Chapter
Managing trade
receivables and payable
23
1
23.1 Managing trade receivables
Most sales between businesses are made on credit. This creates trade receivables, which is a
current asset in the balance sheet. Businesses prefer to buy goods on credit rather than pay for
them on delivery. This hopefully will increase sales of the company, and therefore generous credit
terms can be negotiated.
Trade credit is an interest free source of finance from one business to another business, and a
means of creating or increasing sales for the supplier. There are normally terms on the invoice for
payment for example payment should be made within 30 days of invoice date.
Consumer credit is financing given for by businesses to end consumers for the purchase of goods
and services for personal consumption. This may not necessarily be an interest free source of
financing but available to ease consumer cash flow. Examples of consumer credit are hire purchase
agreements and credit cards.
One of the main costs of extending credit rather than getting the cash in straight away from sales is
the finance cost.
1. Interest forgone to invest cash (opportunity cost). Trade receivables do not earn interest.
2. Additional interest payable on short term finance if the company has cash deficits.
Credit management involves:
The benefits of extending credit to customers versus the cost in extending the credit.
Establishing discounts, level and length of credit that will maximise profits.
Assessing the credit risk of customers by reviewing their accounting information or obtaining
references.
Setting credit limits for customers and terms of payment.
Collecting debts and minimising risk of bad debts (credit control).
2
23.2 Extending credit
Exam questions often ask the benefits of extending credit to customers. As we know the only cost
in having trade receivables is the finance cost as trade receivable is an asset like inventories which
doesn t earn a return.
The effect of extending the credit involves looking at the extra finance costs in investment in the
trade receivables versus the additional benefits like increase in sales / contribution.
Example 23.1
Increase in trade receivables
A plc s current annual sales are Ł15 million. The average trade receivable days currently is 30 and
the company s short term borrowing is at 11%. Contribution from sales is 10%.
A plc wants to increase it sales by Ł1 million over the next year by allowing an extra 15-days credit
to all its customers.
Assuming a 365-day working year, should the company pursue its plan?
Assume that there will be cash deficits next year.
Considerations before extending credit
Extra sales that will be generated from the additional credit terms.
The value of contribution of additional sales.
The additional finance costs.
The effect of additional trade receivables and payables (as more inventories will have to be
purchased).
Length of extra debt collection period.
3
23.3 The credit cycle
The credit cycle is the time between receiving an order and the collection of money from the sale.
Receive order
Verify creditworthiness
of customer
Receive cash
Credit limit
Stages in the
check
Debt collection
credit cycle
procedures
Order accepted after
credit screening
Send statement
Delivery goods issue
delivery note
Raise invoice
stating credit terms
The longer the credit cycle the more time the cash is locked in working capital. Companies should
try to keep the credit cycle as short as possible as this will help with cash flow.
4
23.4 Cash / settlement discounts
This is a discount offered on the sale of goods on credit to customers for early payment.
Benefits of settlement discounts Costs of settlement discounts
� Encourages customers to pay earlier and � The cost of the discount will reduce cash
thus reduce financing costs. received.
� Improves liquidity as cash is received � Extra administrative costs to manage the
earlier. discounts given.
� Encourages customers to buy and � Customers may take the discount and still
therefore increase sales. pay late if there is poor management of
settlement discounts.
� Reduction in bad debts due to reduced
collection period.
Example 23.2
Offering early settlement discounts
A plc s current annual sales are Ł15 million. The average trade receivable days currently are 40
days and the company s short term borrowing is at 11%.
A plc is considering offering a discount of 0.25% for payments within 18 days. A new member of
staff will be employed to administer this new scheme, costing a total of Ł20,000 per year.
Evaluate the new discount scheme for A plc if:
(a) All the customers take up the discount.
(b) Only 20% of the customers take up the discount.
23.5 Effective cost of early settlement discount
Offering discount is gaining access to money earlier rather than later, very much like a bank loan.
Therefore we can calculate the effective cost or interest on the discount offer. This can be
calculated by using compounding interest or simple interest; they will give slightly different
answers.
If the cost of early settlement discount % is less than the borrowing costs, then the early settlement
discounts are beneficial.
