WORKING CAPITAL

MANAGEMENT
At the end of June, 2013, Apple Inc. had $146 billion in
cash and cash equivalents. This cash hoard, enough to
buy either Citigroup Inc. or Bank of America Corp., has
triggered public outcry and shareholder activism. For
example, by August, 2013, investor Carl Icahn had
accumulated shares in Apple valued at $1.5 billion and
pressed the company to buy back more
shares. Apple is not the only company to hold substantial
amounts of cash. In the beginning
of 2013, the S&P 500 firms held a total of $1.2 trillion in
cash, more than the GDP of both
Mexico and South Korea, making corporate cash policy
integral to the whole economy.

1
 WORKING CAPITAL
MANAGEMENT

Working Capital Management

Cash Management
Inventory Management
Receivable and Payable Management
Short Term Financing
2
WORKING CAPITAL MANAGEMENT
(CONT'D)

 What is “Working capital”?

WORKING
 Investment in working capital
CAPITAL
MANAGEME  Financing working capital
NT  Working Capital Characteristics
 Objectives of Working Capital
Management

 Liquidity ratios
ASSESSING  Cash operating cycle
THE  Overtrading
LIQUIDITY  Solutions to liquidity problems
POSITION  Over-capitalization
3
WHAT IS “WORKING
CAPITAL”?
 Working capital represents the net current
assets available for day-to-day operating
activities. It is defined as current assets less
current liabilities and, in exam questions, the
components are usually inventory and trade
receivables, trade payables and bank
overdraft.

4
WHAT IS “WORKING CAPITAL”?
(CONT'D)

Current
Liabilities
Current Assets Net
Working
Capital Long-Term Debt

How much
Fixed Assets
short-term cash
1 Tangible flow does a Shareholders’
2 Intangible company need Equity
to pay its bills?
5
WHAT IS “WORKING CAPITAL”?
(CONT'D)
 Key current assets and liabilities
Current assets
Cash
Inventory of raw materials
Inventory of work in
progress
Inventory of finished goods
Amounts receivable from
customers
Marketable securities
Current liabilities
Trade accounts payables
Taxation payable
Dividend payments due
Short-term loans
Long-term loans maturing
within one year
Lease rentals due within one
year
6
WHAT IS “WORKING CAPITAL”?
(CONT'D)
 Working capital management is crucial to the
effective management of a business because:
 Current assets comprise over half the assets of
some companies.
 Shareholder wealth is more closely related to
cash generation than accounting profits.
 A failure to control working capital and
therefore liquidity, is a major cause of business
failure.
 Two questions must be considered: How much to
invest in working capital? and how to finance it?
7
INVESTMENT IN WORKING
CAPITAL
LIQUIDITY v
PROFITABILITY

High investment in Low investment in working

working capital capital
More liquid Less liquid
But may not be using But may be using
working capital efficiently working capital
Less profitable efficiently
 More profitable
 Is there an OPTIMAL level of working
8
INVESTMENT IN WORKING CAPITAL
(CONT'D)
 Businesses must avoid the extremes:
 Overtrading- an insufficient working capital
base to support the level of activity. This can
also be described as under-capitalization
 Over–capitalization: too much working
capital, leading to inefficiency

9
INVESTMENT IN WORKING CAPITAL
(CONT'D)
 Working capital policy
 Working capital policy refers to the level of
investment in current assets for attaining their
targeted sales.
 It can be of three types: restricted, relaxed, and
moderate.
 Relaxed policy has higher levels of current assets
 Restricted policy has lower levels of current assets
 Moderate policy places itself between relaxed and
restricted 10
FINANCING WORKING
CAPITAL
 Long term  Short term
 Equity  Overdraft
 Expensive as it is flexible
 New share issues
 Risky as repayable on
 Retained profits demand
 Debt  Accounts payable –
 Debentures appears cheap but
refusing quick
 Long-term bank settlement discounts can
loans be expensive

11
FINANCING WORKING
CAPITAL
 New terms
 Debenture: A long-term unsecured corporate
bond. Debentures are usually issued by large
firms having excellent credit ratings in the
financial.
 Business overdraft borrowing takes place when
the business makes payments out of its current
account and exceeds its available balance.

12
FINANCING WORKING CAPITAL
(CONT'D)
 Permanent & temporary
 Permanent current assets: businesses hold will
include a minimum level of receivables owing
money, and minimum balances of inventory and
cash held for safety reasons. These minimum
levels represent permanent working capital.
 Temporary current assets are assets held over and
above the minimum amounts.

