while sellers enjoy quicker debt collection This discount strategy not only appeals to customers looking for price reductions but also decreases the days sales outstanding (Brigham & Ehrhardt, 2013) To maximize benefits, companies like THM should implement discount rates for early payments, which can attract customers and expedite cash flow.
In addition, varying the credit period can make the difference and the flexibility in the product price (Cheng & Pike, 2003) In the credit policy, THM only offer a period of
45 days for all customers It is not flexible and efficient Therefore THM should offer the period based on the size of the purchase contract
Implementing late payment penalties is essential for encouraging timely debt repayment among customers Without such penalties, THM customers may be incentivized to postpone their payments Therefore, THMC should establish a clear penalty rate in purchase contracts and enforce this fine whenever payments are delayed.
To enhance debt collection efforts, THM should focus on systematic and prompt collection strategies rather than relying solely on phone calls and letters By emphasizing a structured approach to receivables, the company can create a psychological impact on customers, reinforcing their awareness of outstanding obligations and encouraging timely payments.
Other legal actions should be used when there is a debtor who delays the debt for too long period
Altering credit policies can significantly affect a company's performance Implementing stricter credit policies may lead to a decline in sales and potentially damage customer relationships (Molina & Preve, 2009).
- Tightening credit policy makes the reduction in levels of account receivables, along with the decrease in the related costs The risks taken by a firm is also low
- It can also improve the efficiency and consistency in coordination among departments
- It brings the consistency in approaching customers and making decision is easier, based on a credit standard
- Flexible credit period and discount rate brings the price discrimination
- The disadvantages of this approach are mainly the reduction of sales, goodwill and profit due to the lack of trade extension to customers
- Tighten credit policy may harm the relationships with customers.
Alternative 2 - Bank guarantee
To mitigate the risk of default, THM should mandate that customers sign bank guarantee contracts, which serve as a commitment from a lending institution to fulfill the customer's debt obligations This means that if a debtor fails to make payments, the bank will assume responsibility for the debt By utilizing bank guarantees, THM can effectively transfer the default risk to the bank, ensuring greater financial security for the company (Knezević & Lukić, 2012).
In 2012, bank guarantees emerged as a more secure option than other financial instruments, providing comprehensive protection for accounts receivable against contract non-performance risks For suppliers in construction projects, where purchasing contracts often involve significant sums, THM should consider bank guarantees as a viable solution This approach allows THM to manage risks more effectively than traditional credit financing Furthermore, when issuing a bank guarantee, the bank establishes a credit limit based on the customer's creditworthiness, streamlining the trade credit process and saving valuable time for THM (Vlasák, 2013).
A bank guarantee is a formal legal document that outlines the rights and obligations of the three involved parties: the bank, the buyer, and the seller It requires both the buyer and seller to complete the necessary forms with all critical elements agreed upon in the primary contract (Knezević & Lukić, 2012) However, this process can cause inconvenience for customers, leading to feelings of distrust and potentially harming customer relationships.
- It is convenient and save more time for
THM in the process granting the trade credit
- Bank guarantee gives full protection for accounts receivable, reduce risk of delinquency and default
- Process of bank guarantee causes the inconvenient for buyers Thus it makes the customer feel uncomfortable and unpleasant
- Being required to sign bank guarantee contract, customer will feel not being trusted It will harm customer’s relation.
Alternative 3 - Factoring accounts receivable
Factoring is a financial service that allows businesses to obtain short-term capital by selling their accounts receivable to a factoring company for immediate cash at a discount This solution is particularly beneficial for companies experiencing financial distress, as it provides an alternative to traditional bank financing By utilizing factoring, businesses can effectively improve their cash flow and reduce the burden of outstanding accounts receivable.
Factoring is categorized into two types: recourse factoring and nonrecourse factoring Recourse factoring offers short-term financing by using a company's accounts receivable as collateral, allowing the factoring company to seek payment directly from the client if the customer defaults In contrast, nonrecourse factoring provides full protection against bad debts, as the factoring company assumes the risk and covers the total amount of receivables if the customer fails to repay their debts.
