FIN2101
Business Finance II
Module 4
Working Capital Management
(Week 2)
Student Activities (Receivables)
Reading
Text,Chapter 17 (pp,616-31,633-4 only)
Text Study Guide,Chapter 17 (part only)
Study Book,Module 4.4 (pp,4.20 to 4.26)
Tutorial Activities
Tutorial Workbook,Self Assessment Activity 4.3
Text Study Guide,Chapter 17,T/F 1-6,MC 1-8 & 10,
Problems 1 to 5
Student Activities (General)
Reading
Text,Chapter 15 (pp,544-9 only)
Text Study Guide,Chapter 15 (part only)
Study Book,Module 4.1 (pp,4.1 to 4.4)
Tutorial Work
Tutorial Workbook,Self Assessment Activity 4.1
Text Study Guide,Chapter 15,T/F 1 & 2,MC 1-3,
Problem 1
Credit Management Decisions
Do we grant credit?
If so,to whom?
On what terms?
credit period
cash discount
discount period
Credit Management Objectives
Maximise the probability of receipt
Accelerate receipt
Costs of Granting Credit
Opportunity cost
Administration costs
Bad debts
Additional inventory
Discounted value of sale
Benefit of Granting Credit
Additional sales
Costs of NOT Granting Credit
Foregone sales
Higher security costs
Higher insurance costs
Loss of customer goodwill
Benefits of NOT Granting Credit
Accelerated cash flows
No bad debts or delinquent accounts
Credit Selection
It involves the decision whether to extend credit to a
customer and how much credit to extend.
It has the dimensions of credit analysis and credit
standard
A credit applicant’s creditworthiness can be assessed
using the five C’s of credit – character,capacity,capital,
collateral and conditions – see page 618 of text.
Character and capacity are the two basic requirements
for extending credit to a customer.
Credit Analysis
It involves the collection and evaluation of credit
information on credit applicants to determine
while they can meet the firm’s credit standard
The evaluation of credit applicants.
Line of credit is the maximum amount a credit
customer can owe at any one time.
Credit scoring involves ranking an applicant’s
overall credit strength on the basis of key financial
and credit characteristics – see example on page
621 of the text.
Credit Information Sources
Common for applicant to fill out an application
form.
Additional information can be obtained from
various sources:
financial statements
credit bureaus,eg Dun & Bradstreet
Credit Reference Association of Australia
applicant’s bank
Credit Standards
The minimum requirements for extending credit
to a customer.
The impact of varying credit standards on key
variables – sales volume,investment in accounts
receivables and bad debts – must be examined.
Table on page 623 of text.
Very high standards will lead to virtually no bad
debts but will probably result in lost sales.
Credit Terms
Specify the repayment terms required of a firm’s
credit customers.
Credit terms are:
cash discount,if any
cash discount period
credit period
Varying any of the credit terms may affect the
firm’s overall profitability – see pp,626-9 of the
text.
Collection Policy
The procedures for collecting a firm’s accounts
receivable when they are due.
A balanced approach is essential.
Ageing of accounts receivable identifies the proportion
of receivables that has been outstanding for a
specified period of time.
Increased collection efforts should reduce the
investment in receivables and the level of bad debts,
but may also lead to lost sales if the collection effort
is too intense.
Collection Techniques
Letters
Telephone calls
Personal visits
Collection agencies
Legal action
Financial Evaluation of Credit Decisions
n
1t
tk,t II - PV I F CF N PV
Example 1
Terms Sales Expenses
Current Cash Only $ 80 000 $48 000
New 5/30,n/60 $100 000 $60 000
Increment $ 20 000 $12 000
Rate of return on investment is 1.25% per month.
Assumptions:
1,Credit terms offered to new customers only.
2,60% will take the discount (ie 60% of new sales).
3,Remainder will pay in 60 days.
Should the firm introduce the new credit policy?
063 $7 =
000 12 - 804 7 + 259 11 =
000 12 -
1,0 12 5
0,4 000 20
+
1,0 12 5
0,9 5 0,6 000 20
= N PV
2
Decision,Introduce new policy.Decision,Introduce new policy.
Example 2
Current,Cash only
Sales $400 000 p.a.
New,Credit
Sales $600 000 p.a.