5
Compound formula for cost of early settlement discount (APR)  normally used
365
N- S
100
100 - D - 1 x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
Example 12.3  Worked example (Compound formula)
Find the annual equivalent rate of interest implicit on offering a 0.25% discount for payment within
18 days rather than 40 days. The short term borrowing rate is 11%.
Solution
{100 / (100-0.25)}365/(40-18) - 1 x 100%
= (1.0025)16.591 -1 x 100%
= 1.0424 -1 x 100%
= 4.24%
This is less than the short term borrowing rate which means it is worth taking up the discount offer,
as it costs less than borrowing.
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Simple formula for cost of early settlement discount
D x 365
100  D N - S x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
Example 23.4  Worked example (simple formula)
Find the annual equivalent rate of interest implicit on offering a 0.25% discount for payment within
18 days rather than 40 days. The short term borrowing rate is 11%.
0.25 / (100-0.25) x 365 / (40  18) x 100% = 4.16%
This is less than the short term borrowing rate which means it is worth taking up the discount offer,
as it costs less than borrowing.
Example 23.5
Settlement discount
Trotters Ltd s gives it customers credit term of 60 days net.
It also offers an early settlement discount of 2% for payment within 30 days.
What is the cost of early settlement discount to Trotters Ltd using both the compound and
simple formula?
7
23.6 Assessing credit worthiness
Credit risk means that there is a possibility that the debt will go bad. A credit assessment is a
judgement about the creditworthiness of a customer, providing a basis for a decision as to whether
credit should be granted.
Credit assessment will not only be needed when credit is first granted, but also when customers
request higher limits or their volume of trade takes them above their existing limits.
Assessing credit worthiness can be expensive in both time and money. More detailed
investigations need to be done for high-risk customers. The normal standard procedure for
companies is to obtain 2 trade references and the customer s bank reference.
(i) Trade references
Considerations in obtaining trade references
References are obtained from companies that the customer has traded with however it is important
to be aware for the following:
� The customer may maintain an untypically good relation with the referee or there maybe a
relationship between them and so the information given maybe biased.
� The referee should be offering similar terms to you.
� References should be followed up to ensure a conclusion can be reached.
� Unknown or newly created company s references should be treated with caution.
(ii) Bank references
A reference can be obtained from the customer s bank but when asking the bank for references the
precise terms should be stated in the letter to the bank. However the bank maybe protective of their
client s interests especially if they are in financial difficulties and may choose to be limited in their
response, in addition the law may prevent certain disclosures in order to protect the company. This
may limit the usefulness of bank references.
Example
Do you consider X Ltd to be good for a trade credit of Ł3,500 per month on terms of 30 days?
8
(iii) Financial numbers and credit risk
A good way of finding information about customers is to have a look at their published financial
statements; of course this is only relevant to incorporated entities.
The financial statements give a useful insight into the company s profitability and liquidity. Ratio
analysis can be undertaken. The disadvantage of this is that the financial statements are historical
and the situation may have changed now.
(iv) Credit reporting agencies (credit bureaux)
Credit bureaux provide information about businesses so that suppliers can assess their
creditworthiness. (e.g. Dunn & Bradstreet).
Consideration of information from credit bureaux
� The information given by the bureaux may be too summarised when more detail about the
company is needed.
� The information will be historical and may not be an indication of their current status.
� It will cost to obtain the information.
But this information can be cross referenced against other sources and therefore give a thorough
risk assessment.
(v) Other information
Other ways in checking the credit worthiness of the customer are:
� Press  which will contain update information about any difficulties the customer is facing.
� Companies registry search will give you information about it s financial affairs.
� County court records will show any convictions against the company.
� Personal visits to customers address to see if they exist and are bona fide.
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23.7 Monitoring and collecting trade receivables
Management need to ensure effective control of trade receivables collection, otherwise it could end
up facing severe liquidity problems. Care needs to be taken for a major customer, as slow payment
by them will result in cash flow problems.
To ensure effective control of trade receivables the following procedures should be adopted:
Efficient administration of the sales ledger
Prompt dispatch of invoices and statements which state payment terms and also the prompt
recording and banking of receipts.