13
FINANCING WORKING CAPITAL
(CONT'D)
Failure to realize the firm’s permanent current assets
causes the problems of inadequate financing

14
FINANCING WORKING CAPITAL
(CONT'D)

15
FINANCING WORKING CAPITAL
(CONT'D)
Toward an Optimal Financing Working Capital
Policy

1 Most aggressive asset – financing mix plan

4 Most conservative asset – financing mix plan

2, 3 Moderate approach
16
FINANCING WORKING CAPITAL
(CONT'D)
 The ratio of long-term financing to short-term
financing at any point in time will be greatly
influenced by the term structure of interest rates
 Term structure of interest rates
 It is often referred to as a yield curve
 The term structure of interest rates shows the
relative level of short-term and long-term
interest rates at a point in time.
17
FINANCING WORKING CAPITAL
(CONT'D)
 The shape of yield curve:
 The liquidity premium theory indicates that long-term
rates should be higher than short-term rates.
 The market segmentation theory states that Treasury
securities are divided into market segments by the
various financial institutions investing in the market
such as commercial banks, savings and loans and other
mortgage-oriented financial institutions, pension funds
and life insurance companies.
 The expectations hypothesis theory maintains that the
yields on long-term securities are a function of short-
term rates. 18
WORKING CAPITAL
CHARACTERISTICS
 Holding inventory (from their purchase from external
suppliers, through the production and warehousing of
finished goods, up to the time of sale).
 Taking time to pay suppliers and other accounts
payable (creditors)
 Allowing customers (accounts receivable) time to pay

Smaller companies
Supermarket Wholesaler with a limited
s trading record

selling and Problem: Co- difficult to

advantage of ordinating make use of
obtain credit
significant cash buying mainly the flow of
short-term
borrowings from 19
holdings  invest on credit cash suppliers
 OBJECTIVES OF WORKING
CAPITAL MANAGEMENT
 Working Capital Management: The techniques for
managing the short-term assets and the associated
liabilities are examined. The material is introduced
in the context of risk-return analysis. The financial
manager must constantly choose between liquid,
low-return assets (perhaps marketable securities)
and more profitable, less liquid assets (such as
inventory). Sources of short-term financing are also
considered.
 To ensure it has sufficient liquid resources to
continue in business 20

 To increase its profitability

 ASSESSING THE LIQUIDITY
POSITION
 Ratios
 Cash operating cycle
 Overtrading
 Solutions to liquidity problems
 Over capitalization

21
 LIQUIDITY RATIOS
 What is liquidity ratios ?
 A group of ratios that allows one to measure the
firm’s ability to pay off short-term obligations
as they come due. Primary attention is directed
to the current ratio and the quick ratio.
 They're both measures of a company's financial
health

22
 (CONT'D)
 Current ratio
 Current ratio is calculated as current assets
divided by current liabilities; a measure of the
firm’s ability to pay off its current assets.
 Current ratio
 The ratio in excess of 1 should be expected, but
what is 'comfortable' varies between different
types of businesses such as traditional
manufacturing and modern manufacturing
firms. 23
 (CONT'D)
 Quick ratio
 Quick ratio is calculated as current assets minus
inventory divided by current liabilities. This
ratio is sometimes called the acid test ratio and
is a more stringent measure of liquidity because
it eliminates inventory (the least liquid asset)
from current assets.
 Formula: Quick Ratio
 This ratio should ideally be at least 1 for
companies with a slow inventory turnover.
24
 (CONT'D)
 How do the current ratio and Quick Ratio
Differ?
 The quick ratio offers a more conservative
view because it doesn't include inventory
that is more difficult to liquidate.
 By excluding inventory, the quick ratio
focuses on the company’s more liquid
assets.

25
 (CONT'D)
 Notes:
 Both ratios include accounts receivable, but
some receivables might not be able to be
liquidated very quickly. As a result, even the
quick ratio may not give an accurate
representation of liquidity if the receivables are
not easily collected and converted to cash.
 No single ratio will suffice in every circumstance
It's important to include other financial ratios in
your analysis, including both the current ratio
and the quick ratio, as well as others. 26
 (CONT'D)
 Example: calculate current and quick
ratios