The method proposed by Hartmann-Wendels & Stüter (n.d.) enables companies to transfer risks and costs linked to receivables, thereby enhancing their free cash flow This increased liquidity allows businesses to invest in more lucrative assets, ultimately improving their financial position.
While factoring can help reduce accounts receivable and alleviate cash shortages, it may also decrease profitability due to associated commission and interest costs Banks carefully evaluate various factors influencing the quality of accounts receivable before purchasing, including the company's size, product type, financial statements, industry, customer demographics, management practices, collectability, and credit notes (Soufani, 2002) Consequently, only high-quality accounts receivable are eligible for factoring, leaving lower-quality receivables on the books.
In reality, there are some factoring companies which allow buying low quality accounts
Companies may incur costs ranging from 20% to 40% of their accounts receivable when utilizing certain financial options While this can be an expensive choice, it allows businesses to decrease their accounts receivable and significantly lessen potential losses.
- Factoring can bring suitable solution for short term financing in cash flow
- It decreases the amount of accounts receivable
- Nonrecourse factoring can minimize the losses
- This solution makes deduction in the profitability due to the high costs of factoring price
- Only high quality accounts receivable amount can be sold and the low quality one is still exist in the account.
Selection of solutions
Based on theoretical insights and data gathered from interviews, three potential alternatives are identified that could influence the volume and ratio of accounts receivable However, not all alternatives are applicable or suitable for the specific circumstances of THM Company.
Alternative 1: Change the trade credit policy; make it tighter and more flexible
Alternative 2: Using bank guarantee to secure the accounts receivable
Alternative 3: Factoring accounts receivable to reduce the amount of this balance
The primary focus should be on establishing an effective trade credit policy, as it is crucial for managing accounts receivable at THM A well-defined credit policy serves as a key tool for regulating receivables and can significantly enhance the efficiency of both accounts receivable and overall company operations Additionally, a clear policy fosters better collaboration among departments, leading to improved productivity Furthermore, implementing alternative solutions can provide robust protection for accounts receivable, mitigating risks of delinquency and default This year, THM has already adopted such measures, resulting in notable advancements in their receivable management.
In the case of alternative 3, while high-quality accounts receivable can be easily factored, low-quality accounts remain on the books, addressing only short-term cash flow issues At THM, only 18% of accounts receivable are classified as high quality, and selling low-quality accounts could lead to significant costs, negatively impacting profitability and performance Consequently, alternatives 1 and 2 are more suitable and appropriate for THM's situation.
IMPLEMENTATION
As the alternative 1, the credit policy of THM has to be made clearer and tighter
Implementing an overly restrictive credit policy can lead to a detrimental decrease in sales and profitability due to excessive reduction of receivables Therefore, effective management of receivables is essential According to Brigham and Ehrhardt (2013), a well-defined credit policy should encompass credit standards, the credit period, early payment discounts, and a robust collection strategy.
A credit standard is essential for companies to assess customer creditworthiness and establish appropriate credit limits based on financial capacity and risk (Mian and Smith, 1992) Credit history plays a critical role in credit scoring classification (Somol et al., 2005) To mitigate the uncertainty of buyer default risk due to imperfect information, companies like THM can analyze past transactions and aging receivables to evaluate existing customers' creditworthiness For new customers, it is crucial to gather comprehensive information, which can include contacting suppliers for payment history, reviewing financial reports, and consulting bankers about credit lines Additionally, THM may require new customers to provide mortgages, collateral, or deposits as part of the contract Utilizing the 5Cs model—character, capacity, collateral, capital, and condition—can further enhance THM's understanding of potential borrowers and improve loan performance (Edward, 1997).
- Offering a discount rate for early payment
Offering discounts can encourage customers to settle their debts before the credit period expires Therefore, THM should implement an early payment discount strategy, such as a credit term of "1/15 net 45." This means that customers who pay within 15 days will receive a discount, while the total amount is due in 45 days.
Customers can enjoy a 1% discount for payments made within 15 days of delivery, while payments can also be deferred for up to 45 days This initial 15-day period acts as a free credit window, but the subsequent 30 days incur costs The early payment discount effectively represents an interest rate for the credit extended during the contract period.
