F9 Financial Management

Chapter 9 Managing Inventory, Accounts Receivable and

Accounts Payable

SYLLABUS

1. Discuss, apply and evaluate the use of relevant techniques in managing inventory,
including the EOQ model and JIT techniques.
2. Discuss, apply and evaluate the use of relevant techniques in managing accounts
receivable, including:
(a) assessing creditworthiness
(b) managing accounts receivable
(c) collecting amounts owing
(d) offering early settlement discounts
(e) using factoring and invoice discounting
(f) managing foreign accounts receivable
3. Discuss and apply the use of relevant techniques in managing accounts payable,
including:
(a) using trade credit effectively
(b) evaluating the benefits of discounts for early settlement and bulk purchase
(c) managing foreign accounts payable

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1. Managing Inventories

1.1 Costs of inventories

1.1.1 Inventory is a major investment for many companies. Manufacturing companies can
easily be carrying inventory equivalent to between 50% and 100% of the revenue of
the business. It is therefore essential to reduce the levels of inventory held to the
necessary minimum.

1.1.2 Costs of High Inventory Levels

Keeping inventory levels high is expensive owing to:
(a) purchase costs
(b) holding costs
(i) storage
(ii) stores administration
(iii) risk of theft/damage/obsolescence

1.1.3 Carrying inventory involves a major working capital investment and therefore levels
need to be very tightly controlled. The cost is not just that of purchasing the goods,

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but also storing, insuring, and managing them once they are in inventory.
1.1.4 Purchase costs: once goods are purchased, capital is tied up in them and until sold
on (in their current state or converted into a finished product), the capital earns no
return. This lost return is an opportunity cost of holding the inventory.
1.1.5 Stores administration: in addition, the goods must be stored. The company must
incur the expense of renting out warehouse space, or if using space they own, there is
an opportunity cost associated with the alternative uses the space could be put to.
There may also be additional requirements such as controlled temperature or light
which require extra funds.
1.1.6 Other risks: once stored, the goods will need to be insured. Specialist equipment may
be needed to transport the inventory to where it is to be used. Staff will be required to
manage the warehouse and protect against theft and if inventory levels are high,
significant investment may be required in sophisticated inventory control systems.
1.1.7 The longer inventory is held, the greater the risk that it will deteriorate or become
out of date. This is true of perishable goods, fashion items and high-technology
products, for example.

1.1.8 Costs of Low Inventory Levels

If inventory levels are kept too low, the business faces alternative problems:
(a) stockouts
(i) lost contribution
(ii) production stoppages
(iii) emergency orders
(b) high re-order/setup costs
(c) lost quantity discounts

1.1.9 Stockout: if a business runs out of a particular product used in manufacturing it may
cause interruptions to the production process – causing idle time, stockpiling of
work-in-progress (WIP) or possibly missed orders. Alternatively, running out of goods
held for onward sale can result in dissatisfied customers and perhaps future lost
orders if custom is switched to alternative suppliers. If a stockout looms, the
business may attempt to avoid it by acquiring the goods needed at short notice. This
may involve using a more expensive or poorer quality supplier.
1.1.10 Re-order/setup costs: each time inventory runs out, new supplies must be acquired. If
the goods are bought in, the costs that arise are associated with administration –
completion of a purchase requisition, authorisation of the order, placing the order with
the supplier, taking and checking the delivery and final settlement of the invoice. If the

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goods are to be manufactured, the costs of setting up the machinery will be incurred
each time a new batch is produced.
1.1.11 Lost quantity discounts: purchasing items in bulk will often attract a discount from
the supplier. If only small amounts are bought at one time in order to keep inventory
levels low, the quantity discounts will not be available.

1.1.12 The Objectives of Good Inventory Management

The objective of good inventory management is therefore to determine:
(a) the optimum re-order quantity – how many items should be ordered when
the order is placed for all material inventory items.
(b) the optimum re-order level – how many items are left in inventory when
the next order is placed, and
In practice, this means striking a balance between holding costs on the one hand
and stockout and re-order costs on the other.

1.2 Economic Order Quantity (EOQ)

(Dec 07, Jun 08, Dec 10, Dec 13, Sep 16)
1.2.1 For businesses that do not use JIT (discussed in more detail below), there is an
optimum order quantity for inventory items, known as the EOQ.
1.2.2 The EOQ model is based on a cost function for holding stock which has two terms:
holding costs and ordering costs.
1.2.3 The aim of the EOQ model is to minimise the total cost of holding and ordering
inventory.