27
 (CONT'D)
 Compare the industry average

28
 (CONT'D)
 Exercise:
 Total current assets: $ 560,000
 Total current liabilities: $ 280,000
Calculate the current ratio and conclude the
liquidity position if the industry average is 1.5.
 Inventory: $ 200,000
Calculate the quick ratio and conclude the
liquidity position if the industry average is 1.2
29
 RATIOS
 Asset utilization ratios is a group of ratios that
measure the speed at which the firm is turning
over or utilizing its assets.
 They measure inventory turnover, fixed asset
turnover, total asset turnover, and the average
time it takes to collect accounts receivable.
 They include receivables turnover, average
collection period, inventory turnover, fixed
asset, turnover and total asset turnover.
30
 RATIOS
 Receivables turnover show how quickly debts
are collected.
 Formula: Receivables turnover

31
(CONT'D)
 Example: Calculate receivables turnover
ratio

Receivables Turnover = 32
(CONT'D)
 Example: Compare the industry average
Ratio Saxton Industry
Receivables turnover 11.4 10.0

33
(CONT'D)
 Receivables turnover show how quickly
debts are collected.
 Formula: Average collection period

 An increase in the average collection

period may be the result of a
predetermined plan to expand credit
terms or the consequence of poor credit
administration.
34
(CONT'D)
 Example: Calculate average collection
period
 Accounts receivable: $350,000
 : 11.111
 Average collection period
= = 32

35
(CONT'D)
 Example: Compare the industry average
Ratio Saxton Industry
Average collection period 32 36

36
 RATIOS
 Inventory turnover ratio
 Inventory turnover ratio indicates how many
times a firm sells and replaces its inventory over
the course of a year and is computed by sales
divided by total inventory.
 Inventory Turnover
 A high inventory turnover is considered “good”
unless it is achieved by maintaining unusually
low inventory levels, which may hurt future
sales and profitability.
37
(CONT'D)
 Example: Calculate inventory turnover

Inventory Turnover = 38
(CONT'D)
 Example: Compare the industry average
Ratio Saxton Industry
Inventory turnover 10.8 7.0

39
 CASH OPERATING CYCLE
 The cash operating cycle (also known as the
working capital cycle or the cash conversion
cycle) is the number of days between paying
suppliers and receiving cash from sales.
 Calculate: Cash operating cycle = Inventory days
+ Receivables days – Payables days.

40
CASH OPERATING
CYCLE

41
 CASH OPERATING CYCLE
Calculate
Raw materials inventory holding period

Accounts payable payment period =

*365 (2)
Average production period
*365 (3)

42
 (CONT'D)
Calculate
Inventory turnover period (Finished goods) =
*365 (4)
Accounts receivable payment period =
* 365 (5)

 Cash Operating cycle = (1)-(2)+(3)+(4)+(5)

43
 (CONT'D)
Example: Tipple Plc has the following estimated figures
for the coming year:
Sales $3,600,000
Gross profit margin 25%
Finished goods Inventory $200,000
Work in Progress Inventory $350,000
Raw Materials Inventory $150,000
Accounts payable $130,000
Work-In-Progress (WIP) is 80% complete. Purchases
represent 60% of production cost.
Account receivable: $306,000 44
 (CONT'D)
The length of operating cycle is affected by various factors e.g.
Type of industry
Liquidity and profitability trade-off
Efficiency of management

45
 (CONT'D)
 Overtrading occurs when a company tries to
support a large volume of trade from a small
working capital base.
 It can also be referred to as under-capitalization
and often occurs when a business grows very
rapidly without increasing its level of long-term
finance.
 The result can be a liquidity crisis.

46
 (CONT'D)
 Indicators of overtrading
 Decline in liquidity
 Rapid increase in turnover
 Increase in inventory days
 Increase in accounts receivable days
 Increase in short-term borrowing and a decline
in cash holdings
 Large and rising overdraft
 Reduction in profit margin
 Increase in ratio of sales to fixed assets
47
 (CONT'D)
 Solutions to liquidity problems
 Reducing the inventory-holding period for both
finished goods and raw materials
 Reducing the production period – not easy to do
but it might be worth investigating different
machinery or working methods
 Reducing the credit period extended to accounts
receivable, and tightening up on cash collection
 Increasing the period of credit taken from
suppliers
 An increase in the level of long-term finance
48

 Reducing the level of sales growth to a more

OVER-CAPITALIZATION
 If there is excessive inventories, accounts
receivable and cash, and very few accounts
payable, there will be an over-investment by the
company in current assets.
 Working capital will be excessive and the
company will be over-capitalized.