Aged receivables analysis
A regular report should be produced showing the outstanding balances for customers, the length
of time they have been outstanding and the credit limits. This is a very useful aid in the
management and controlling of receivables.
Reviewing credit risk regularly
Ensuring that the customers credit risk is reviewed regularly especially high risk customers.
Collecting the debts is aided by ensuring efficient control of the sales ledger:
Invoicing Monthly statements Chasing slow payers
detailing
Customer fully aware of New invoices. Reminders.
payment terms.
Cash received. Telephone calls.
Invoice correct and issued
promptly with payment Outstanding balance due. Personal visit approach.
terms.
Age analysis. Debt collection agency.
Knowledge of customer s
system used (i.e. when is the Payment reminder. Legal action but may
month end and so prompt have an impact on
payment can occur). goodwill of customer.
Customer queries are
resolved quickly.
Monthly statements issued
promptly.
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23.8 Factoring
One way to release the cash on trade receivables is by factoring. The factor is a specialised
company, which manages the company s sales ledger by providing an advance and charging a fee.
The fee consists of an admin fee and interest on the amount of money advance to the company
based on the value of the sales ledger for example 80% of the sales ledger. The sales ledger is taken
by the factor as collateral against this advance. The interest on the advance is paid for an agreed
time period or until the receivables have paid.
The factor company offers following services:
- Administration of invoices, sales accounting and debt collection service.
- Credit protection for client s debts.
- Factor finance, payments in advance.
Factoring can either be a:
Recourse service  where the factor company will underwrite the sales ledger however if there
were any trade receivables that could not be recovered then the factor has the right to go back to the
company for compensation.
Non-recourse service - where the factor company will underwrite the sales ledger however if there
were any trade receivables that could not be recovered then the factor company does not have the
right to go back to the company for compensation.
Advantages of factoring Disadvantages of factoring
Savings in sales ledger administrative costs Cost of fee to the factoring company for their
such as credit control. services is expensive.
Cash received quicker, which means savings in May give a negative image of insolvency to
finance costs. potential investors.
Can pay suppliers quicker and take advantage of Factors objective is to recover the monies and
discounts. may not be friendly or courteous and this may
result in lost goodwill with your customer.
Optimum stock levels can be maintained as cash
available. Loss of close relationship with large important
customers which prevent possible sales leads
Factors are specialist, therefore are more from being exploited.
effective in chasing debts.
11
Evaluating the use of a factoring company
Companies need to do a cost benefit analysis before taking the decision to factor their debts.
Costs Savings
Service fees Administration savings
Interest payable on amounts advanced
Example 23.6
Factoring debts
Tefal plc is a small company selling household goods to the main retailers. It is facing cash flow
problems and is considering factoring its trade receivables.
Tefal plc has annual credit sales of Ł5 million and it allows customers credit terms of 60 days from
date of invoice.
The factoring company would advance Tefal 70% of the value of its invoices immediately on
receipt of the invoices. It will charge a service fee of 1.5% of the total invoices and also change
interest of 12% annually on amounts advanced.
Tefal plc will make 2 credit controllers redundant if the factoring decision is taken saving Ł55,000
per year in total.
Calculate the annual net cost of the factoring agreement for Tefal plc.
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23.9 Collecting money from customers
The credit control department is usually responsible for collecting debts. Efficient and effective
credit control is imperative for the company s cash flow and it also reduces bad debts.
To motivate the credit control team to collect as much as possible, targets can be set each month to
ensure that sufficient amounts are being collected. A bonus scheme can be put into place for when
these targets are met. This is a good way of controlling trade receivables.
One way of controlling trade receivables and reducing the risk of bad debt is using age analysis of
receivables. This is a report that is generated by the sales processing system and it shows age of
the debts, usually less than one month, between one and two months and greater than three months.
Bad debt is a debt, which is considered to be uncollectible and is written off against the profit and
loss account or doubtful debts provision.
Bad debts ratio = Bad debts x 100%
Turnover or credit or total trade receivables
The bad debt report will give details of when the original debt arose and when the debt was written
off.