1.2.4 EOQ Formula

EOQ =

C0 = Cost of placing one order

CH = Holding cost per unit of inventory for one period
D = Annual demand

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1.2.5 Example 1
The demand for a commodity is 40,000 units a year, at a steady rate. It costs $20 to
place an order, and 40 cents to hold a unit for a year. Find the order size to
minimize inventory costs, the number of orders placed each year, the length of the
inventory cycle and the total costs of holding inventory for the year.

Solution:

EOQ = = 2,000 units

This means that there will be = 20 orders placed each year.

The inventory cycle is therefore = 2.6 weeks

Total costs will be (20 × $20) + = $800 a year.

1.2.6 Limitations of EOQ

(a) Only based on two types of costs: holding costs and ordering costs.
(b) Demand for stock, holding cost per unit per year and order cost are
assumed to be certain and constant. In practice, demand is likely to be
variable or irregular and costs will not remain constant.
(c) Ignore the cost of running out of stock (stockouts). This has caused some to
suggest that the EOQ model has little to recommend it as a practical model for

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the management of stock.

(d) Developed on the basis of zero lead time and no buffer stock. However,
these are not difficulties that prevent the practical application of the EOQ
model. The EOQ model can be used in circumstances where buffer stock
exists and provided that lead time is known with certainty.

Multiple Choice Questions

1. Gogo plc is a retailer of large storage boxes. The company has an annual demand of
120,000 units. The costs incurred each time an order is placed are $200. The carrying
cost per unit of the item each month is estimated at $3. The purchase price of each
unit is $4.

When using this formula to find the optimal quantity to be ordered, which of the
following amounts are not included in the calculation?

A Cost per order ($200)

B Carrying cost per unit ($3)
C Purchase price per unit ($4)
D Estimated usage of the inventory item over a particular period (120,000 units per
annum)

2. The Economic Order Quantity (EOQ):

A is a formula that calculates a realistic purchase price for an item

B determines the lowest order quantity by balancing the cost of ordering against
the cost of holding inventory
C is used to calculate how much safety inventory should be carried
D should be calculated once a year

3. Which of the following are assumptions used when calculating the economic order
quantity for inventory?

(i) Lead time is constant

(ii) Demand is constant
(iii) Purchase costs are constant

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A All of the above

B (i) and (ii) only
C (i) and (iii) only
D (ii) and (iii) only

4. According to a colleague, the basic economic order quantity (EOQ) inventory model is
based on a number of limiting assumptions, which include the following:

1. lead times are constant or zero

2. selling prices remain constant
3. demand is constant
4. the purchase price of inventory items remains constant

Which TWO of the above assumptions are correct?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

5. A retailer sells 25,000 units of a particular product each year and the demand for the
product is even throughout the year. The purchase price of the product is $4 per unit.
The cost of placing each order for the product is $10, the cost of holding one unit in
stock for one year is $2 and the economic order quantity is 500 units.

What is the total annual cost of trading in this particular product?

A $100,500
B $101,000
C $101,500
D $102,500

6. A business keeps an item in stock for which demand is 30,000 units per year. The cost
of placing an order for the item is $40 and the cost of holding one unit of the item is
$0·60 per year. The business uses the economic order quantity (EOQ) approach to

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derive the optimal order quantity for the item. Demand for the item is even throughout
the year.

What is the combined annual cost of stock holding and stock ordering for the item?

A $1,200
B $1,800
C $40,600
D $41,200

7. A retailer sells 80,000 units of a particular product each year and demand for the
product is even throughout the year. The cost of placing each order for the product is
$12, the cost of holding one unit in stock for one year is $6 and the retailer orders in
batches of 1,600 units. A buffer stock of 10,000 units is held throughout the year.

What is the combined annual cost of ordering and holding this particular product?

A $5,400
B $10,200
C $65,400
D $70,200

8. Lechtal Co sells a particular product for which it pays $6 per unit. Annual sales are
60,000 units and demand accrues evenly throughout the year. The cost of ordering the
product is $15 per order and the inventory cost of holding one unit of the product for
one year is $3. It is Lechtal Co’s policy to have an order quantity of 1,200.

What is the total annual cost to the business of trading in this product?

A $360,750
B $361,800
C $362,550
D $364,550

9. ABC Co has calculated the following in relation to its inventories.

Buffer inventory level 50 units
Reorder size 250 items

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Fixed order costs $50 per order

Cost of holding onto one item pa $1.25 pa
Annual demand 10,000 items
Purchase price $2 per item

What are the total inventory related costs for a year (to the nearest whole $)?

