The payment will be made 20 days earlier than usual so t = 20. Cost of discount = − − 365 20 100 1 100 1.5 = 31.8%
Learning outcome E1(f)
Gamma grants credit terms of 60 days net to customers, but offers an early settlement discount of 2% for payment within seven days. What is the cost of the discount to Gamma?
Exam skills
Make sure you learn the formula for the percentage cost of an early settlement discount.
As far as an individual customer is concerned, the principles are similar. For example, assume Boris has an average $10,000 outstanding, representing two months sales. You offer Boris a 1% settlement discount which would reduce the average amount outstanding to $5,000 (before discounts). You borrow money at 5%. A 1% discount on annual sales of $60,000 would cost you $600. Overdraft interest saved is $250 ($5,000 × 5%) so it is not worth offering the discount.
4.4 Late payment
It has been suggested that businesses should charge interest on overdue debts, however:
(a) Charging for late payment might be misconstrued (The supplier might assume that charges for late payment give the customer the authority to pay late.)
(b) A statutory rate for interest on overdue debts may not have been established in the country. (c) Charging for payments relates only to the effect of the late payment on profitability, not on liquidity
Learning outcome E1(a)
Thinking back to topics covered in earlier chapters, explain how good cash management may realise each of the following benefits.
(a) Better control of financial risk (b) Opportunity for profit
(c) Strengthened statement of financial position
(d) Increased confidence with customers, suppliers, banks and shareholders
Solution
Question 4.6
Good cash managementLearning outcome E1(f)
Your company has been growing rapidly over the last two years and now wishes to introduce a more formal credit control policy. You are asked to give a brief presentation on the factors involved in setting up such a policy.
Section summary
A firm must consider suitable payment terms and payment methods. Settlement discounts can be offered, if cost effective and if they improve liquidity.
5 Maintaining information on receivables
Introduction
For control purposes, receivables are generally analysed by age of debt.
5.1 Receivables age analysis 11/12, 5/10
An aged receivables listing will probably look very much like the schedule illustrated below. The analysis splits up the total balance on the account of each customer across different columns according to the dates of the transactions which make up the total balance. Thus, the amount of an invoice which was raised 14 days ago will form part of the figure in the column headed 'up to 30 days', while an invoice which was raised 36 days ago will form part of the figure in the column headed 'up to 60 days'. (In the schedule below, 'up to 60 days' is used as shorthand for 'more than 30 days but less than 60 days'.) HEATH COAGE ANALYSIS OF RECEIVABLES AS AT 31.1.X2
Account Up to Up to Up to Over
number Customer name Balance 30 days 60 days 90 days 90 days
B004 Brilliant 804.95 649.90 121.00 0.00 34.05 E008 Easimat 272.10 192.90 72.40 6.80 0.00 H002 Hampstead 1,818.42 0.00 0.00 724.24 1,094.18 M024 Martlesham 284.45 192.21 92.24 0.00 0.00 N030 Nyfen 1,217.54 1,008.24 124.50 0.00 84.80 T002 Todmorden College 914.50 842.00 0.00 72.50 0.00 T004 Tricorn 94.80 0.00 0.00 0.00 94.80 V010 Volux 997.06 413.66 342.15 241.25 0.00
Y020 Yardsley Smith & Co 341.77 321.17 20.60 0.00 0.00
Totals 6,745.59 3,620.08 772.89 1,044.79 1,307.83
Percentage 100% 53.6% 11.5% 15.5% 19.4%
An age analysis of receivables can be prepared manually or, more easily, by computer. In theory this should represent actual invoices outstanding, but there are problems, which we shall discuss later in this chapter, of unmatched or 'unallocated' cash and payments on account.
The age analysis of receivables may be used to help decide what action to take about older debts. Going down each column in turn starting from the column furthest to the right and working across, we can see that there are some rather old debts which ought to be investigated.
A number of refinements can be suggested to the aged receivables listing to make it easier to use.
(a) A report can be printed in which overdue accounts are seen first: this highlights attention on these items.
(b) It can help to aggregate data by class of customer.
(c) There is no reason why this should not apply to individual receivable accounts as below. You could also include the date of the last transaction on the account (eg last invoice, last payment).
Sales
revenue
Account Customer Up to Up to Up to Over in last 12 Days sales number name Balance 30 days 60 days 90 days 90 days months outstanding
B004 Brilliant 804.95 649.90 121.00 0.00 34.05 6,789.00 43
We can see from the age analysis of Heath's receivables given earlier that the relatively high proportion of debts over 90 days (19.4%) is largely due to the debts of Hampstead. Other customers with debts of this age are Brilliant, Nyfen and Tricorn.
Exam alert
The May 2010 exam had a question requiring the preparation of an age analysis of trade receivables and an explanation of its benefits. The November 2012 exam also had a question requiring the preparation of an aged debt analysis.