Payments Schedule
- Within 1 month of sale 35%
- Within 2 months of sale 40%
- Within 3 months of sale 20%
- Bad debts 5%
Other data for Example 2:
Variable costs are 80% of sales
Req’d rate of return is 1% per month
All customers will switch to credit terms.
Required:
Using the NPV approach,should management
proceed with the proposed switch to a credit
policy?
663 $79 =
000 480 - 471 116 + 271 235 + 921 207 =
4 8 0 0 0 0 -
1,0 1
1 2 0 0 0 0
+
1,0 1
2 4 0 0 0 0
+
1,0 1
2 1 0 0 0 0
4 8 0 0 0 0 -
1,0 1
0,26 0 0 0 0 0
1,0 1
0,46 0 0 0 0 0
1,0 1
0,3 56 0 0 0 0 0
= N PV
32
32
NPV of credit policy is $79 663.
NPV of cash only policy is $80 000.
Conclusion,Do not proceed with
credit terms.
Example 3
Present level of sales p.a,$1.2m
Average collection period 30 days
Sale price $10/unit
Variable costs $8/unit
Req’d rate of return 25%p.a.
Assume 360 days per year.
Option Increase Increase
in ACP in Sales
To 45 days 15 $100 000
To 60 days 30 $150 000
Should the firm extend its average
collection period? If so,to 45 days
or 60 days?
Solution
Increase in A.C.P.
15 days
1,Additional profit contribution $20 000
from sales
(New sales x profit margin)
2,Beginning level of receivables $100 000
{Existing Sales/(360/Existing A.C.P.)}
Increase in A.C.P.
15 days
3,Receivables level after $162 500
change in policy
{New Sales/(360/New A.C.P.)}
4,Additional receivables $ 62 500
(3,- 2.)
5,Additional investment $ 50 000
in receivables
(4,x variable cost %)
Increase in A.C.P.
15 days
1,Additional profit contribution $20 000
from sales
6,Required return on $12 500
additional investment
(5,x 0.25)
7,Net advantage $7 500
(1,- 6.)
Increase in A.C.P.
15 days 30 days
1,Additional profit $20 000 $10 000
contribution from sales
(New sales x profit margin)
2,Beginning level of $100 000 $162 500
receivables
{Existing Sales/(360/Existing A.C.P.)}
Increase in A.C.P.
15 days 30 days
3,Receivables level after $162 500 $225 000
change in policy
{New Sales/(360/New A.C.P.)}
4,Additional receivables $ 62 500 $ 62 500
(3,- 2.)
5,Additional investment $ 50 000 $ 50 000
in receivables
(4,x variable cost %)
Increase in A.C.P.
15 days 30 days
1,Additional profit $20 000 $10 000
contribution from sales
6,Required return on $12 500 $12 500
additional investment
(5,x 0.25)
7,Net advantage $7 500 ($2 500)
(1,- 6.)
Example 3 Extended
What if we assume that relaxing the average
collection period to 45 days will result in an
increase in bad debts from the current level of
0.5% of sales to 1% of sales?
Should the firm still increase the ACP to 45 days?
Net advantage $7 500
Current policy bad debts $ 6 000
($1.2m x 0.005)
New policy bad debts $13 000
($1.3m x 0.01)
Increase in bad debts $7 000
Revised net advantage $ 500
Inventory and Receivables
There is a close relationship between inventory
and accounts receivable.
A decision to grant credit can result in increased
sales,which must be supported by higher levels
of inventory and accounts receivable.
Their management should not be viewed
independently!
Working Capital in General
Management of current assets should not
be left to itself.
Around 40% of a firm’s total assets are in
current asset form.
Efficient management is of vital
importance.
Some Evidence
20-25% of new businesses fail in first 5
years.
80% of these show evidence of poor
working capital management,particularly
in the areas of inventory and accounts
receivable.
Reasons
Integration factor
Failure to recognise the integration of
the three major types of current assets.
Cost factor
General ignorance of the cost involved
in working capital.
Objective
To have enough of a particular asset to
meet its operating needs for that asset and
to minimise the cost of having that asset.
The balanced approach.
Operating Cycle
Extends from the time of purchase of raw
materials to the collection of accounts receivable.
The longer the operating cycle,the greater the
investment in current assets.
A small increase in the level of investment in
current assets will bring about an increase in
benefits and an increase in costs.
Optimal Policy
One which equates the increasing costs with
the increased benefits.