Doubtful debt is a debt for which there is some uncertainty as to whether it is bad.
Doubtful debt provision is an amount charged against profit and deducted from debtors to allow
for estimated non-recovery of proportion of debts.
Note that bad debt affects cash flow as the money has not been received. Doubtful debt provision
doesn t affect cash flow and is just an accounting entry.
Ways of dealing with bad debt customers
� Stopping supplies to that customer and closing their account.
� Use of collection agencies.
� Legal action.
� Liquidation or winding up of a company.
� But the costs of pursuing these courses of action need to be considered.
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Example 23.7  Worked example (Past CIMA question)
The trade receivables ledger account for customer C shows the following entries:
Debits Credits
$ $
Balance brought forward 0
10 June 06 Invoice 201 345
19 June 06 Invoice 225 520
27 June 06 Invoice 241 150
3 July 06 Receipt 1009  Inv 201 200
10 July 06 Invoice 311 233
4 August 06 Receipt 1122  Inv 225 520
6 August 06 Invoice 392 197
18 August 06 Invoice 420 231
30 August 06 Receipt 1310  Inv 311 233
7 September 06 Invoice 556 319
21 September 06 Receipt 1501  Inv 392 197
30 September 06 Balance 845
Prepare an age analysis showing the outstanding balance on a monthly basis for
customer C at 30 September 2006.
C Due on Current less Between 1 Between Greater than
30/09/06 than 1 and 2 2 and 3 3 months
month months months
$845 $319 (W1) $231 (W2) 0 (W3) $295 (W4)
Workings
W1 - Sept 06 = $319
W2 - Aug 06 = $197 + $231 - $197 = $231
W3 - Jul 06 = $233 - $233 = $0
W4 - Jun 06 = $345 + $520 + $150 - $200 - $520 = $295
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Example 23.8  (Past CIMA question)
The trade receivables ledger account for customer X is as follows:
Debits Credits Balance
01-Jul-07 Balance b/fwd 162
12-Jul-07 Invoice AC34 172 334
14-Jul-07 Invoice AC112 213 547
28-Jul-07 Invoice AC215 196 743
08-Aug-07 Receipt RK 116 (Balance + AC34) 334 409
21-Aug-07 Invoice AC420 330 739
03-Sep-07 Receipt RL162 (AC215) 196 543
12-Sep-07 Credit note CN92 (AC112) 53 490
23-Sep-07 Invoice AC615 116 606
25-Sep-07 Invoice AC690 204 810
05-Oct-07 Receipt RM223 (AC420) 330 480
16-Oct-07 Invoice AC913 233 713
25-Oct-07 Receipt RM360 (AC615) 116 597
(a) Prepare an age analysis showing the outstanding balance on a monthly basis for customer
X.
(b) Explain how an age analysis of receivables can be useful to an entity.
Example 23.9
Trade receivables management
(a) Explain the purposes of companies preparing an age analysis of trade receivables
analysed by individual debts.
(b) Describe the main considerations that managers should take into account when
formulating a credit management policy.
15
23.10 Managing trade payables
Trade payables are people or organisations to which you owe money to for purchases of goods and
services. Trade credit is an important source of short-term finance.
The following need to be in place to ensure correct recording of trade payables and reporting on
debts due:
Good accounting system or recording system.
Authorisations systems with delegated authority.
Verification systems, checking orders and invoices.
Payment authorisation system, when invoices are passed for payment.
Methods of payments (BACS, cheques etc).
Establishing creditor policies, i.e. who to order from and when to pay early to take advantage
of settlement discounts etc.
23.11 The purchasing cycle
Goods or services
requisitioned
Authorise order and
Make payment
send to supplier
Stages in the
Goods received. Check
order and raise goods
purchase cycle
Authorise
received note (GRN)
payment
Invoice received, check
against order and GRN
Check statement
received from
supplier
16
Management of trade payables involves:
Obtaining satisfactory credit, by ensuring a good credit history.
The ability to extend credit if cash is short. This means good supplier relationships are
maintained.
If payments are delayed, this may result in loss of goodwill.
23.12 Settlement discounts
One of the decisions that need to be made is whether or not to take up the settlement discount
offered by suppliers by paying earlier.
