working capital and strategic debtor management

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Working Capital and Strategic Debtor Management

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Robert Alan Hill

Working Capital and Strategic Debtor Management

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Working Capital and Strategic Debtor Management

1st edition

ISBN 978-87-403-0335-3

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Contents

Précis – Working Capital Management And Strategic Debtor Investment 8

2 he Objectives and Structure of Working Capital Management 17

2.2 he Objectives of Working Capital Management 19

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Working Capital and Strategic

Debtor Management

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Contents

3 he Accounting Concept of Working Capital: A Critique 25

3.4 Financial Interpretation: An Overview 29

4 he Working Capital Cycle and Operating Eiciency 39

5 Real World Considerations and the Credit Related Funds System 47

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6 he Efective Credit Price and Decision to Discount 56

7 he Opportunity Cost of Capital and Credit Related Funds System 67

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Contents

8 he Strategic Impact of Alternative Credit Policies on Working Capital

8.3 Alternative Credit Policies, Working Capital Investment

9.4 Late Payment and the Case for Legislation 95

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Précis – Working Capital

Management And Strategic Debtor Investment

his free book critically evaluates working capital management and the strategic marketing function of credit terms within a theoretical context of wealth maximisation and empirical research he accounting convention that management must present an image of solvency and liquidity to the outside world by maintaining an excess of current assets over current liabilities is seriously questioned A irm’s objectives should be to minimise current assets and maximise current liabilities compatible with its debt paying ability, based upon future cash proitability dictated by optimum terms of sale, which may be unique

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Part One:

An Introduction

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1 An Overview

1.1 Introduction

hroughout all the previous texts in my bookboon series (referenced at the end of this Chapter) we deined Strategic Financial Management in terms of two inter-related policies:

The determination of a maximum net cash inlow from investment opportunities at an acceptable level of risk,

underpinned by the acquisition of funds required to support this activity at minimum cost.

You will also recall that if management employ capital budgeting techniques, which maximise the expected net present value (NPV) of all a company’s investment projects, these inter-related policies should conform to the normative objective of business inance, namely, the maximisation of shareholders wealth

Having dealt comprehensively with the pivotal role of capital budgeting and ixed asset formation elsewhere in the “Strategic Financial Management” texts of the bookboon series, the initial purpose of this study is to focus on current asset investment and the strategic importance of working capital management Not only do current assets comprise more than 50 per cent of many irms’ total asset structure, but their inancing is also an integral part of project appraisal that is frequently overlooked

We shall then explain why the “terms of sale” (credit terms) ofered to customers determine a company’s sales turnover and hence the debtor, inventory and cash balances, which deine its working capital requirements Properly conceived, debtor (accounts receivable) policies should underpin the proitability

of ixed asset formation, without straining liquidity or compromising a irm’s future plans

Comprehensive, yet concise, all the material is presented logically as a guide to further study, using the time- honoured approach adopted throughout all my bookboon series Each Chapter begins with theory, followed by its application and an aprropriate critique From Chapter to Chapter, summaries of the text

so far are presented to reinforce the major points Each Chapter also contains Activities (with indicative solutions) to test understanding at your own pace

1.2 Objectives of the Text

he text assumes that you have prior knowledge of Financial Accounting and an ability to interpret corporate inancial statements using ratio analysis So, at the outset, you should be familiar with the following glossary of terms:

Working capital: a company’s surplus of current assets over current liabilities, which measures the extent

to which it can inance any increase in turnover from other fund sources

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An Overview

Current assets: items held by a company with the objective of converting them into cash within the near future he most important items are debtors or account receivable balances (money due from customers), inventory (stocks of raw materials, work in progress and inished goods) and cash or near cash (such as short term loans and tax reserve certiicates)

Current liabilities: short term sources of inance, which are liable to luctuation, such as trade creditors (accounts payable) from suppliers, bank overdrats and tax payable

On completion of this text you should be able to:

- Distinguish between the internal working capital management function and an external interpretation of a irm’s working capital position revealed by its published accounts,

- Calculate the working capital operating cycle and inancing cycle from published accounting data and analyse the inter-relationships between the two,

- Deine the dynamics of a company’s credit-related funds system,

- Explain how the terms of sale, which comprise the credit period, cash discount and discount period, afect the demand for a irm’s goods and services,

- Understand the impact of alternative credit policies on the revenues and costs which are associated with a capital budgeting decision,

- Appreciate the disparities between the theory and practice of working capital management, given our normative wealth maximisation assumption

1.3 Outline of the Text

he remainder of our study is divided into three sections

Part Two begins by explaining the relationship between working capital management and inancial strategy You are reminded that the normative objective of inancial management is the maximisation

of the expected net present value (NPV) of all a company’s investment projects Because working capital

is an integral part of project appraisal, we shall deine it within this context

We then reveal why the traditional accounting concept of working capital is of limited use to the inancial manager he long-standing rule that a irm should strive to maintain a 2:1 ratio of current assets to current liabilities is questioned Using illustrative examples and Activities you will be able to conirm that:

- Eicient working capital management should be guided by cash proitability, which may conlict with accounting deinitions of solvency and liquidity developed by external users of published inancial statements,

- An optimal working capital structure may depart from accounting conventions by relecting

a balance of credit-related cash lows, which are unique to a particular company

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Part hree initially considers how the terms of sale ofered by a company to its customers is a form of price competition, which can inluence the demand for its goods and services We shall begin by using the time value of money concept within a framework of “efective prices” to explain how the availability

of credit periods and cash discounts for prompt payment provide customers with reductions in their cash price

Items bought on credit will be shown to create a utility in excess of their eventual purchase price measured by the debtors’ opportunity to utilise this amount during the credit period, or discount period

By conferring enhanced purchasing power upon its customers, a company’s terms of sale will be seen to have true “marketing” signiicance hey represent an aspect of inancial strategy, whereby the creditor irm can translate potential demand into actual demand and increase future proitability Your Activities will conirm this

For the provider of goods and services (the creditor irm) we then explain why the availability of trade credit is not without cost:

- Invoiced payments for accounts receivable, which are deferred or discounted, represent a claim to cash that has a value inversely related to the time period in which it is received,

- Credit policies are a key determinant of the structure, amount and duration of a irm’s total working capital commitment tied to its price-demand function,

- Alternative credit policies, therefore, produce diferent levels of proit

So, when a irm decides to sell on credit, or revise credit policy variables, it should ensure that the incremental beneits from any additional investment exceed the marginal costs

Part Four challenges the extent to which companies adhere to standard industry terms based on empirical evidence Given our critique of conventional working capital analysis compared to a time-honoured theoretical framework for analysing efective prices associated with diferent credit terms

- Typical cash discounts confer unnecessary beneits on cash customers,

- Non-discounting customers oten remit payment beyond the permitted credit period,

- Standard industry terms produce a sub-optimal investment in working capital, which do not make an eicient contribution to proit

Having applied diferent credit policy variables to practical illustrations throughout the text to evaluate

why adhering to existing terms or setting terms equal to those of competitors can fail to maximise the combined proit on output sold and the terms of sale extended to diferent classes of customer, we shall draw the following conclusion:

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