A $2,219
B $22,219
C $20,894
D $20,219

10. To aid financial planning, Elburz Co has adopted the following target financial ratios
for the forthcoming financial year:

Return on equity 10% (using year-end equity figure)

Non-current liabilities: Equity 2:1
Total assets less current liabilities: Current assets 3:1
Current ratio 1:1
Acid test ratio 0·8:1
The net profit after tax for the forthcoming year is forecast to be $500,000.

What will be the forecast level of inventory at the end of the year?

A $0·5m
B $1·0m
C $4·0m
D $9·0m

11. A company’s typical inventory holding period at any time is as follows:

Days
Raw materials 15
Work in progress 35
Finished goods 40

Annual cost of goods cosld as per the financial statements is $100m of which the raw

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material purchases account for 50% of the total.

The company has implemented plans to reduce the level of inventory held, the effects
of which are expected to be as follows:

(1) Raw material holding time to reduced by 5 days

(2) Production time to be reduced by 4 days
(3) Finished goods holding time to be reduced by 5 days

Assume a 365-day year, what will be the reduction in inventory held?

A $2.603m
B $3.836m
C $1.918m
D $3.151m
(ACCA F9 Financial Management March 2017)

Question 1 – EOQ, early settlement discount and JIT

TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling
price of £19 per unit and is purchased for £11 per unit from a supplier, MKR Co. TNG
places an order for 50,000 units of product X at regular intervals throughout the year.
Because the demand for product X is to some degree uncertain, TNG maintains a safety
(buffer) stock of product X which is sufficient to meet demand for 28 working days. The
cost of placing an order is £25 and the storage cost for Product X is 10 pence per unit per
year.

TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for
cash settlement within 20 days.

TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365
days.

Required:

(a) Calculate the annual cost of the current ordering policy. Ignore financing costs in this
part of the question. (4 marks)
(b) Calculate the annual saving if the economic order quantity model is used to determine

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an optimal ordering policy. Ignore financing costs in this part of the question.
(5 marks)
(c) Determine whether the discount offered by the supplier is financially acceptable to
TNG Co. (4 marks)
(d) Critically discuss the limitations of the economic order quantity model as a way of
managing stock. (4 marks)
(e) Discuss the advantages and disadvantages of using just-in-time stock management
methods. (8 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control June 2005 Q5)

Question 2 – Objectives of working capital management, EOQ, AR management

PKA Co is a European company that sells goods solely within Europe. The recently-
appointed financial manager of PKA Co has been investigating the working capital
management of the company and has gathered the following information:

Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units. The
cost of placing and processing an order is €250, while the cost of holding a unit in stores is
€0•50 per unit per year. Both costs are expected to be constant during the next year. Orders
are received two weeks after being placed with the supplier. You should assume a 50-week
year and that demand is constant throughout the year.

Accounts receivable management

Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co
show that the average accounts receivable period in the last financial year was 75 days. The
financial manager also noted that bad debts as a percentage of sales, which are all on credit,
increased in the last financial year from 5% to 8%.

Required:
(a) Identify the objectives of working capital management and discuss the conflict that
may arise between them. (3 marks)
(b) Calculate the cost of the current ordering policy and determine the saving that could be
made by using the economic order quantity model. (7 marks)
(c) Discuss ways in which PKA Co could improve the management of domestic accounts
receivable. (7 marks)

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(ACCA F9 Financial Management December 2007 Q4(a), (b) & (c))

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1.3 Quantity discount (bulk purchase discount)

(Jun 11, Dec 12)
1.3.1 Discounts may be offered for ordering in large quantities. If the EOQ is smaller than
the order size needed for a discount, should the order size be increased above the
EOQ?

1.3.2 Example 2
The annual demand for an item of inventory is 125 units. The item costs $200 a
unit to purchase, the holding cost for one unit for one year is 15% of the unit cost
and ordering costs are $300 an order. The supplier offers a 3% discount for order of
60 units or more, and a discount of 5% for orders of 90 units or more. What is the
cost minimizing order size?

Solution:
(a) The EOQ ignoring discount is:

= 50 units

$
Purchases (no discount) 125 × $200 25,000
Holding costs (50/2) 25 units × $30 (15% x $200) 750
Ordering costs 2.5 orders × $300 750
Total annual costs 26,500

(b) With a discount of 3% and an order quantity of 60 units costs are as follows.
$
Purchases $25,000 × 97% 24,250
Holding costs 30 (= 60/2) units × (15% × 97% × $200) 873
Ordering costs 2.08 (= 125/60) orders × $300 625
Total annual costs 25,748

(c) With a discount of 5% and an order quantity of 90 units costs are as follows.
$
Purchases $25,000 × 95% 23,750
Holding costs 45 (=90/2) units × (15% × 95% × $200) 1,282.5
Ordering costs 1.39 (= 125/90) orders × $300 416.7
Total annual costs 25,449.2

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The cheapest option is to order 90 units at a time.