Remember that trade credit is an interest free source of finance, and by paying suppliers early to
take advantage of the settlement discount means less finance is being taken on which is interest
free. This  loss in interest free credit needs to be compared with the savings in the discount for
cost-benefit analysis.
Example 23.10
Trade payables settlement discount
Baggins Ltd buys its goods from Potter Ltd. Baggins Ltd purchases goods worth Ł15million every
year and is allowed 60 days credit. Baggins Ltd always pays on time.
Potter Ltd is offering 1.5% discount if payment is made within 25 days.
Overdraft interest is currently at 11% pa.
Should Baggins take up the discount offer for early settlement of its debts?
Assume a 365 working days per year
17
The cost of taking the early settlement discount can be expressed as an effective annual interest rate
(APR). This percentage can then be compared with the interest rates for financing for the business.
Note that paying early is advancing of cash which requires financing.
Compound formula for cost of early settlement discount (APR)  normally used
365
N- S
100
100 - D - 1 x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
Simple formula for cost of early settlement discount
D x 365
100  D N - S x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
Example 23.11
Cost of early settlement discount
Following on from the previous lecture example, what is the annual rate of interest implied
by the discount offered to Baggins Ltd under the compound formula and the simple formula?
18
23.13 Age analysis of trade payables
One way of controlling trade payables is using an age analysis of payables. This is a report that is
generated by the purchase processing system and shows the age of payables, usually less than one
month, between one and two months and greater than three months.
The report is similar to the aged trade receivables analysis and shows the company how long
amounts are outstanding owed to suppliers.
The report can highlight important things like:
� When are we paying suppliers? If we are paying them too early then we may not be taking
advantage of the interest free credit offered.
� Are we taking advantage of discounts for early settlement? If discounts are taken then this
may result in substantial savings on supplier costs.
� Old trade payable amounts. These should be easier to review and can be investigated as to
why they are still outstanding. Reasons for outstanding payables maybe because there are
disputes over the quality of the items received, the wrong items were received and we are
still awaiting the correct items or accounting errors.
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Key summary of chapter
Trade credit is an interest free source of finance from one business to another business, and a
means of creating or increasing sales for the supplier.
Consumer credit is financing given for by businesses to end consumers for the purchase of goods
and services for personal consumption.
One of the main costs of extending credit rather than getting the cash in straight away from sales is
the finance cost.
Credit management involves:
The benefits of extending credit to customers versus the cost in extending the credit.
Establishing discounts, level and length of credit that will maximise profits.
Assessing the credit risk of customers by reviewing their accounting information or obtaining
references.
Setting credit limits for customers and terms of payment.
Collecting debts and minimising risk of bad debts (credit control).
20
Considerations before extending credit
Extra sales that will be generated from the additional credit terms.
The value of contribution of additional sales.
The additional finance costs.
The effect of additional trade receivables and payables (as more inventories will have to be
purchased).
Length of extra debt collection period.
Benefits of settlement discounts Costs of settlement discounts
� Encourages customers to pay earlier and � The cost of the discount will reduce cash
thus reduce financing costs. received.
� Improves liquidity as cash is received � Extra administrative costs to manage the
earlier. discounts given.
� Encourages customers to buy and � Customers may take the discount and still
therefore increase sales. pay late if there is poor management of
settlement discounts.
� Reduction in bad debts due to reduced
collection period.
Compound formula for cost of early settlement discount (APR)  normally used
365
N- S
100
100 - D - 1 x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
21
Simple formula for cost of early settlement discount
D x 365
100  D N - S x 100%
Where:
D =is discount offered in %
S = number of days credit allowed with settlement discount
N = the number of days credit offered net, for no discount
A credit assessment is a judgement about the creditworthiness of a customer, providing a basis for
a decision as to whether credit should be granted.
Trade references are obtained from companies that the customer has traded with.
Bank references can be obtained from the customer s bank but when asking the bank for
references the precise terms should be stated in the letter to the bank.
The financial statements give a useful insight into the company s profitability and liquidity.