Business Finance II
Module 4
Working Capital Management
(Week 2)
Student Activities (Receivables)
Reading
Text,Chapter 17 (pp,616-31,633-4 only)
Text Study Guide,Chapter 17 (part only)
Study Book,Module 4.4 (pp,4.20 to 4.26)
Tutorial Activities
Tutorial Workbook,Self Assessment Activity 4.3
Text Study Guide,Chapter 17,T/F 1-6,MC 1-8 & 10,
Problems 1 to 5
Student Activities (General)
Reading
Text,Chapter 15 (pp,544-9 only)
Text Study Guide,Chapter 15 (part only)
Study Book,Module 4.1 (pp,4.1 to 4.4)
Tutorial Work
Tutorial Workbook,Self Assessment Activity 4.1
Text Study Guide,Chapter 15,T/F 1 & 2,MC 1-3,
Problem 1
Credit Management Decisions
Do we grant credit?
If so,to whom?
On what terms?
credit period
cash discount
discount period
Credit Management Objectives
Maximise the probability of receipt
Accelerate receipt
Costs of Granting Credit
Opportunity cost
Administration costs
Bad debts
Additional inventory
Discounted value of sale
Benefit of Granting Credit
Additional sales
Costs of NOT Granting Credit
Foregone sales
Higher security costs
Higher insurance costs
Loss of customer goodwill
Benefits of NOT Granting Credit
Accelerated cash flows
No bad debts or delinquent accounts
Credit Selection
It involves the decision whether to extend credit to a
customer and how much credit to extend.
It has the dimensions of credit analysis and credit
standard
A credit applicant’s creditworthiness can be assessed
using the five C’s of credit – character,capacity,capital,
collateral and conditions – see page 618 of text.
Character and capacity are the two basic requirements
for extending credit to a customer.
Credit Analysis
It involves the collection and evaluation of credit
information on credit applicants to determine
while they can meet the firm’s credit standard
The evaluation of credit applicants.
Line of credit is the maximum amount a credit
customer can owe at any one time.
Credit scoring involves ranking an applicant’s
overall credit strength on the basis of key financial
and credit characteristics – see example on page
621 of the text.
Credit Information Sources
Common for applicant to fill out an application
form.
Additional information can be obtained from
various sources:
financial statements
credit bureaus,eg Dun & Bradstreet
Credit Reference Association of Australia
applicant’s bank
Credit Standards
The minimum requirements for extending credit
to a customer.
The impact of varying credit standards on key
variables – sales volume,investment in accounts
receivables and bad debts – must be examined.
Table on page 623 of text.
Very high standards will lead to virtually no bad
debts but will probably result in lost sales.
Credit Terms
Specify the repayment terms required of a firm’s
credit customers.
Credit terms are:
cash discount,if any
cash discount period
credit period
Varying any of the credit terms may affect the
firm’s overall profitability – see pp,626-9 of the
text.
Collection Policy
The procedures for collecting a firm’s accounts
receivable when they are due.
A balanced approach is essential.
Ageing of accounts receivable identifies the proportion
of receivables that has been outstanding for a
specified period of time.
Increased collection efforts should reduce the
investment in receivables and the level of bad debts,
but may also lead to lost sales if the collection effort
is too intense.
Collection Techniques
Letters
Telephone calls
Personal visits
Collection agencies
Legal action
Financial Evaluation of Credit Decisions
n
1t
tk,t II - PV I F CF N PV
Example 1
Terms Sales Expenses
Current Cash Only $ 80 000 $48 000
New 5/30,n/60 $100 000 $60 000
Increment $ 20 000 $12 000
Rate of return on investment is 1.25% per month.
Assumptions:
1,Credit terms offered to new customers only.
2,60% will take the discount (ie 60% of new sales).
3,Remainder will pay in 60 days.
Should the firm introduce the new credit policy?
063 $7 =
000 12 - 804 7 + 259 11 =
000 12 -
1,0 12 5
0,4 000 20
+
1,0 12 5
0,9 5 0,6 000 20
= N PV
2
Decision,Introduce new policy.Decision,Introduce new policy.
Example 2
Current,Cash only
Sales $400 000 p.a.
New,Credit
Sales $600 000 p.a.