49
OVER-CAPITALIZATION
 Indicators of over-capitalization
 Sales/net working capital: compare with
previous years or similar companies
 Liquidity ratios: compare with previous
years or similar companies
 Turnover periods: Long turnover periods for
inventory and accounts receivable or short
credit period from suppliers may be
unnecessary
50
 KEYWORDS
Working capital
Working capital requirement
Relaxed policy
Restricted policy
Moderate policy
permanent current assets
Temporary current assets
Aggressive approach
Conservative approach
51

Moderate approach
 CASH MANAGEMENT
Cash management involves control over the
receipt and payment of cash to minimize
nonearning cash balances.
It’s inefficiency if the firm holds excessive levels
of cash.
Holding cash has a cost – the loss of earnings
which would otherwise have been obtained by
using the funds in another way. The financial
manager must try to balance liquidity with
profitability 52
 CASH MANAGEMENT
(CONT'D)
 Reason for cash holding
 Transactions motive: to provide sufficient
liquidity to meet current day-to-day financial
obligations, e.g. payroll, the purchase of raw
materials, etc.
 Precautionary motive: a cash reserve to give
cushion against unplanned expenditure. This
reserve may be held in the form of “cash
equivalents” – short-term, low risk, highly liquid
investments, e.g. treasury bills.
 Speculative motive – to quickly take advantage
53

of investment opportunities that may arise.

 CASH FLOW CYCLE
 The simple cash flow cycle assume that:
 The sale of finished goods or services produces
either a cash sale or an account receivable for
future collection.
 The accounts receivable are collected and become
cash, which is used to buy or produce inventory
that is then sold.

54
CASH FLOW CYCLE

55
EXPANDED CASH FLOW
CYCLE

56
 CASH FLOW PROBLEMS
Making losses
Inflation
Growth
Seasonal business
One-off items of expenditure
Float

57
 COLLECTIONS AND
DISBURSEMENTS
 Float:
 Float is the difference between the
corporation’s recorded amount and the amount
credited to the corporation by the bank.

Float = Available balance – Ledger balance (book balance)

 Checks written by a firm generate

disbursement float.
 Checks received by the firm create collection
float 58
 COLLECTIONS AND DISBURSEMENTS
(CONT'D)
Disbursement Float:
8 June: buy some raw materials and pays with a check of $100,000
Supplier

- Book balance
immediately reduced by
$100,000

Until the check is presented, 14

June, the available balance is
greater than its book balance by Supplier’s bank
Company $100,000

•Before 8 June: float = 0

•From 8 June to 14 June: 59
Has an account of $100,000
float = $100,000
Company’s
 COLLECTIONS AND DISBURSEMENTS
(CONT'D)
Collection Float
8 October: Receive a check of $100,000

•Before 8 Oct: float = 0

•From 8 Oct to 14 Oct:
float = - $100,000 - Book balance
immediately increases by
$100,000
Company
Deposit the check to
14 Oct: Present the company’s bank.
check

Customer’s bank

Had an account of $100,000

60
 CASH FLOW FORECASTS
 Cash flow forecasts show the expected receipts
and payments during a forecast period and are a
vital management control tool, especially during
times of recession.
 A simple pro-forma is given below:
 Sales volume
 Revenue
 Costs
 One-off expenses
 Typical format (the following slide)
61
(CONT'D)

62
 (CONT'D)
 Usefulness
 Give management an indication of potential
problems that could arise and allows them the
opportunity to take action to avoid such
problems.
 A cash flow forecast can show four positions

63
INVENTORY MANAGEMENT

Working Capital Management

Cash Management
Inventory Management
Receivable and Payable
Management
Short Term Financing
64
 DEFINITION
 Three basic categories
 Raw materials used in the product
 Work in process, which reflects partially
finished products
 Finished goods, which are ready for sale

65
 DEFINITION
 The systematic regulation of inventory levels
 If inventory is too high: inefficient => profit
produced
 If inventory is too low: insufficient to satisfy
customers => profit produced

66
REASONS FOR HOLDING
INVENTORY
 To reduce the risk of stockouts
 To ensure continuous production
 To take advantage of quantity discounts
 To buy in ahead of a shortage or ahead of a
price rise
 For technical reasons
 To ordering costs

67
 CHARACTERISTICS
 Level versus Seasonal Production
 Level (even) production throughout the year allows for
maximum efficiency in the use of manpower and
machinery, it may result in unnecessarily high
inventory buildups before shipment, particularly in a
seasonal business.
 If we produce on a seasonal basis, the inventory
problem is eliminated, but we will then have unused
capacity during slack periods.
 Determine whether a plan of level or seasonal production should
be followed. 68
 CHARACTERISTICS
 Inventory Policy in Inflation (and Deflation)
 Only the most astute inventory manager can hope to
prosper in this type of environment.
 The problem can be partially controlled by taking
moderate inventory positions (not fully committing at
one price).
 Another way of protecting an inventory position is by
hedging with a futures contract to buy or sell at a
stipulated price some months from now.