Question 3
A company uses an item of inventory as follows.

Purchase price: $96 per unit

Annual demand: 4,000 units
Ordering cost: $300
Annual holding cost: 10% of purchase price
Economic order quantity: 500 units

Should the company order 1,000 units at a time in order to secure an 8% discount?

Question 4 – Changes in receivables policy, bulk purchase discount, reasons for

holding cash and factors in formulating receivables management policy
KXP Co is an e-business which trades solely over the internet. In the last year the company
had sales of $15 million. All sales were on 30 days’ credit to commercial customers.

Extracts from the company’s most recent statement of financial position relating to working
capital are as follows:

$000
Trade receivables 2,466
Trade payables 2,220
Overdraft 3,000

In order to encourage customers to pay on time, KXP Co proposes introducing an early

settlement discount of 1% for payment within 30 days, while increasing its normal credit
period to 45 days. It is expected that, on average, 50% of customers will take the discount
and pay within 30 days, 30% of customers will pay after 45 days, and 20% of customers
will not change their current paying behaviour.

KXP Co currently orders 15,000 units per month of Product Z, demand for which is
constant. There is only one supplier of Product Z and the cost of Product Z purchases over
the last year was $540,000. The supplier has offered a 2% discount for orders of Product Z
of 30,000 units or more. Each order costs KXP Co $150 to place and the holding cost is 24
cents per unit per year.

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KXP Co has an overdraft facility charging interest of 6% per year.

Required:

(a) Calculate the net benefit or cost of the proposed changes in trade receivables policy
and comment on your findings. (6 marks)
(b) Calculate whether the bulk purchase discount offered by the supplier is financially
acceptable and comment on the assumptions made by your calculation. (6 marks)
(c) Identify and discuss the factors to be considered in determining the optimum level of
cash to be held by a company. (5 marks)
(d) Discuss the factors to be considered in formulating a trade receivables management
policy. (8 marks)
(25 marks)
(ACCA F9 Financial Management December 2012 Q2)

1.4 Re-order level (ROL)

1.4.1 Having decided how much inventory to re-order, the next problem is when to re-
order. The firm needs to identify a level of inventory which can be reached before an
order needs to be placed.
1.4.2 When lead time and demand are known with certainty, ROL = demand during
lead time. Where there is uncertainty, an optimum level of buffer inventory must
be found.
1.4.3 If an order is placed too late, the organization may run out of inventory, a stock-out,
resulting in a loss of sales and/or a loss of production.
1.4.4 If an order is placed too soon, the organization will hold too much inventory, and
inventory holding costs will be excessive.

1.4.5 Re-order Level Formula

Re-order level = maximum usage × maximum lead time

Lead time – the lag between when an order is placed and the item is delivered.

Use of a re-order level builds in a measure of safety inventory and minimizes the
risk of the organization running out of inventory. This is particularly important
when the volume of demand or the supply lead time are uncertain.

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Multiple Choice Questions

12. Which of the following statements is true?

Statement 1: The reorder level is the measure of inventory at which a replenishment

order should be made.
Statement 2: Use of a reorder level builds in a measure of safety inventory and
minimises the risk of the organization running out of inventory.

Statement 1 Statement 2
A True True
B True False
C False True
D False False

1.5 Maximum and minimum inventory levels

1.5.1 Formula
Maximum inventory level =
re-order level + re-order quantity – (minimum usage × minimum lead time)

Minimum inventory level or buffer safety inventory =

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Re-order level – (average usage × average lead time)

Average inventory = minimum level + re-order quantity / 2

1.5.2 The maximum level acts a warning signal to management that inventories are
reaching a potentially wasteful level.
1.5.3 The minimum level acts as a warning to management that inventories are
approaching a dangerously low level and that stock-outs are possible.
1.5.4 Under average inventory, it assumes that inventory levels fluctuate evenly between the
minimum (or safety) inventory level and the highest possible inventory level.
1.5.5 This approach assumes that a business wants to minimize the risk of stock-outs at all
costs. In the modern manufacturing environment stock-outs can have a disastrous
effect on the production process.

1.5.6 Example 3
ABC Ltd uses three raw materials P, Q and R, for the production of its final
product. The stock record for the month of July was shown below:

Raw Usage per unit Re-order Price per Delivery Re-order Minimum
materials of product quantity kg period level stock level
(kg) (kg) ($) (weeks) (kg) (kg)
P 10 11,000 0.18 1 to 2 9,500 -
Q 7 8,500 0.32 2 to 4 4,500 -
R 5 10,000 0.44 3 to 5 - 3,000

Weekly production of product varies from 400 to 550 units, averaging 475.