A "1/15 net 45" contract allows customers to receive credit at a 1% rate for 30 days, translating to an approximate annual interest rate of 12% This rate is significantly higher than typical bank loan rates, prompting customers to consider early payment for discounts Consequently, this can lead to a shorter average collection period and a decrease in the investment required for receivables.
THM currently offers a fixed 45-day credit period for all customers, which lacks flexibility and efficiency To enhance their credit policy, THM should consider adjusting the credit period based on the size of the purchase contract, implementing a 30-day credit period for smaller contracts and maintaining a 45-day period for larger ones Additionally, the company should introduce an early payment discount period of 10 to 15 days to incentivize prompt payments.
In this thesis, I give out 2 examples of credit term: 1/10net30 and 1.5/15net45
Ferris (1981) states that for trade credit to be beneficial, the net present value (NPV) of revenue generated from trade credit must exceed the NPV without it Assuming an average bank interest rate of 7.5% and that customers will settle their debts by the end of the discount or credit period, the present value of receivables can be calculated accordingly.
A: the original price i: the discount rate the company offer t: days of discount period or the credit period
The following tables indicate the percentage of original price that the company receive when offer those credit terms
Cash payment Early payment Maturity
Cash payment Early payment Maturity
The analysis shows that the net present value of revenue from trade credit exceeds that of cash payments, making both credit terms advantageous for THM's trade credit policy.
Setting penalties for late payment
When entering a trade credit contract, it is essential for companies to clearly define the due date, payment methods, and late-payment penalties Without a late-payment penalty, customers may be incentivized to postpone their payments Therefore, THMC should establish a penalty rate in purchase agreements and actively enforce it Setting the penalty rate above the market average, such as 10-15% per year on the overdue amount, can effectively encourage timely payments from customers.
Put more effort on collecting credit
THM should proactively remind customers of their payment obligations by sending courteous reminders as the due date approaches, making phone calls, or conducting personal visits If accounts remain unpaid, the company may need to initiate legal actions, but it is essential to assess the financial situation of the debtors beforehand This consideration is crucial, as aggressive legal measures could lead to bankruptcy for customers experiencing significant financial difficulties, ultimately diminishing the likelihood of recovering payments.
Suppliers can enforce payment by threatening to halt the supply of goods, which can be costly for customers seeking new suppliers (Cuủat, 2007) In Vietnam, Akzo Nobel has several agencies, but THMC is one of only three authorized distributors for their painting products in major construction projects in Ho Chi Minh City The strong relationship between Akzo Nobel and its agencies makes it challenging for defaulting buyers to find alternative suppliers Consequently, THMC can apply pressure on these customers by suspending supplies until their outstanding debts are settled.
An effective credit policy enhances both account receivables and sales while fostering collaboration between the sales and credit departments (Ojeka, 2011) To promote a clear understanding of these policies, companies should conduct regular meetings among departments and make necessary adjustments to the credit policy By consistently revisiting and refining the policy, organizations can improve accounts receivable management and overall operational efficiency (Ojeka, 2011).
To enhance accounts receivable security, THM should require customers to utilize bank guarantee services when extending trade credit, particularly for large contracts Although this approach may strain customer relationships, it has proven effective; THM implemented this strategy this year and experienced significant improvements in receivable management.
Accounts receivable is a crucial source of external financing for businesses, as it allows suppliers to offer credit terms, assures buyers of product quality, and strengthens customer relationships, ultimately boosting sales and profitability (Petersen & Rajan, 1997) However, high levels of accounts receivable and extended days sales outstanding can negatively impact a company's profitability by tying up capital and incurring various costs THMC faces challenges in managing accounts receivable due to both internal and external factors, leading to increased receivables and prolonged collection periods To improve accounts receivable quality, THMC should consider revising its trade credit policy, implementing credit insurance such as bank guarantees to mitigate default risks, and potentially transferring receivables to factoring companies or credit-collection agencies to reduce outstanding amounts and improve cash flow.