Credit reporting agencies or credit bureaux provide information about businesses so that
suppliers can assess their creditworthiness. (e.g. Dunn & Bradstreet).
22
Monitoring and collecting trade receivables
Management need to ensure effective control of trade receivables collection, otherwise it could end
up facing severe liquidity problems.
Efficient administration of the sales ledger
Aged receivables analysis
Reviewing credit risk regularly
Factoring is a way to release the cash on trade receivables. The factor is a specialised company,
which manages the company s sales ledger by providing an advance and charging a fee.
Age analysis of receivables is a report that shows the age of debts, usually less than one month,
between one and two months and greater than three months.
Bad debt is a debt, which is considered to be uncollectible and is written off against the
profit and loss account or doubtful debts provision.
Bad debts ratio = Bad debts x 100%
Turnover or credit or total trade receivables
Doubtful debt is a debt for which there is some uncertainty as to whether it is bad.
Doubtful debt provision is an amount charged against profit and deducted from debtors to allow
for estimated non-recovery of proportion of debts.
23
Ways of dealing with bad debt customers
� Stopping supplies to that customer and closing their account.
� Use of collection agencies.
� Legal action.
� Liquidation or winding up of a company.
� But the costs of pursuing these courses of action need to be considered.
Management of trade payables involves:
Obtaining satisfactory credit, by ensuring a good credit history.
The ability to extend credit if cash is short. This means good supplier relationships are maintained.
If payments are delayed, this may result in loss of goodwill.
Age analysis of payables is a report that is generated by the purchase processing system and
shows the age of payables, usually less than one month, between one and two months and greater
than three months.
24
Solutions to Lecture Examples
Example 23.1
Increase in trade receivables
We need to compare the increased contribution with the increase finance cost of additional trade
receivables.
Current trade receivables = 30 / 365 x Ł15 million = Ł1.234 million
New trade receivables = 45 / 365 x Ł16 million = Ł1.973 million
Increase in trade receivables Ł0.739 million
Additional finance cost if this amount needs to borrowed at 11% = Ł0.739m x 0.11 = Ł81,290
Increase in contribution = Ł1 million x 10% = Ł100,000
Therefore it is worthwhile increasing the credit terms to 45 days as the cost of additional trade
receivables is less than the increase in contribution through increase in sales.
The net benefit is 100,000  81,290 = Ł18,710
Example 23.2
Offering early settlement discounts
In both the above requirements, the reduction in finance costs due to reduction in trade receivables
needs to be compared with the increased admin costs and reduction in revenue due to discount
allowable expense.
(a) All the customers take up the discount
A Reduction in finance cost for reduced trade receivables
Old trade receivables = Ł15m x 40/365 = Ł1,643,836
New trade receivables = Ł15m x 18/365 = Ł 739,726
Reduction in trade receivables = Ł 904,110
Saving in finance charge (904,110 x 11%) = Ł 99,452
Reduction in debtors can alternatively be worked out as:
25
 Change in trade receivable days x old trade receivable = (22 / 40) x Ł1,643,836 = Ł904,110
Old trade receivable days
B Costs of discount scheme
Reduction in revenue = Ł15m x 0.0025 = Ł 37,500
Extra staff costs = Ł 20,000
Total costs = Ł 57,500
Net benefit of discount scheme = A - B = (99,452  57,500) = Ł41,952
The scheme should be introduced if all customers take up the discount offer as it will increase the
profits by Ł41,952.
(b) Only 20% of the customers take up the discount.
A Reduction in finance cost for reduced trade receivables
Old trade receivables = Ł15m x 40/365 = Ł1,643,836
New trade receivables
Don t take up offer = Ł15m x 40/365 x 80% = Ł1,315,068
Do take up offer = Ł15m x 18/365 x 20% = Ł 147,945
Ł1,463,013
Reduction in trade receivables Ł 180,823
Saving in finance charges (Ł180,823 x 11%) = Ł 19,891
B Costs of discount scheme
Reduction in revenue = Ł15m x 0.0025 x 20% = Ł 7,500
Extra staff costs = Ł 20,000
Total costs = Ł 27,500
Net cost of discount scheme = A - B = (19,891  27,500) = (Ł7,609)
If only 20% of the customers take up the discount offer, the scheme should not be introduced as the
profits will reduce by Ł7,609.