Required:

Calculate:

(a) minimum stock level of P.

(b) maximum stock level of Q.
(c) re-order level of R.
(d) average stock level of R.

Solution:

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(a)
Minimum stock level of P
= Re-order level – (average usage × average lead time)
= 9,500 – (4,750 × 1.5)
= 2,375 units

Average usage = 475 × 10 = 4,750

Average lead time = (1 + 2) / 2 = 1.5

(b)
Maximum stock level of Q
= re-order level + re-order quantity – (minimum usage × minimum lead time)
= 4,500 + 8,500 – (2,800 × 2)
= 7,400 units

Minimum usage = 400 × 7 = 2,800

(c)
Re-order level of R
= maximum usage × maximum lead time
= 2,750 × 5
= 13,750 units

Maximum usage = 5 × 550

(d)
Average stock level of R
= minimum level + re-order quantity / 2
= 3,000 + 10,000 / 2
= 8,000 units

1.6 Inventory management systems – Just-in-time (JIT)

1.6.1 JIT

JIT is a series of manufacturing and supply chain techniques that aim to minimise

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inventory levels and improve customer service by manufacturing not only at the
exact time customers require, but also in the exact quantities they need and at
competitive prices.

JIT procurement is a term which describes a policy of obtaining goods from

suppliers at the latest possible time (i.e. when they are needed) and so avoiding
the need to carry any materials or components inventory.

1.6.2 Benefits of JIT (Dec 10)

(a) Holding costs can be reduced by reducing the level of inventory held by a
company. Holding costs can be reduced to a minimum if a company orders
supplies only when it needs them, avoiding the need to have any inventory
at all of inputs to the production process.
(b) Investment in working capital can be reduced. Since inventory level have
been minimized.
(c) Improved relationship with suppliers. Since supplier and customer need
to work closely together in order to make JIT procurement a success.
(d) Improved operating efficiency, due to the need to streamline production
methods in order to eliminate inventory between different stages of the
production process.
(e) Lower reworking costs due to the increased emphasis on the quality of
supplies, since hold-ups ( 耽 擱 ) in production must be avoided when
inventory between production stages has been eliminated.

1.6.3 Disadvantages of JIT

(a) JIT may not run as smoothly in practice as theory may predict, since there
may be little room for manoeuvre ( 迴 旋 的 餘 地 ) in the event of
unforeseen delays. There is little room for error, for example, on delivery
times.
(b) The buyer is also dependent on the supplier for maintaining the quality of
delivered materials and components. If delivered quality is not up to the
required standard, expensive downtime or a production standstill may
arise, although the buyer can protect against this eventuality by including
guarantees and penalties into the supplier’s contract.

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(c) If the supplier increases prices, the buyer may find that it is not easy to find
an alternative supplier who is able, at short notice, to meet his needs.

1.6.4 JIT will not be appropriate in some cases. For example, a restaurant might find it
preferable to use the traditional EOQ approach for staple non-perishable food
inventories but adopt JIT for perishable and exotic items. In a hospital, a stock-out
could quite literally be fatal and so JIT would be quite unsuitable.

Multiple Choice Questions

13. Which of the following is NOT generally a benefit of a ‘just in time’ approach?

A Lower inventory levels

B Better product customisation
C Ease of production scheduling
D Higher quality

14. The following statements have been made about the probable long-term effects of
introducing a just-in-time system of inventory management:

(i) Inventory holding costs increase

(ii) Labour productivity improves
(iii) Manufacturing lead times decrease

Which of the above statements is true?

A (i), (ii) and (iii)

B (i) and (ii) only
C (i) and (iii) only
D (ii) and (iii) only

15. Which of the following would be LEAST likely to arise from the introduction of a
just-in-time inventory ordering system?

A Lower inventory holding costs

B Less risk of inventory shortages
C More frequent deliveries
D Increased dependence on suppliers

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16. Which of the following is an aim of a just in time system of inventory control?

A Increase in capital tie up in inventory

B Creation of an inflexible production process
C Elimination of all activities performed that do not add value
D Lowering of inventory ordering costs

Question 5 – Just-in-time
PS Co has an opportunity to engage in a just-in-time inventory delivery arrangement with
its main customer, who normally takes 90 days to settle accounts with PS Co. The customer
accounts for 20% of PS Co's annual turnover of $20 million. This involves borrowing
$0.5m on overdraft to invest in dedicated handling and transport equipment. This would be
depreciated over five years on a straight-line basis. The customer is uninterested in the early
payment discount but would be prepared to settle after 60 days and to pay a premium of 5%
over the present price in exchange for guarantees regarding product quality and delivery. PS
Co judges the probability of failing to meet these guarantees in any one year at 5%. Failure
would trigger a penalty payment of 10% of the value of total sales to this customer
(including the premium). PS Co borrows from the bank at 13%.