69
 INVENTORY
 Carrying costs: interest on funds tied up in inventory
and the costs of warehouse space, insurance premiums,
and material handling expenses; an implicit cost
associated with the dangers of obsolescence or
perishability and rapid price change.
 Ordering Costs: the cost of ordering and processing
inventory into stock. a relatively low average inventory
in stock = order many times  total ordering costs will
be high.

70
 INVENTORY
 Purchase price  Shortage costs
 Holding costs  Production stoppages caused
by lack of raw materials
 Cost of capital tied up
 Stockout costs for finished
 Insurance
goods
 Deterioration, obsolescence and theft  Emergency re-order costs
 Warehousing  Systems costs – people and
computers
 Stores administration

 Re-order costs The benefits of holding

inventory must outweigh
 Transport costs the costs
 Clerical and administrative expenses
 Batch set-up costs for goods
produced internally
71
 EOQ MODEL
 Definition
 The Economic Order Quantity (EOQ) is the
quantity of inventory that should be ordered
each time a purchase order is made.
 EOQ aims to minimize the costs which are
relevant to ordering and holding inventory.

72
 EOQ MODEL
 Determination of EOQ
 Assumption of EOQ
 Purchase price per units is constant
 Constant demand
 No risk of stockouts

73
 EOQ MODEL
 Determination of EOQ
 EOQ graph

74
 EOQ MODEL
 Determination of EOQ
 The total annual relevant cost to be minimized
= annual holding cost + annual order cost
The cost of holding The cost of an
one unit in inventory order * the
for one year * the number of orders
= +
average number of in a year
units held
𝑪𝟎
= + 𝑫
𝒙
75
 EOQ MODEL
 Determination of EOQ
 The total cost is minimized when:

 X=order quantity
 = cost of holding one unit for one year
 D = annual demand
 = cost of placing an order

76
 EOQ Model
Example 1: using the following data calculate the EOQ
D = 40,000 units
= $2
= $1

77
 JUST-IN-TIME
 What is Just-in-time
 Just-in-time inventory management is part of a
total production concept that often interfaces
with a total quality control program.
 Production and purchasing are linked closely
to sales demand on a week-to-week basic.
 The aim is to create a continuous flow of raw
materials inventory into work progress, which
becomes finished goods to go immediately to
the customer.
78
 JUST-IN-TIME
 Basic requirements
 Quality production that continually satisfies
customer requirements;
 Close ties among suppliers, manufacturers, and
customers;
 Minimization of the level of inventory.

79
 JUST-IN-TIME
 Condition necessary:
 Flexibility of both supplier and internal
workforce
 Quality must be maintained at every stage
 Close working relationship with supplier to
make immediate deliveries
 High technology production methods have
made this easier to achieve

80
 JUST-IN-TIME
 Benefits
 Cost savings from lower levels of inventory
and reduced financing costs.
 The manufacturer pushes some of the cost of
financing onto the supplier.
 If the supplier also imposes JIT on its suppliers, these
efficiencies work their way down the supplier chain to
create a leaner production system for the whole
economy.
 Measure: inventory-to-sales ratios and the reduction
of inventory in-process and in-transit 81
 JUST-IN-TIME
 Benefits
 Other benefits
 Reduced warehouse space for inventory  save
construction costs and reduce overhead expenses for
utilities and manpower
 The Internet and electronic data interchange (EDI)
systems reduce rekeying errors and duplication of
forms for the accounting and finance functions
 Reduced costs from quality control because of JIT
prevents defects rather than detecting poor quality
82
 JUST-IN-TIME
 Costs
 Lost sales and slowing growth
 Sales increased much more rapidly than
forecast, and manufacturers could not keep up
with the demand.
 Macro conditions

83
 RECEIVABLE AND PAYABLE
MANAGEMENT

Working Capital Management

Cash Management
Inventory Management
Receivable and Payable
Management
Short Term Financing

84
 CREDIT CONTROL (CONT'D)
 What is Accounts Receivable?
 The word receivable stands for the amount of
payment not received. Accounts receivable is the
money that a business has a right to receive after a
certain period of time when the business has sold
goods or services on credit.
 For example, the accounts receivable is the record
of fact that a company has done some work for
customer X and that customer X owes money to the
company. 85
 CREDIT CONTROL (CONT'D)
 What is Accounts receivable management?
 Accounts receivable management is the process of
ensuring that customers pay their dues on time. It
helps the businesses to prevent themselves from
running out of working capital at any point of time.
It also prevents overdue payment or non-payment
of the pending amounts of the customers. It builds
the businesses financial and liquidity position.