Additional ratios which might be useful in management of receivables, in addition to days sales outstanding, are as follows.
(a) Overdues as a percentage of total debt. For example, assume that Heath (Paragraph 1.1) offers credit on 30 day terms. Brilliant's debt could be analysed as:
$804.95 $34.05
$121.00+ = 19.3% overdue.
(b) If debts are disputed, it is helpful to see what proportion these are of the total receivables and the total overdue. If, of Heath's total receivables of $6,745.59, an amount of $973.06 related to disputed items, the ratio of disputed debts to total outstanding would be:
59 . 745 , 6 $ 06 . 973 $ = 14.4%
As a percentage of total items over 30 days old:
08 . 620 , 3 $ 59 . 745 , 6 $ 06 . 973 $ − = 31%
An increasing disputes ratio can indicate: (i) Invoicing problems
(ii) Operational problems
5.2 Receivables' ageing and liquidity
Also of interest to the credit controller is the total percentage figure calculated at the bottom of each column. In practice the credit controller will be concerned to look at this figure first of all, in order to keep the ageing figures consistent. Why might a credit controller be worried by an increase in the ageing? If the credit controller knows the customers are going to pay, should it matter?
Think back to your work on cash forecasting. This is based on the expectation that a company's debts will be paid within, say, 30 days after receipt of goods. In other words revenue booked in Month 1 would be
followed up by cash in Month 2. The cash forecast also has an outflow side. Any reduction in the inflow caused by an overall increase in the receivables period affects the company's ability to pay its debts and increases its use of overdraft finance: unauthorised overdrafts carry a hefty fee as well as interest.
5.3 Delays in payments by specific customers
It may be the case that an increase in the overall receivables ageing is caused by the activities of one customer, and there is always the possibility that cut-off dates for producing the report can generate anomalies. (For example, a customer might pay invoices at the end of every calendar month, whereas the receivables ageing analysis might be run every 30 days.)
However, the credit controller should try and avoid situations where a customer starts to delay payment. He or she should review information from:
• Sales staff regarding how the company is doing • The press for any stories relevant to the company • Competitors
• The trade 'grapevine'
These can supply early warning signals.
If, however, there is a persistent problem, the credit controller might have to insist on a refusal of credit. (a) This is likely to be resented by sales staff who will possibly receive less commission as a result of
lower sales.
(b) However, if there is a possibility of default, the loss of a potential sale is surely less severe than the failure of actual money to arrive.
Section summary
For control purposes, receivables are generally analysed by age of debt.
Some customers are reluctant to pay. The debt collector should keep a record of every communication. A staged process of reminders and demands, culminating in debt collection or legal action, is necessary.
6 Collecting debts
3/13, 11/12, 11/10
Introduction
There should be efficiently organised procedures for ensuring that overdue debts and slow payers are dealt with effectively.
Exam alert
A question might require you to evaluate different methods of debt collection and to recommend the most appropriate method. The November 2010 exam asked for a calculation of expected receipts from
customers and two methods that could be used to reduce the possibility of bad debts occurring. The November 2012 exam asked for actions that a firm could take to encourage outstanding invoices to be paid. The March 2013 exam asked for advantages and disadvantages of two actions that could be taken regarding the collection of overdue debts.
6.1 Collecting debts
Collecting debts is a two-stage process.
(a) Having agreed credit terms with a customer, a business should issue an invoice and expect to receive payment when it is due. Issuing invoices and receiving payments is the task of sales ledger staff. They should ensure that:
(i) The customer is fully aware of the terms.
(ii) The invoice is correctly drawn up and issued promptly.
(iii) They are aware of any potential quirks in the customer's system. (iv) Queries are resolved quickly.
(v) Monthly statements are issued promptly.
(b) If payments become overdue, they should be 'chased'. Procedures for pursuing overdue debts must be established, for example:
(i) Instituting reminders or final demands
These should be sent to a named individual, asking for repayment by return of post. A second or third letter may be required, followed by a final demand stating clearly the action that will be taken. The aim is to goad customers into action, perhaps by threatening not to sell any more goods on credit until the debt is cleared.
(ii) Chasing payment by telephone
The telephone is of greater nuisance value than a letter, and the greater immediacy can encourage a response. It can however be time-consuming, in particular because of problems in getting through to the right person.
(iii) Making a personal approach
Personal visits can be very time-consuming and tend only to be made to important customers who are worth the effort.
(iv) Notifying debt collection section
This means not giving further credit to the customer until he has paid the due amounts. (v) Handing over debt collection to specialist debt collection section
Certain, generally larger, organisations may have a section to collect debts under the supervision of the credit manager.
(vi) Instituting legal action to recover the debt
Premature legal action may unnecessarily antagonise important customers. (vii) Hiring an external debt collection agency to recover the debt
This is an expense which must be justified.