Required:

(a) Calculate the improvement in profits before tax to be expected in the first
trading year after entering into the JIT arrangement. Comment on your results.
(8 marks)
(b) Briefly describe the benefits and disadvantages of a just-in-time (JIT)
procurement policy. (7 marks)
(15 marks)

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2. Managing Accounts Receivable

2.1 Cost of financing receivables

2.1.1 Management must establish a credit policy. The optimum level of trade credit
extended represents a balance between two factors:
(a) profit improvement from sales obtained by allowing credit
(b) the cost of credit allowed.

2.1.2 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.
2.1.3 A lenient ( 寬 大 的 ) credit policy may well attract additional customers, but at a
disproportionate increase in cost.

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2.1.4 Example 4
Paisley Co has sales of $20 million for the previous year, receivables at the year
end were $4 million, and the cost of financing receivables is covered by an
overdraft at the interest rate of 12% pa.

Required:

(a) calculate the receivables days for Paisley

(b) calculate the annual cost of financing receivables.

Solution:

(a) Receivables days = $4m ÷ $20m × 365 = 73 days

(b) Cost of financing receivables = $4m × 12% = $480,000.

2.2 Key areas of accounts receivable management

(Pilot, Dec 07, Jun 10, Jun 13, Jun 15, Sep 16, Mar/Jun 17)

2.2.1 Four key areas of a accounts receivable management

(a) Policy formulation

(b) Credit analysis
(c) Credit control
(d) Collection of amounts due

(A) Policy formulation

2.2.2 Policy formulation

(a) This is concerned with establishing the framework within which

management of accounts receivable in an individual company takes place.
(b) The elements to be considered include:
(i) establishing terms of trade, such as period of credit offered and early
settlement discounts;
(ii) deciding whether to charge interest on overdue accounts;
(iii) determining procedures to be followed when granting credit to new
customers;
(iv) establishing procedures to be followed when accounts become

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overdue, and so on.

(B) Credit analysis

(Jun 15)
2.2.3 A firm should assess the creditworthiness of:
(a) all new customers immediately
(b) existing customers periodically.
2.2.4 Credit control involves the initial investigation of potential customers and continuing
control of outstanding accounts. The main points to note are as follows:
(a) New customers should give good references, including one from a bank,
before being granted credit, or credit reference agencies such as Dunn &
Bradstreet publish general financial details of many companies, together with a
credit rating.
(b) Credit ratings might be checked through a credit rating agency.
(c) A new customer’s credit limit should be fixed at a low level and only
increased if his payment record subsequently warrants it.
(d) For large value customers, a file should be maintained of any available
financial information about the customer. This file should be reviewed
regularly. Information is available from, for example, an analysis of the
company’s annual report and accounts.
(e) Press comments may give information about what a company is currently
doing.
(f) The company could send a member of staff to visit the company concerned, to
get a first-hand impression of the company and its prospects. This would be
advisable in the case of a prospective major customer.

(C) Credit control

2.2.5 Regular Monitoring

Regular monitoring of accounts receivables is very important. Individual accounts

receivables can be assessed using a customer history analysis (i.e. aging report)
and a credit rating system. The overall level of accounts receivable can be
monitored using an aged accounts receivable listing and credit utilization report,
as well as reports on the level of bad debts.

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2.2.6 Example 5 – Credit Utilisation Report

The total amount of credit offered, as well as individual accounts, should be policed
to ensure that the senior management policy with regard to the total credit limits is
maintained. A credit utilization report can indicate the extent to which total limits
are being utilized. An example is given below.

Customer Limit Utilisation

$000 $000 %
Alpha 100 90 90
Beta 50 35 70
Gamma 35 21 60
Delta 250 125 50
435 271
62.2%

This might also contain other information, such as days sales outstanding and so
on.

Reviewed in aggregate, this can reveal the following.

(a) The number of customers who might want more credit
(b) The extent to which the company is exposed to accounts receivable
(c) The tightness of the policy.

2.2.7 Extension of credit – to determine whether it would be profitable to extend the level
of total credit, it is necessary to assess: (Pilot, Dec 12)
(a) The extra sales that a more generous credit policy would stimulate.
(b) The profitability of the extra sales.
(c) The extra length of the average debt collection period.
(d) The required rate of return on the investment in additional accounts
receivable.