Payments Schedule
- Within 1 month of sale 35%
- Within 2 months of sale 40%
- Within 3 months of sale 20%
- Bad debts 5%
Other data for Example 2:
Variable costs are 80% of sales
Req’d rate of return is 1% per month
All customers will switch to credit terms.
Required:
Using the NPV approach,should management
proceed with the proposed switch to a credit
policy?
663 $79 =
000 480 - 471 116 + 271 235 + 921 207 =
4 8 0 0 0 0 -
1,0 1
1 2 0 0 0 0
+
1,0 1
2 4 0 0 0 0
+
1,0 1
2 1 0 0 0 0
4 8 0 0 0 0 -
1,0 1
0,26 0 0 0 0 0
1,0 1
0,46 0 0 0 0 0
1,0 1
0,3 56 0 0 0 0 0
= N PV
32
32
NPV of credit policy is $79 663.
NPV of cash only policy is $80 000.
Conclusion,Do not proceed with
credit terms.
Example 3
Present level of sales p.a,$1.2m
Average collection period 30 days
Sale price $10/unit
Variable costs $8/unit
Req’d rate of return 25%p.a.
Assume 360 days per year.
Option Increase Increase
in ACP in Sales
To 45 days 15 $100 000
To 60 days 30 $150 000
Should the firm extend its average
collection period? If so,to 45 days
or 60 days?
Solution
Increase in A.C.P.
15 days
1,Additional profit contribution $20 000
from sales
(New sales x profit margin)
2,Beginning level of receivables $100 000
{Existing Sales/(360/Existing A.C.P.)}
Increase in A.C.P.
15 days
3,Receivables level after $162 500
change in policy
{New Sales/(360/New A.C.P.)}
4,Additional receivables $ 62 500
(3,- 2.)
5,Additional investment $ 50 000
in receivables
(4,x variable cost %)
Increase in A.C.P.
15 days
1,Additional profit contribution $20 000
from sales
6,Required return on $12 500
additional investment
(5,x 0.25)
7,Net advantage $7 500
(1,- 6.)
Increase in A.C.P.
15 days 30 days
1,Additional profit $20 000 $10 000
contribution from sales
(New sales x profit margin)
2,Beginning level of $100 000 $162 500
receivables
{Existing Sales/(360/Existing A.C.P.)}
Increase in A.C.P.
15 days 30 days
3,Receivables level after $162 500 $225 000
change in policy
{New Sales/(360/New A.C.P.)}
4,Additional receivables $ 62 500 $ 62 500
(3,- 2.)
5,Additional investment $ 50 000 $ 50 000
in receivables
(4,x variable cost %)
Increase in A.C.P.
15 days 30 days
1,Additional profit $20 000 $10 000
contribution from sales
6,Required return on $12 500 $12 500
additional investment
(5,x 0.25)
7,Net advantage $7 500 ($2 500)
(1,- 6.)
Example 3 Extended
What if we assume that relaxing the average
collection period to 45 days will result in an
increase in bad debts from the current level of
0.5% of sales to 1% of sales?
Should the firm still increase the ACP to 45 days?
Net advantage $7 500
Current policy bad debts $ 6 000
($1.2m x 0.005)
New policy bad debts $13 000
($1.3m x 0.01)
Increase in bad debts $7 000
Revised net advantage $ 500
Inventory and Receivables
There is a close relationship between inventory
and accounts receivable.
A decision to grant credit can result in increased
sales,which must be supported by higher levels
of inventory and accounts receivable.
Their management should not be viewed
independently!
Working Capital in General
Management of current assets should not
be left to itself.
Around 40% of a firm’s total assets are in
current asset form.
Efficient management is of vital
importance.
Some Evidence
20-25% of new businesses fail in first 5
years.
80% of these show evidence of poor
working capital management,particularly
in the areas of inventory and accounts
receivable.
Reasons
Integration factor
Failure to recognise the integration of
the three major types of current assets.
Cost factor
General ignorance of the cost involved
in working capital.
Objective
To have enough of a particular asset to
meet its operating needs for that asset and
to minimise the cost of having that asset.
The balanced approach.
Operating Cycle
Extends from the time of purchase of raw
materials to the collection of accounts receivable.
The longer the operating cycle,the greater the
investment in current assets.
A small increase in the level of investment in
current assets will bring about an increase in
benefits and an increase in costs.
Optimal Policy
One which equates the increasing costs with
the increased benefits.
