ACCOUNTS RECEIVABLES AND PAYABLES

Objectives of accounts receivables management:

1. Profit improvement from sales by allowing credit.
2. The cost of credit allowed.

Problem:
A company has sales of $20 million for the previous year. Receivables at the
end of the year were $4 million, and the cost of financing the receivables is
covered by an overdraft at the interest rate of 12%.
a. Calculate the receivables days for the company.
b. Calculate annual cost of financing the receivables.

Solution:
a. Receivables day = (Average receivables/Credit sales) X 365
= (4/20) X 365
= 73 days.
b. Cost of financing the receivables = $40 00 000 X 12%
= $ 4 80 000.
A company has sales of $20 million for the previous year, receivables at the end
of the year are $4 million and cost of financing the receivables is covered by an
overdraft at the interest rate of 12% per annum. It is now considering offering
cash discount of 2% for payment of debts within 10 days. Should it be
introduced if 40% of customers will take up the discount?

Solution:
To determine if the early settlement discount should be introduced, a
comparison must be made between the COST and the BENEFIT.

A. COST:
Revenue of $20 million X 40% of debtors X 2% discount
= $ 1 60 000

B. BENEFIT:
The benefit is a reduction in the receivables balance which will result in
higher cash balance, thereby reducing the interest payable on overdraft
balance.
Steps:
1. Calculate the current level of receivables and receivable days.
2. Calculate the cost of financing the above.
3. Calculate the new level of receivables and receivable days.
4. Calculate the cost of financing this new level.
5. Compare the old cost with the new cost to determine the
benefit.

1. The current level of receivables is given in the problem, viz., $4

million. The receivables day will be:
(Average receivables/Credit sales) X 365 = 73 days
2. Cost of financing $4 million.
$4 million X 12% = $4 80 000
 3. Receivable days and amount of receivables:
a. 40% will pay within 10 days, while the rest 60% will pay
within 73 days.
$20 million = 365 days
= 10 days X 40% = $ 219178
$20 million = 365 days
= 73 days X 60% = $ 24 00 000
Therefore, the total receivables will be = $ 26 19 178
4. Cost of financing the new level of receivables:
$26 19 178 X 12% = $ 3 14 301
5. Compare old cost with new cost to determine the benefit
(Compare 2 and 4)
Therefore, the benefit is $4 80 000 - $ 3 14 301 = $ 1 65 699

COMPARISON OF COST AND BENEFIT:

Cost: $ 1 60 000
Benefit: $ 1 65 699
Net benefit: $ 5 699
Therefore, the company should go ahead and offer early settlement
discount to its customers.
Invoice Discounting:
At the beginning of August, ABC Ltd, sells goods for a total value of
$3 00 000 to regular customers but decides that it requires payment
earlier than the agreed 30-day credit period for these invoices.
A discounter agrees to finance 80% of their face value, viz., $ 2 40 000,
at an interest cost of 9% per annum.
The invoices were due for payment in early September, but were
subsequently settled in mid-September, exactly 45 days after the initial
transactions. The invoice discounter’s service charge is 1% of the invoice
value. A special account is set up with a bank, into which all payments
are made.
Required: Summarize the sequence of cash flows.

Solution:
The sequence of cash flows is:
August - ABC Ltd receives cash advance of $ 2 40 000

Mid- September – Customers pay $ 3 00 000

Invoice discounter receives the $ 3 00 000 paid into the special bank
account.
Charges charged by Invoice discounter against ABC Ltd:
Financing cost = $ 2 40 000 X 9% X 45/365 = $ 2663
Service fee = $ 3 00 000 X 1% = $ 3000
Therefore, total charges = $ 5 663.
ABC Ltd receives from the invoice discounter:
$ 3 00 000 - $ 2 40 000 - $ 5663 = $ 54 337