SUPPORTING INFORMATION
Methodology
This thesis utilizes both primary and secondary data to gather comprehensive insights Primary data is collected through direct interviews with the director and staff from the Accounting-Finance and Sales departments, with additional interviews scheduled as needed to enhance the research For secondary data, annual financial reports from 2011 to 2014 are analyzed, alongside relevant previous research, papers, journals, and textbooks accessed through Proquest and the University’s library.
The thesis employs both qualitative and quantitative methods to analyze the company's financial performance, utilizing data from balance sheets and income statements to calculate key ratios that reflect receivable management efficiency Horizontal and vertical analyses are conducted through tables and graphs to assess the company's overall effectiveness Additionally, the calculated ratios are compared with those of other companies within the industry to clarify the company's market position The thesis also incorporates literature reviews from credible sources to provide substantiated evidence throughout the analysis.
Definition of theoretical frameworks
This part provides brief descriptions, theories and literature reviews about the features of accounts receivable
Receivables are a crucial component of working capital in any enterprise, representing the amount of unpaid sales when customers purchase goods or services on credit These accounts receivable are classified as assets owned by the business, reflecting the seller's decision to allow customers to postpone payment for their products This practice is known as granting trade credit.
According to Brigham and Ehrhardt (2013), contents of trade credit policy should include the credit standards, the credit period, the discount and the collection policy
Credit standards assess a customer's creditworthiness and financial strength, determining eligibility for regular credit terms and the amount of credit to be extended.
The credit period refers to the time allowed for payment after a purchase, and extending this period can boost sales; however, it also incurs additional costs associated with the capital tied up in accounts receivable.
- The discount is the price deduction given the customer for their early payment
Discounts in purchasing contracts are typically expressed as a percentage, incentivizing customers to pay within a specified timeframe This encourages early payments, allowing customers to benefit from reduced prices before the credit period expires.
- The collection policy is procedures which the firm need to follow to collect accounts from its debtors when such amount is due after the expiry
The enterprises generally offer trade credit by their credit term, which include the credit period and the discount The form of a credit term can be as follow: K%/D net P
K%: Discount percentage on selling price if the buyer pay early
D: the number of days that qualify for early payment
P: maximum of day for payment
The receivable turnover rate is a key metric that indicates the productivity of a company's accounts receivable This ratio illustrates the relationship between credit sales and accounts receivable, revealing the amount of credit sales generated for each VND invested in receivables Additionally, it highlights how frequently receivables are collected throughout the year, providing insights into the efficiency of a firm's credit management.
(Subramanyam & Wild, 2011) It also displays the liquidity of accounts receivable
Therefore, the higher turnover rate is the better According to Subramanyam and Wild
(2011), the receivable turnover rate is defined as follow:
Days Sales Outstanding (DSO) measures the average number of days that sales remain tied up in accounts receivable, reflecting a company's efficiency in collecting payments A lower DSO indicates a quicker capital reinvestment into the business, showcasing better operational performance To assess a company's financial position, DSO is often compared to that of competitors or the overall industry average.
The cash conversion cycle is a key metric in working capital management, representing the duration between cash outflows for purchasing goods and cash inflows from sales to customers This cycle effectively illustrates the interplay among the three components of working capital.
Figure 6.1 Cash conversion cycle (Jose, Lancaster & Stevens, 1996) The CCC is measured by the formula:
The length of CCC has a negative correlation with the profitability of the firm (Deloof,
A longer Cash Conversion Cycle (CCC) indicates more funds tied up in working capital, which can decrease a firm's profitability Reducing the CCC to a reasonable minimum not only enhances profitability but also improves productivity and liquidity (Johnson & Templer, 2011) Managers can add value for shareholders by minimizing the CCC One significant factor contributing to a prolonged CCC is high accounts receivable and extended days sales outstanding, which can lead to reduced profitability and cash flow issues for the business (Gill et al., 2010).
