ACCA paper f9 financial management study materials F9FM session16 d08

SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE OVERVIEW Objective To consider the factors involved in the granting and accepting of trade credit CREDIT CONTROL INVOICE DISCOUNTING AND FACTORING Invoice discounting Debt factoring SETTLEMENT DISCOUNTS Granting credit Credit periods and settlement discounts Credit rating Collection procedures Charging interest on overdue invoices MANAGEMENT OF ACCOUNTS PAYABLE Credit as a source of finance Advantages of trade credit as a source of finance 1601 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE CREDIT CONTROL 1.1 Granting credit Should credit be granted at all? Consider normal trade practice, but also consider leading a change Providing credit may stimulate sales 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 Credit periods can be changed to respond to competition but will be largely influenced by trade custom Settlement discounts – again influenced largely by accepted practice within the industry The company must ensure the discounts allowed expense does not exceed the benefit in terms of reduced finance costs 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 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: an assessment of the customer’s financial statements; the use of credit rating agencies (e.g Dun and Bradstreet); contacting credit managers in other firms to exchange information; references from the customer’s bank or accountant, although these may be of limited value; the impression of credit-worthiness gained when visiting customers’ premises and meeting the management; review of the aged accounts receivables ledger to identify customers who have significant debts outstanding for long periods 1602 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 1.4 Collection procedures Establish timings for issuing letters of demand, making chasing telephone calls, and the point when further deliveries should stop Ensure credit controllers liaise with sales management to avoid insensitive collection procedures that may damage customer relations Consider using a “stop list” i.e suspending supplies 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 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: A company issues an invoice to a customer and sends a copy to the discounter The discounter pays the company a percentage of the invoice value e.g 90%, and takes responsibility for collecting the debt from the customer The customer pays the discounter 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 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 of customers with high credit ratings Therefore discounting is most advantageous for companies which are selling to customers with high credit ratings and a good payment record 1603 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 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: 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 Credit control – the factor is responsible for chasing the customers and speeding up the collection of debts 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 Administrative savings; Provides a flexible source of finance; Obtain benefits from the factor’s economies of scale; Obtain benefits from the factor’s expertise 2.2.2 Disadvantage Cost; Loss of customer contact/goodwill; Possible damage to company reputation 2.2.3 Recourse vs Non-recourse Factoring with recourse – bad debts remain the company’s problem Non-recourse factoring – bad debts are the factor’s problem – in effect the company is insured against bad debts Fees are higher 1604 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 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 — 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 Solution 1605 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE 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 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 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 Solution 1606 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE MANAGEMENT OF TRADE ACCOUNTS PAYABLE 4.1 Credit as a source of finance 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; the firm may lose any discounts for prompt payment; 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; if the cost of refusing discount > overdraft rate then the discount should be accepted Example 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 Solution 1607 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE Example 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 Convenient and informal Can be used if unable to obtain credit from financial institutions 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 Can be used on a short-term basis to overcome unexpected cash flow crises 1608 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE Key points 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 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: explain the role of accounts receivable in the working capital cycle; explain how the credit-worthiness of customers may be assessed; explain the role of factoring and invoice discounting; explain the role of settlement discounts 1609 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE EXAMPLE SOLUTIONS Solution — Factoring (admin only) Administration savings Bad debt reduction Factor’s fee Reduction in financing cost (W) Net annual saving Annual (costs)/ savings $ 10,000 20,000 (40,000) 16,438 6,438 WORKING Reduction in cost of financing working capital 60 Current average accounts receivable 2,000,000 × 365 40 Revised average accounts receivable 2,000,000 × 365 $ 328,767 (219,178) _ One-off cash flow improvement 109,589 Annual saving thereon at 15% 16,438 _ Solution — Factoring (with finance)   60 × 500 ,000  = 82,192 Current accounts receivable    365 Finance cost (82,192 × 17%) = 13,973   45 New accounts receivable  × 500 ,000  = 61,644   365 Finance by factor = 61,644 × 80% × 18% Finance by overdraft = 61,644 × 20% × 17% $ 8,877 2,096 10,973 1610 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE P & L impact: $ Reduced interest expense (13,973 – 10,973) Saved admin expense Service fee (500,000 × 2%) 3,000 8,000 (10,000) Increased profits 1,000 Solution — Settlement discount It costs 1.5% to receive 98.5% of accounts receivable 40 days sooner 40 day interest rate = Annual effective rate = 1.5 = 1.52% 98.5 1.0152 365 40 – = 1.0152 9.125 – = 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 — Settlement discount Current accounts receivable = New accounts receivable = 100,000 × 60 = 16,438 365 (100,000 × 50% × = 1,370 + 8,219 = 9,589 10 60 ) + (100,000 × 50% × ) 365 365 $ Reduced interest expense (16,438 – 9,589) × 18% Discounts allowed expense 100,000 × 50% × 2% 1,233 (1,000) _ 233 _ Increased profit 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% × 10 60 ) + (100,000 × 50% × ) = 9, 561 365 365 The examiner has stated that he would accept this variation 1611 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE Solution — 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  20  This is an equivalent compound rate of +    980  365 / 20 − = 44.6%pa 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 — Discount Current accounts payable = 100,000 × New accounts payable = 100,000 × 40 = 10,959 365 15 = 4,110 365 $ Increased interest expense (4,110 – 10,959) × 13% Discounts received (100,000 ì 1ẵ%) (890) 1,500 _ Increase in profit 610 _ Conclusion: The discount should therefore be accepted 1612 ... premises and meeting the management; review of the aged accounts receivables ledger to identify customers who have significant debts outstanding for long periods 1602 SESSION 16 – MANAGEMENT OF ACCOUNTS... Calculate the impact on annual profit of the discount Solution 1606 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE MANAGEMENT OF TRADE ACCOUNTS PAYABLE 4.1 Credit as a source of finance Firms... flow crises 1608 SESSION 16 – MANAGEMENT OF ACCOUNTS RECEIVABLE AND PAYABLE Key points Many exam questions on this area require candidates to use working capital management ratios “in reverse”