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2.2.8 Example 6 – A change in credit policy

ABC Co is considering a change of credit policy which will result in an increase in
the average collection period from one to two months. The relaxation in credit is
expected to produce an increase in sales in each year amounting to 25% of the
current sales volume.

Selling price per unit $10

Variable cost per unit $8.50
Current annual sales $2,400,000

The required rate of return on investments is 20%. Assume that the 25% increase in
sales would result in additional inventories of $100,000 and additional accounts
payable of $20,000.

Advise the company on whether or not to extend the credit period offered to
customers, if:

(a) All customers take the longer credit of two months

(b) Existing customers do not change their payment habits, and only the new
customers take a full two months credit.

Solution:

The change in credit policy is justifiable if the rate of return on the additional
investment in working capital would exceed 20%.

Extra profit
Contribution/sales ratio 15%
Increase in sales revenue $600,000
Increase in contribution and profit $90,000

(a) Extra investment, if all accounts receivable take two months credit

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Average accounts receivable after the sales increase

(2/12 × $3,000,000) 500,000
Less: Current average accounts receivable
(1/12 × $2,400,000) 200,000
Increase in accounts receivable 300,000
Increase in inventories 100,000
400,000
Less: Increase in accounts payable 20,000
Net increase in working capital investment 380,000

Return on extra investment = $90,000 / $380,000 = 23.7%

(b) Extra investment, if only the new accounts receivable take two months credit
Increase in accounts receivable (2/12 × $600,000) 100,000
Increase in inventories 100,000
200,000
Less: Increase in accounts payable 20,000
Net increase in working capital investment 180,000

Return on extra investment = $90,000 / $180,000 = 50%

In both case (a) and case (b) the new credit policy appears to be worthwhile.

Question 6
ABC Co currently expects sales of $50,000 a month. Variable costs of sales are $40,000 a
month (all payable in the month of sales). It is estimated that if the credit period allowed to
accounts receivable were to be increased from 30 days to 60 days, sales volume would
increase by 20%. All customers would be expected to take advantage of the extended credit.
If the cost of capital is 12.5% a year (or approximately 1% a month), is the extension of the
credit period justifiable in financial terms?

(D) Collecting overdue debts

2.2.9 Collection of amounts due

Ideally, all customers will settle within the agreed terms of trade. If this does not
happen, a company needs to have in place agreed procedures for dealing with

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overdue accounts. These could cover logged telephone calls, personal visits,
charging interest on outstanding amounts, refusing to grant further credit and, as
a last resort, legal action. With any action, potential benefit should always exceed
expected cost.

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

Multiple Choice Questions

17. Which of the following statements, concerning receivables management, is incorrect?

A Credit limits should be reviewed periodically

B Credit analysis depends on the provision of relevant information, for example
trade references
C Delaying payment of invoices is likely to make receivables management more

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effective
D Longer term credit may increase revenue but also increases the risk of bad debts

18. Which of the following would not be a key aspect of a company’s accounts receivable
credit policy?

A Assessing creditworthiness
B Checking credit limits
C Invoicing promptly and collecting overdue debts
D Delaying payments to obtain a free source of finance.

19. A company is considering increasing its credit period to customers from one month to
two months. Annual revenue is currently $1,200,000. It is expected that the increased
credit period would increase sales by 25% and result in an increase in profit of
$45,000, before any INCREASE in finance charges have been taken into account. The
company’s cost of capital is 10%.

What is the financial effect of this proposal, after taking into account any increase
in finance charges?

A Increase in profit of $35,000

B Decrease in profit of $35,000
C Increase in profit of $30,000
D Decrease in profit of $30,000

20. The management of XYZ Co has annual credit sales of $20 million and accounts
receivable of $4 million. Working capital is financed by an overdraft at 12% interest
per year. Assume 365 days in a year.

What is the annual finance cost saving if the management reduces the collection period
to 60 days?

A $85,479
B $394,521

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C $78,904
D $68,384
(ACCA F9 Financial Management Pilot Paper 2014)

Question 7 – Changes of credit policy, Miller-Orr Model, AR management and

working capital funding policy
Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit,
although customers on average take ten days more than this to pay. Contribution represents
60% of sales and the company currently has no bad debts. Accounts receivable are financed
by an overdraft at an annual interest rate of 7%.

Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days
and to extend the maximum credit offered to 60 days. The company expects that these
changes will increase annual credit sales by 5%, while also leading to additional incremental
costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers,
with the remaining customers taking an average of 60 days to pay.