26
Example 23.5
Settlement discount
Compound
100 / (100-2) 365/30 -1 x 100% = 27.9%
Simple
(2/ (100  2) x 365/(60-30)) = 24.8%.
The discount is only worthwhile financially if Trotters Ltd borrowing costs are greater than 24.8%
or 27.9% depending on which calculation is used.
If they did not offer the discount then they would have to borrow at the interest rate chargeable for
short term finance to source their requirements for cash. If the borrowing interest rate was say 35%
then it is cheaper to give the settlement discount to their trade receivables which will only cost
them 24.8% or 27.9%.
Example 23.6
Factoring debts
Annual factoring costs
Service fees payable to factoring company (1.5% x Ł5 million) Ł75,000
Interest payable to factoring company (60/365 x Ł5m x 70% x 12%) Ł69,041
Annual savings  costs of two credit controllers (Ł55,000)
Net costs Ł89,041
The factoring brings in cash immediately, which will help ease, the cash flow problems.
27
Example 23.8
(a) Aged analysis
Tick and bash the invoices with the payments. The outstanding items are shown in the age analysis
 group the items according to their age.
05/10 to 25/10 = less than 1 month
03/09 to 25/09 = between 1 month and 2 months
28/07 to 21/08 = between 2 month and 3 months
01/07 to 14/07 = Greater than 3 months
> 3 months 2 to 3 months 1 to 2 months < than 1 month Total
160 0 204 233 597
(b) Usefulness of age analysis of receivables
� It is useful to the management in controlling debtors.
� It highlights slow payers and therefore action can be taken to reduce the amount of credit to
these customers.
� It can be used to set credit limits to customers.
� Effective and appropriate action can be taken to collect debts.
� It can be used to estimate a provision for bad debts for the year end accounts.
Example 23.9
Debtor management
(a) Analysis of debts
Aged trade receivable listing splits up the total balance on the account of each customer across
different columns according to the dates of transactions which make up the total balance.
The analysis highlights:
(a) Overdue accounts.
(b) Customers who have exceeded their credit limit.
The main purposes of the aged analysis:
(a) Help to decide what action to take about older debts.
(b) Highlights outstanding amounts, therefore important tool for cash management and
revising cash forecasts.
(c) Evaluating staffs who are involved in debt collection.
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(b) Policy for credit management
When a policy is formulated, the management should consider the following notes:
1 Average period of credit to be given.
2 Investigating credit worthiness of new customers.
3 Debt collection policies.
4 Accounting reports required i.e. aged trade receivables list.
5 Policies on persuading debtors to pay promptly i.e. discount schemes.
6 Consider the use of factoring services.
Example 23.10
Trade payables settlement discount
1 The reduction in trade payables needs to be established first.
Old trade payables - Ł15m x 60/365 = Ł2,465,753
New creditors - Ł15m x 25/365 = Ł1,027,397
Reduction = Ł1,438,356
Reduction in creditors can alternatively be worked out as:
Change in creditor days x old creditors = (35 / 60) x Ł2,465,753 = Ł1,438,356
Old creditor days
2 The loss of interest free credit = Ł1,438,356 x 11% = Ł158,219
3 The cash benefit of the discount = 1.5% x Ł15m = Ł225,000
Therefore the net benefit (3-2) = Ł225,000 - Ł158,219 = Ł66,781. Baggins should take up the
discount offer and pay the supplier by 25 days.
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Example 23.11
Cost of early settlement discount
Compound
(100 / 98.5) 365 (60-25) -1 x 100% = 17.07%
Simple
1.5 / (100-1.5) x 365 / (60-25) x 100% = 15.88%
Taking up the discount is only worthwhile if the cost of borrowing for Baggins Ltd is less than
15.88% or 17.07% as this is the rate they are saving if they take up the settlement discounts.
Currently the borrowing rate for any cash flow needs is at 11% this is a smaller cost compared to
the savings made if they accept the settlement discount rate of 15.88% or 17.07%. It is therefore
worthwhile taking up the discount.
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