(DPO) Cash conversion cycle (CCC)
Cash management, particularly through the lens of the Cash Conversion Cycle (CCC), plays a crucial role in improving company performance (Muscettola, 2014) It assesses a firm's efficiency in managing bill payments, collecting receivables, and selling inventory The cash cycle serves as an effective tool for analyzing the management of working capital in manufacturing companies.
Consequences of ineffective accounts receivable management
Figure 6.2 Consequences of high accounts receivable
Accounts receivable are a type of investment of companies By varying the credit period and the discount for early payment, granting trade credit for customers makes
Price discrimination allows businesses to sell products at varying prices based on customer segments, potentially enhancing profitability (Martínez-Sola, García-Teruel & Martínez-Solano, 2014) Accounts receivable serve as a strategic tool to boost sales, enabling customers to evaluate product quality prior to payment (Deloof & Jeger, 1996) By extending trade credit, companies can increase their sales and potentially achieve higher profitability However, excessive investment in accounts receivable may lead to significant costs and adversely impact overall company performance.
6.3.1 High accounts receivable makes in effective working capital management
Effective management of working capital is crucial for enterprises, as it significantly influences both profitability and liquidity Achieving optimal levels of working capital components presents a challenge for managers Research indicates a negative relationship between working capital management and firm profitability, highlighting that excessive accounts receivable can lead to increased working capital, ultimately harming the profitability and liquidity of the firm.
Granting trade credit, similar to managing inventory, ties up working capital and increases the cost of capital, negatively impacting both profitability and liquidity Research by Gill et al (2010) in the USA highlights this significant relationship.
Reducing working capital to its optimal level can significantly enhance a company's profitability, as costs arise not only from tied-up capital in accounts receivable but also from unpaid accounts.
6.3.2 High accounts receivable effects on cash conversion cycle (CCC):
CCC is used as a comprehensive measure of working capital management (Deloof,
In recent years, THM Company has seen its current assets dominate its total assets, making effective cash flow and cash conversion cycle management crucial for its financial stability While extending credit can benefit the company, it also leads to higher accounts receivable and potential uncollectible debts, which may result in future cash flow challenges if revenue heavily relies on credit sales Additionally, a notable negative correlation exists between the company's profitability, liquidity levels, and cash conversion cycle.
Dong and Su (2010) conducted research in Vietnam, confirming a correlation between cash conversion cycle (CCC) components and company profitability They assert that managers can boost profits by minimizing the CCC, particularly focusing on days sales outstanding, which negatively affects both liquidity and profitability Consequently, the longer a company takes to collect cash from customers, the lower its profitability will be.
6.3.3 High accounts receivable makes increase in the costs
Trade credit, as defined by Ferris (1981), is a unique form of short-term financing linked to the timing and value of goods exchanged, making it a vital component of corporate financing strategies While extending credit to customers can boost sales and strengthen buyer-seller relationships, it also incurs costs related to the gap between the delivery of goods and payment (Garcia-Teruel & Martínez-Solano, 2010) These costs associated with managing accounts receivable can negatively impact a company's profitability.
According to Oh (1976) and Nadiri (1969), one significant cost of trade credit is the opportunity cost, as a company's limited resources can be tied up in maintaining a large volume of accounts receivable This blockage of capital restricts the ability to invest in alternative opportunities, leading to a substantial loss in potential returns Consequently, companies with considerable accounts receivable, such as THM, face significant opportunity costs each year.
When a company offers trade credit to its customers, it incurs administrative costs due to the necessary credit management activities (Gupta & Gupta, 2015) As credit sales and the number of debtors increase, the firm faces expenses related to credit information, maintaining a credit department, salaries for credit staff, accounting records, collection costs, and other associated issues With a substantial amount of accounts receivable, THMC must invest significant effort in managing, administering, and collecting these accounts effectively.
Delinquency costs arise from delays or failures in customer payments, leading to what are known as doubtful debts When customers exceed their credit period, capital becomes tied up in overdue accounts receivable According to accounts receivable ledgers, only 18% of receivables are current, while a staggering 82% are overdue, resulting in significant amounts of money being blocked and consequently high delinquency costs associated with these overdue debts.
