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Debtors/receivables management
Managing debtors / receivables is a key aspect of working capital management.

The objectives of accounts receivable management is to ascertain the optimum level of trade
credit to offer customers and to manage that credit.

The amount of credit represents a balance between two factors:

 profit improvement from sales obtained by allowing credit


 the cost of credit allowed.

Importance of receivables management


Allowing credit to customers will encourage sales, or at least the absence of the availability of
credit will encourage customer to select an alternative supplier offering more favourable
credit terms.

Allowing too much credit, or not managing the credit policy carefully enough, could result
in irrecoverable debts. This represents a loss of income to the company, affecting both
profitability and cash flow.

The balancing act: Profitability v Liquidity

Credit policy
As part of the management of accounts receivable, a company must establish a credit policy.
This policy will be influenced by:

 demand for the company's products


 competitors' terms
 risk of irrecoverable debts
 financing costs
 costs of credit control.

Importance of having a credit policy


A firm must establish a policy for credit terms given to its customers. Ideally the firm would
want to obtain cash with each order delivered, but that is impossible unless substantial
settlement (or cash) discounts are offered as an inducement. It must be recognised that
credit terms are part of the firm's marketing policy. If the trade or industry has adopted a
common practice, then it is probably wise to keep in step with it.

Assessing creditworthiness
To minimise the risk of irrecoverable debts occurring, a company should investigate the
creditworthiness of all new customers immediately and should continue to assess existing
customers periodically.

Information for assessing creditworthiness may come from a variety of sources, such as bank
references, trade references, competitors, published information, credit reference agencies.
company sales records or credit scoring.

Credit limits
Credit limits should be set for each customer to reflect both the amount of credit available
and the length of time allowed before payment is due. A ledger account should be set up and
monitored for each customer.

Invoicing and collecting overdue debts


A credit period only begins once an invoice is received so prompt invoicing is essential. If
debts are allowed to go overdue, the risk of default increases, therefore a system of follow-up
procedures is required.

Most companies would typically follow a collection procedure such as:


Monitoring the system
The position of receivables should be regularly reviewed as part of managing overall working
capital and corrective action taken when needed. Methods used in monitoring the credit
system would include aged debt analysis, financial ratios and statistical data.

Early settlement discounts


Cash discounts are offered to customers to encourage early payment. The cost of the
discount is balanced against the savings the company receives from having less capital tied
up due to a lower receivables balance and a shorter average collection period. Discounts
may also reduce the number of irrecoverable debts.

Annual cost of a discount


The calculation of the annual cost of a discount can be expressed as a formula:

Notice that the annual cost calculation is always based on the amount left to pay, i.e. the
amount net of discount.

If the cost of offering the discount exceeds the rate of overdraft interest then the discount
should not be offered.

Factoring
Factoring is the outsourcing of the credit control department to a third party.

The debts of the company are effectively sold to a factor (normally owned by a bank). The
factor takes on the responsibility of collecting the debt for a fee.

Factoring is primarily designed to allow companies to accelerate cash flow, providing finance
against outstanding trade receivables. This improves cash flow and liquidity. Factoring is of
particular value to smaller firms or fast growing firms.

Recourse or non-recourse
Factoring can be arranged on either a 'without recourse' basis or a 'with recourse' basis.

When factoring is without recourse or 'non-recourse', the factor provides protection for the
client against irrecoverable debts. The factor has no 'comeback' or recourse to the client if a
customer defaults. When a customer of the client fails to pay a debt, the factor bears the loss
and the client receives the money from the debt.

When the service is with recourse ('recourse factoring'), the client must bear the loss from
any irrecoverable debt, and so has to reimburse the factor for any money it has already
received for the debt.
Credit protection is provided only when the service is non-recourse and this is obviously
more costly.

Typical factoring arrangements


The company can choose some or all of the following services offered by the factor:

(1) administration and debt collection

(2)financing

Administration and debt collection

Including financing

Invoice discounting
Invoice discounting is a method of raising finance against the security of receivables without
using the sales ledger administration services of a factor.

While specialist invoice discounting firms exist, this is a service also provided by a factoring
company. Selected invoices are used as security against which the company may borrow
funds. This is a temporary source of finance, repayable when the debt is cleared. The key
advantage of invoice discounting is that it is a confidential service,and the customer need not
know about it.

In some ways it is similar to the financing part of the factoring service without control of credit
passing to the factor.
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Creditors/Payables Management
Managing creditors / payables is a key part of working capital management.

Trade credit is the simplest and most important source of short-term finance for many
companies. The objectives of payables management is to ascertain the optimum level of
trade credit to accept from suppliers.

Deciding on the level of credit to accept is a balancing act between liquidity and profitability.

By delaying payment to suppliers companies face possible problems:

 supplier may refuse to supply in future


 supplier may only supply on a cash basis
 there may be loss of reputation
 supplier may increase price in future.
Early settlement discounts
A proportion of the firm's suppliers will normally offer early settlement discounts which
should be taken up where possible by ensuring prompt payment within the specified terms
where settlement discount is allowed. However, if the firm is short of funds, it might wish to
make maximum use of the credit period allowed by suppliers regardless of the settlement
discounts offered.

Annual cost of a discount

The calculation of the annual cost of a discount can be expressed as a formula:


Notice that the annual cost calculation is always based on the amount left to pay, i.e. the
amount net of discount.

If the annual cost of the discount exceeds the rate of overdraft interest then the discount
should not be accepted