Summary:
Total receipts by ABC Ltd = $ 2 40 000 + $ 54 337 = $ 2 94 337
Receipts of the invoice discounter (Interest plus service fees) = $ 5663
FACTORING:
ABC Ltd is a medium sized company producing a range of engineering
products, which it sells to wholesale distributors. Recently, its sales have begun
to rise rapidly due to economic recovery. However, it is concerned about its
liquidity position and is looking at ways of improving cash flow.
Its sales are $16 million pa, and average receivables are $3.3 million
(representing about 75 days of sale).
One way of speeding up collection from receivables is to use a factor.
REQUIRED:
Determine the relative costs and benefits of using the factor in each of the
following ‘scenarios’:
a. The factor will operate on service-only basis, administering and
collecting payment from ABC’s customers. This is expected to generate
administrative savings of $100000 each year.
The factor has undertaken to pay outstanding debts after 45 days,
regardless of whether the customers have actually paid or not. The factor
will make a service charge of 1.75% of ABC’s revenue. ABC can borrow
at an interest rate of 8% pa.
b. It is now considering a factoring arrangement with a different factor
where 80% of the book value of invoices is paid immediately, with
finance costs charged on the advance at 10% pa.
Suppose that this factor will charge 1% of sales as their fee for managing
the sales ledger, that there will be administrative savings of $100000 as
before, but that outstanding balances will be paid after 75 days (viz., there
is no change in the typical payment pattern by customers this time).
SOLUTION:
Scenario A: -
Reduction in receivable days = 75 – 45 = 30 days
Reduction in receivables (30/365) X $ 16 million $ 1 315 068
Savings in finance cost 8% of $ 1 315 068 $ 105 205
Administrative savings Given $ 100 000
Service charge $16 m X 1.75% $ 280 000

Summary:
Service charge = ($ 280 000)
Finance cost saved by reducing receivables = $ 105 205
Administrative costs saved = $ 100 000
Therefore, net cost of the service = ($ 74 795)
Scenario B: -
Cost of factoring Savings
Sales ledger $16 m X 1% $ 160 000
administration
Administrative $ 100 000
cost savings
Cost of factor $3.3 m X 80% X $ 264 000
financing 10% p.a
Overdraft finance $3.3 m X 80% X $ 211 200
costs saved 8%
TOTAL $ 424 000 $ 311 200

Therefore, net cost of factoring = ($ 112 800)

Accounts Payables:
Trade credit is the simplest and most important source of short-term finance for
many organizations.
It is a balancing act between liquidity and profitability.
Profitability – Delaying payment to suppliers for a long time may cause
difficulties for the company in the long run.
Liquidity – Delaying payment to suppliers to obtain a ‘free’ source of finance.
By delaying payment to suppliers the companies face the following possible
problems:
 Supplier may refuse to supply in the future.
 Supplier may only supply on cash basis.
 There may be loss in reputation.
 Supplier may increase price in the future.
Problem:
One supplier has offered a discount of 2% on an invoice of $7500, if the
payment is made within one month, rather than the three months normally taken
to pay. If the OD rate is 10% per annum, is it financially worthwhile for them to
accept the discount and pay early?
SOLUTION:
Savings on discount = 2% X $ 7500 = $ 150
Cost of OD = 10% X $ 7500 X 2/12 = $ 125
Net Savings = $ 25
Therefore, it is beneficial for the company to accept the discount.
MCQs:
1. In order to improve operational cash flows, indicate whether a company
would need to increase or decrease their receivables balance and payables
balance.
Receivables Payables
i. Increase Increase
ii. Increase Decrease
iii. Decrease Decrease
iv. Decrease Increase
Answer is iv.

2. The main aspect of debt factoring include/s:

i. Administration of client’s invoicing, sales accounting and
debt collection services.
ii. Making payment to the client in advance of collecting the
debts.
iii. Credit protection when the service is non-recourse.

a. I only.
b. I and ii only
c. II and iii only
d. All of the above.
Answer is d

3. Which of the following statements, concerning invoice discounting, are

true?
1. Invoice discounting is the purchase of a selection of invoices of trade
debts at a discount.
2. With ‘confidential discounting’ the client’s customers are unaware
that the business is using invoice discounting.
3. The invoice discounter does not take over the administration of the
client’s sales ledger.
a. 1 only
b. 1 and 2 only
c. 2 and 3 only
 d. All of the above.
Answer is d.
4. Which of the following statements, concerning receivables
management, is INCORRECT?
a. Credit limits should be reviewed periodically.
b. Credit analysis depends on the provision of relevant
information, for example trade references.
c. Delaying payment of invoices is likely to make receivables
management more effective.
d. Longer term credit may increase revenue but also increases the
risk of bad debts.
Answer is d.