86
 CREDIT CONTROL
 Benefits of accounts receivable
 Stimulate sales and increase profit
 The incremental cash flows can offer a valuable
asset to the firm

87
 CREDIT CONTROL
 Benefits of accounts receivable
 Motives of granting accounts receivable
 Reduces the information asymmetry between buyer and
seller
 The firm’s pricing policy designed to stimulate demand
 Brings down exchange costs
 Reinforce the supplier–customer relation.
 Generate an implicit interest income for delayed payment
if the seller can charge a higher price by offering credit
terms. 88
 CREDIT CONTROL
 Costs of accounts receivable
 Exposes the firm to financial risks limits firms
growth, exposes liquidity problems and go
bankrupt.
 The value of the interest charged on an overdraft to fund
the period of credit
 Forgo funds on which interest could be earned.
 Incur credit management costs.

89
 CREDIT CONTROL (CONT'D)
 Costs related to granting credit

90
 CREDIT CONTROL
 The role of accounts receivable
 Providing credit may stimulate sales.
 Increasing profitability by reducing the risk of any
bad debts.
 Reminding the customers and collecting the money on
time.
 Identifying the reasons for such delays and finding a
solution to those issues.

91
CREDIT CONTROL (CONT'D)
 Account receivable in a balance sheet

92
 CREDIT CONTROL (CONT'D)
 Three keys of granting credit
 Before granting credit
 Ensure that the customer is worthy and bad debts will not
result.
 Checks should continue to be carried out on existing
customers as a company would like to have early warning
of any problems which may be developing.
 Granting credit: Suitable credit terms must be set
and the receivables that arise must be monitored
efficiently if the costs of giving credit are to be kept
93

under control.
 CREDIT CONTROL (CONT'D)
 Three keys of granting credit
 After granting credit
 The final collection of cash from customers.
 A rigorous system to ensure that all customers pay in a
timely fashion
 Without this, the level of receivables and the cost of
financing these receivables will inevitably rise, as will the
risk and cost of bad debts.

94
 CREDIT CONTROL (CONT'D)
 Assessing creditworthiness
 A bank reference – fairly easily obtained, but the
other company is the bank’s customer and so a
bank reference will stick to the facts  unlikely to
raise any fears the bank may have about the
company.
 A trade reference – obtained from another
company dealings with your potential
customer/customer. Due to the litigious nature 
difficult to obtain a written reference but able to
95

call contacts you have in the trade and obtain an

 CREDIT CONTROL (CONT'D)
 Assessing creditworthiness
 Credit rating/reference agency
 These agencies’ professional business sell information
about companies and individuals  keen to give you the
best possible information, so you are more likely to return
and use their services again.
 Financial statements
 Quickly and easily obtained, indicate whether or not a
company should be granted credit
 Note that the financial statements available could be out of
96

date and may have suffered from manipulation.

 CREDIT CONTROL (CONT'D)
 Assessing creditworthiness
 Information from the financial media
 Information in the national and local press, and in suitable
trade journals and on the internet. For example, if a large
contract has been lost or that one or more directors has left
recently, then this may indicate that the company has
problems.

97
 CREDIT CONTROL (CONT'D)
 Assessing creditworthiness
 Visit
 Visiting a potential new customer to discuss their exact
needs is likely to impress the customer with regard to your
desire to provide a good service.
 It gives you the opportunity to get a feel for whether or not
the business is one which you are happy to give credit to.
While it is not a very scientific approach, it can often work
quite well, as anyone who runs their own successful
business is likely to know what a good business looks, feels
and smells like! 98
 CREDIT CONTROL (CONT'D)
 Setting credit terms and monitoring accounts
receivable
 The credit terms should be explained, including:
the normal credit period and any discount for
prompt payment, or interest charged on late
payment.
 Variations within a trade do occur and, indeed, a
company may well offer different terms to
different customers, depending on the credit rating
of each customer and their relationship with each
99

customer.
 CREDIT CONTROL (CONT'D)
 Setting credit terms and monitoring accounts
receivable
 This credit limit is allowed to grow slowly as your
faith in the customer grows and all attempted
breaches should be brought to the attention of the
credit controller or other responsible person.
 Note that: a common trick of an unethical
company is to find a new supplier, make a small
order and pay for it promptly. A large order is
then made and, having taken delivery of this 100