High accounts receivable also increase ability of losses and default risks which have considerable effects on profitability and liquidity of the company According to
According to Aggarwal and Tyagi (2014), the primary cost associated with extending credit is the risk of uncollectable accounts, commonly referred to as bad debt This issue arises when a buyer is unable to fulfill their payment obligations, such as in cases of bankruptcy, leading to a complete loss of expected payments Consequently, these bad debts must be written off in the accounts receivable, potentially resulting in financial distress for the creditor For example, in 2014, 8% of THM's accounts receivable were over two years old, with some customers having relocated, making it challenging and expensive to recover the owed amounts.
Transcript
After receiving and having a glance at the financial statement from 2011 to 2014, we conduct an interview with the Director and some staffs The interviewee:
- Ms Nhi – Chef Accountant, have worked in Accounting department for 9 years
- Mr Hai – Salesman, have worked in Sales department for 5 years
Looking at Financial statement, we can see that the sales dropped too much in the four recent years Would you please tell us the reasons of this drop?
Mrs Nguyet attributes the significant decline in sales primarily to policy changes implemented by Akzo Nobel Vietnam, which, after 2012, shifted THMC's focus to specialized project distribution, leading to a cessation of supplies to second-level agencies This strategic pivot resulted in a notable drop in revenue over the following three years Additionally, the fluctuations in the real estate market, exacerbated by the financial crisis of 2008, further contributed to the downturn, as the overall demand for construction projects diminished significantly.
Mr Hai highlighted the challenges of introducing and selling products in recent years due to intense competition from other brands and the influx of lower-priced new products The market is also plagued by fake, low-quality items, leading customers to opt for cheaper suppliers when faced with similar products However, our company prioritizes maintaining our morality and reputation, choosing not to compromise our values for profit.
The company experienced the decrease in profit in 4 years, even got lost in 2 last years Beside the drop of sales, what other reasons for that?
- Ms Nhi: Mostly, we supply products for big projects and second level agencies
To remain competitive, we must maintain lower prices than the market, despite high costs of goods sold and a modest markup of only 3-5% When sales decline, our net income from sales also suffers The significant operating costs led to insufficient net income in 2013 and 2014, ultimately resulting in losses for the company over the past two years.
Despite low sales, Mrs Nguyet emphasizes that the company faces numerous operational costs, including office and warehouse rental, labor expenses, depreciation, interest payments, and inefficiencies tied to inventory management Additionally, collecting debts has become increasingly challenging due to recent policy changes at Akzo Nobel.
Would you explain clearly how hard it is in collecting debt from customer? And what are the reasons for that?
Ms Nhi highlights a significant challenge with delayed customer payments, with many clients taking 4 to 6 months to settle debts, and some exceeding a year or defaulting entirely At the end of each year, the company must personally contact each customer to recover debts, often receiving less than anticipated Additionally, since Akzo Nobel's policy shift in 2012 focused solely on construction projects, previous customers from secondary agencies have become reluctant to settle their accounts, viewing it as costly to seek alternative suppliers Consequently, a substantial amount of capital is tied up in doubtful accounts receivable.
- Mrs Nguyet: The economic situation also affects the affordability of customer
During those years, the real estate market faced significant challenges, with many customers struggling to repay their debts on time, leading to widespread delayed payments Additionally, selling construction projects became increasingly risky, as developers typically settled their debts only after successfully selling their properties.
Ms Nhi highlights a significant issue within the company, stating that the sales department prioritizes revenue generation over assessing customers' creditworthiness This lack of consideration leads to an influx of bad debt that the finance and accounting department ultimately has to manage Consequently, there is a notable conflict between the sales and accounting teams, stemming from their differing objectives and responsibilities.
Mr Hai explains that a salesperson's primary income is derived from the commission on monthly sales, which drives their motivation to sell as many products as possible However, with recent declines in sales making it increasingly challenging to sell, it is essential for salespeople to intensify their efforts to attract customers and boost revenue.
How does the company grant credit to a customer?