order, the customer delays payment for a

CREDIT CONTROL (CONT'D)
 Credit Periods and Settlement Discounts
 Credit periods can be changed to respond to
competition but will be largely influenced by
trade custom
 Settlement discounts – 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.
101
 CREDIT CONTROL (CONT'D)
 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
Moody’s S&P Quality of Issue
Highest quality. Very small risk of default.
Aaa AAA
High quality. Small risk of default.
Aa AA
High-Medium quality. Strong attributes, but potentially
A A
vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially unreliable.
Ba BB Some speculative element. Long-run prospects questionable.
B B Able to pay currently, but at risk of default in the future.
Poor quality. Clear danger of default .
Caa CCC
Highly speculative. May be in default.
Ca CC
Lowest rated. Poor prospects of repayment.
C C
102
In default.
D -
 CREDIT CONTROL (CONT'D)
 Credit limits should be set for all accounts, based
upon:
 An assessment of the customer’s financial statements
 Use of credit rating agencies (Standard & Poor's,
Moody’s…)
 Contacting credit managers in other firms to exchange
information

103
 CREDIT CONTROL (CONT'D)
 Creditlimits should be set for all accounts,
based upon:
 References from the customer’s bank or
accountant
 Impression of credit-worthiness gained when
visiting customers’ premises and meeting the
management
 Review of the aged account receivables ledger to
identify customers who have significant debts
outstanding for long periods 104
 CREDIT CONTROL (CONT'D)
 Collection procedures
 if cash is to be collected, then the customer must
be invoiced  the invoice is sent out quickly and
accurately. The receipt of your invoice reflects
the efficiency of your debt collection system.
 If the invoice takes a long time to arrive and is
not accurate, then your accounts receivable
department will be viewed as inefficient and
customers may seek to exploit this perceived
weakness and delay payment due to a dispute. 105
 CREDIT CONTROL (CONT'D)
 Collection procedures
 Monthly statements – these can be produced
quickly and easily by any computerised sales
ledger system and sent to customers. Exactly how
much impact they have is however debatable.
 Chasing letters – these should be directed to a
specific person preferably at a reasonably senior
level. However, preparing and sending these
letters has a cost and, like the monthly
statements, their impact is often limited. 106
 CREDIT CONTROL (CONT'D)
 Collection procedures
 Chasing phone calls
 Have a great impact due to having to answer the
telephone
 They have a nuisance value which can generate results.
 Personal approach
 A personal approach from a senior person in the
company to a senior person at the customer can often
yield results. This is quite common in trades where the
personal relationship with clients is important. For
107

instance, this often occurs in professional accountancy

 CREDIT CONTROL (CONT'D)
 Collection procedures
 Stopping supplies
 Used with care if the product being sold is built
specifically to the customers design
 Legal action – this is costly and is likely to
lead to the customer being lost
 External debt collection agency – as with
legal action this is costly and is likely to lead
to the loss of the customer. 108
 INVOICE DISCOUNTING &
FACTORING
 Invoice discounting: Selling selected sales
invoices to a third party for a discounted
cash sum
 Factoring: A range of services in the area of
sales administration and the collection of
amounts due from customers

109
 SETTLEMENT DISCOUNTS
 To offer credit customers a discount if they pay
within a certain number of days
 Example: Customers normally take 60 days credit. A
quick payment discount of 1.5% is offered for payment
within 20 days.
 To decide if this is a good policy, the cost of the
discount must be compared to the cost of
financing accounts receivable (overdraft rate)
 To allow a fair comparison the cost of the
discount must be expressed as an annual effective
110

cost.
 SETTLEMENT DISCOUNTS
(CONT'D)
 Example 1:
 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%

111
 SETTLEMENT DISCOUNTS
(CONT'D)
 Answer to example 1:
 It costs 1.5% to receive 98.5% of accounts receivable 40
days sooner.
 40 day interest rate = = 1.52%
 Annual effective rate = - 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 basic.
112
 SETTLEMENT DISCOUNTS
(CONT'D)
 Example 2:
 Dodgy LTD has sales of $100,000 and accounts
receivable days of 60. it pays overdraft interest at
18%/year
 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

113
 SETTLEMENT DISCOUNTS
(CONT'D)
 Answer to Example 2:
 Current account receivable = 100,000 * = 16,438
 New accounts receivable = (100,000 *50%*) +
(100,000*50%*) = 1,370 + 8,219 = 9,589 $
 Reduced interest expense (16,438 – 9,589) *18% = 1,233
 Discount allowed expense 100,000 *50%*2% = 1,000
 Increased profit 233

114
 ACCOUNTS PAYABLE
MANAGEMENT
 What Are Accounts Payable (AP)?
Accounts payable refers to an account within the
general ledger that represents a company's
obligation to pay off a short-term debt to its creditors
or suppliers. Another common usage of accounts
payable refers to the business department or division
that is responsible for making payments owed by the
company to suppliers and other creditors.
115
 ACCOUNTS PAYABLE
MANAGEMENT
 What Are Examples of Payables?
 A payable is created any time money is owed by a
firm for services rendered or products provided
that has not yet been paid for by the firm. This
can be from a purchase from a vendor on credit,
or a subscription or installment payment that is
due after goods or services have been received.

116
 ACCOUNTS PAYABLE
MANAGEMENT
 What is accounts payable management
 One of the important business processes that help
in managing payable obligations.
 Accounts payable management generally revolves
around a company optimizing its payment process
so that it can make remittance at the best possible
times. When a company gets the best combination
of cashflow, early payment discounts, and goodwill
with suppliers for paying a bill when they do.
117
 ACCOUNTS PAYABLE
MANAGEMENT
 The role of accounts payable management
 Accounts payable management is critical in
managing a business’s cash flow.
 A company with poor AP management might miss
signs of unhappiness from its vendors or even
signals of fraud.

118
 ACCOUNTS PAYABLE
MANAGEMENT
 Improve accounts payable management
 Get to know vendors from the point of onboarding
 Capture invoices small, pay them in large batches
 Empowering vendors and saving company
leaders’ time

119
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Credit as a source of finance
 Firms can use trade credit as a flexible source of
short term finance
 The annual effective cost of refusing a discount
should be calculated. This should be compared to
the cost of financing working capital (overdraft
rate)
 If the cost of refusing discount > overdraft rate
then the discount should be accepted. 120
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Advantages of trade credit as a source of
finance
 Convenience and informal
 Can be used if unable to obtain credit from
financial intuitions
 Canbe used on a short term basic to overcome
unexpected cash flow crises

121
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Example 1:
 A supplier offers a 2% discount if the invoice is paid
within 20 days of receipt, but offers no discount if the
payment is delayed
 Required: Calculate the annual effective cost of refusing
the discount

122
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Answer to example 1:
 If a company receives an invoice of $1,000 under the terms
in the example, and decides to pay after 20 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
 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. 123
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Example 2:
 A company currently takes 40 days credit from its
suppliers, believing this to be free finance
 Annual purchase are $100,000 and the company pays
overdraft interest at 13%/year
 Payment within 15 days would attract a 1 % quick
settlement discount
 Required: Calculate the effect on the profit and loss
account of accepting the discount
124
 ACCOUNTS PAYABLE
MANAGEMENT (CONT'D)
 Answer for Example 2:
 Current account payable = 100,000 x = $10,959
 New accounts payable = 100,000 x = $4,110
 Increased interest expense (10,959 – 4,110) x 13% =
$(890)
 Discounts received (100,000 x 1.5%) = $1,500
 Increase in profit = 1,500 – 890 = $610
 Conclusion: the discount should therefore be accepted.
125
SHORT TERM FINANCING

Working Capital Management

Cash Management
Inventory Management
Receivable and Payable Management
Short Term Financing

126
 DEFINITION
 A range of short-term sources of finance are available
to businesses including overdrafts, short-term loans,
trade credit and lease finance.
 Needed to run day-to-day operations including payment
of wages to employees, inventory ordering and supplies.

127
 OVERDRAFTS
Where payments from a current account exceed income
to the account for a temporary period, the bank finances
the deficit by means of an overdraft

128
 SHORT TERM LOAN
 A term loan is a loan for a fixed amount for a specified
period. It is drawn in full at the beginning of the loan
period and repaid at a specified time or in defined
installments.
 Term loans are offered with a variety of repayment
schedules. Often, the interest and capital repayments
are predetermined.

129
 TRADE CREDIT
 Trade credit is one of the main sources of short-term
finance for a business. Current assets such as raw
materials may be purchased on credit with payment
terms normally varying from between 30 to 90 days.
Trade credit therefore represents an interest free short-
term loan.
 In a period of high inflation, purchasing via trade credit
will be very helpful in keeping costs down. However, it is
important to take into account the loss of discounts
suppliers offer for early payment.
 Unacceptable delays in payment will worsen a
company's credit rating and additional credit may 130

become difficult to obtain.