Mrs Nguyet notes that THM primarily serves construction project contractors who make large bulk purchases To accommodate varying purchasing needs, THM establishes different credit sales limits for each customer, typically around 10% of the total projected spending on painting products based on the design plans provided However, THM will cease supply to customers who fail to settle their overdue debts or exceed their credit limits.
So there is no credit standard for customer assessment?
- Mrs Nguyet: No We set the credit limit based on the projects information
- Ms Nhi: We apply the credit period of 45 days for all customers and offer 2% cash discount for immediate payment purchases
And how much discount rate do you offer for early payment?
- Ms Nhi: There is no discount for early payment for sales on credit After the first day, customer has to pay all the value of the contract
How do you collect the due accounts receivable?
Ms Nguyet states that when debts mature, the company typically reaches out to customers through calls and payment request letters; however, the payments received are often partial and fall short of her expectations.
Do you apply a fine for late payment or use any legal actions to collect the debts?
Ms Nguyet emphasizes that while a penalty interest rate for late payments is included in purchasing contracts, it has never been enforced to maintain positive customer relationships She believes that imposing fines could negatively impact customer satisfaction, so the company only applies legal collection policies for clients who consistently refuse to pay or have excessively delayed payments.
Do you any other way to collect the overdue debt, especially the bad debts?
Ms Nguyet emphasizes that when a debt remains unpaid for an extended period, legal action becomes necessary She recounts an experience where they had to sell a low-quality receivable to a collection agency, which proved to be costly, as these companies typically charge between 20% to 40% of the receivable's value Nonetheless, she believes this approach is preferable to the complete loss of the debt.
Interview with a customer who visit THM to buy products:
How long have you worked with THM company?
I have worked with THM for a long time This is a qualified and reputation firm
What are your standard to choose a supplier?
The success of a project heavily relies on its specific requirements, particularly for larger undertakings that necessitate robust financial backing from suppliers These suppliers must be capable of consistently delivering products over an extended period while managing substantial credit sales Additionally, the quality and pricing of their products must remain competitive in the market.
How about your company’s order amount? Is there any change recently? Why?
The current volume of real estate orders has declined compared to previous years, making it increasingly challenging to sell homes and apartments Additionally, numerous suppliers are offering competitive pricing, attractive promotional policies, and improved credit terms for customers, further intensifying market competition.
Some of the companies somehow delay their payment Our bad debt rate keeps increasing recent years Would you tell me some reasons for that delay?
Our company occasionally faces payment delays, which we strive to avoid The real estate market significantly impacts our cash flow; for instance, when an investor invests in a building, they anticipate selling it to generate cash for debt repayment However, if the property does not sell, the investor may be forced to postpone their debt obligations.
Thank you for your sharing We really appreciate that
Aggarwal, K., & Tyagi, A (2014) Inventory and Credit Decisions under Day-Terms Credit Linked Demand and Allowance for Bad Debts Advances In Decision
Berry, A & Jarvis, R (2006) Accounting in a Business Context (4th ed) London, UK: Thomson
Brennan, M., Maksimovic, V & Zechner, J (1988) Vendor Financing Journal of
Brigham, E., & Ehrhardt, M (2013) Financial Management: Theory & Practice (14th ed) South-Western: Nelson Education, Ltd Retrieved from http://www.swlearning.com/finance/brigham/theory11e/web_chapters/bri59689 _ch27_web.pdf
Burez, J., & Vandenpoel, D (2008) Separating financial from commercial customer churn: A modeling step towards resolving the conflict between the sales and credit department Expert Systems With Applications, 35(1-2), 497-514
Cheng, N., & Pike, R (2003) The trade credit decision: evidence of UK firms
Construction material financial statement (2015) Retrieved from http://www.cophieu68.vn/incomestatementq.php?id=^vlxd
Cuủat, V (2007) Trade Credit: Suppliers as Debt Collectors and Insurance
Providers The Review of Financial Studies,20(2), 491–527
Deakins, D., Logan, D & Steele, L (2001) The Financial Management of the Small Enterprise ACCA Research Report No 64
Deloof, M & Jeger, M (1996) Trade Credit, Product Quality, and Intragroup Trade: Some European Evidence Financial Management, 25(3), 945-968