Required:

(a) Evaluate whether the proposed changes in credit policy will increase the profitability
of Ulnad Co. (6 marks)
(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of
$7,500. The average cost to the company of making deposits or selling investments is
$18 per transaction and the standard deviation of its cash flows was $1,000 per day
during the last year. The average interest rate on investments is 5.11%. Determine the
spread, the upper limit and the return point for the cash account of Renpec Co using
the Miller-Orr model and explain the relevance of these values for the cash
management of the company. (6 marks)
(c) Identify and explain the key areas of accounts receivable management. (6 marks)
(d) Discuss the key factors to be considered when formulating a working capital funding
policy. (7 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper Q3)

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Question 8 – Operating cycle, current ratio, key elements of receivables

TGA Co, a multinational company, has annual credit sales of $5·4 million and related cost
of sales are $2·16 million. Approximately half of all credit sales are exports to a European
country, which are invoiced in euros. Financial information relating to TGA Co is as
follows:

$000 $000
Inventory 473.4
Trade receivables 1,331.5 1,804.9

Trade payables 177.5

Overdraft 1,326.6 1,504.1
Net working capital 300.8

TGA Co plans to change working capital policy in order to improve its profitability. This
policy change will not affect the current levels of credit sales, cost of sales or net working
capital. As a result of the policy change, the following working capital ratio values are
expected:

Inventory days 50 days

Trade receivables days 62 days
Trade payables days 45 days

Other relevant financial information is as follows:

Short-term borrowing rate 5% per year
Short-term dollar deposit rate 4% per year

Assume there are 365 days in each year.

Required:

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(a) For the change in working capital policy, calculate the change in the operating cycle,
the effect on the current ratio and the finance cost saving. Comment on your findings.
(8 marks)
(b) Discuss the key elements of a trade receivables management policy. (7 marks)
(15 marks)
(ACCA F9 Financial Management June 2013 Q3(a)&(b))

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2.3 Early settlement discounts

(Dec 10, Dec 12, Dec 15)
2.3.1 Early settlement discounts
(a) Early settlement discounts are given to encourage early payment by
customers. 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.

(b) The benefit in interest cost saved should exceed the cost of the discounts
allowed.

2.3.2 Advantages and disadvantages of offering early settlement discounts:

Advantages Disadvantages
(a) Early payment reduces the (a) Difficulty in setting the
receivables balance and hence the appropriate terms.
finance costs. (b) Uncertainty as to when cash
(b) Potential to reduce the receipts will be received,
irrecoverable debts arising. complicating cash budgeting.
(c) Offers a choice to customers of (c) Unlikely to reduce irrecoverable
payment terms. debts in practice.
(d) Customers pay over normal terms
but still take the cash discount.

2.3.3 Example 7
A company offers its goods to customers on 30 days’ credit, subject to satisfactory
trade references. It also offers a 2% discount if payment is made within ten days of
the date of the invoice.

Required:

Calculate the cost to the company of offering the discount, assuming a 365 day
year.

Solution:

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Discount as a percentage of amount paid = 2 / 98 = 2.04%.

Saving is 20 days (30 – 10) and there are 365 / 20 = 18.25 periods in a year.
Annualised cost of discount (%) is
(1 + 2.04%)18.25 – 1 = 44.6%

Question 9
A company is offering a cash discount of 2.5% to receivables if they agree to pay debts
within one month. The usual credit period taken is three months.

What is the effective annualized cost of offering the discount and should it be offered, if the
bank would loan the company at 18% pa?

Multiple Choice Questions

21. XYZ Co has annual credit sales of $20 million and accounts receivable of $4 million.
Working capital is financed by an overdraft at 12% interest per year. Assume 365 days
in a year.

What is the annual financial effect if management reduces the collection period to 60
days by offering an early settlement discount of 1% that all customers adopt?

A $85,479 benefit
B $114,521 cost
C $85,479 cost
D $285,479 benefit

22. ABC Co offers an early settlement discount of 2% to its customers if they pay cash
instead of taking 60 days' credit.

What is the annualised percentage cost of this discount to ABC?

A 12%
B 13%
C 6%
D 18%

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23. Olive plc usually takes 2 months to collect its debts from credit customers. It has just
issued an invoice to Alfie plc for $100 and offers a cash discount of 2% if payment is
made within 1 month.

What is the effective annualised cost of the discount if Alfie plc does settle within 1
month?

A 27.4%
B 34.4%
C 20.0%
D 32.6%

3. Factoring and Invoicing Discounting

3.1 Factoring

3.1.1 Factoring (應收帳款承購業務) and invoice discounting (發票貼現) are both ways of
speeding up the receipt of funds from accounts receivable. This improves cash flow
and liquidity.

3.1.2 Factoring (Jun 08, Dec 13)

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.
(所謂應收帳款承購(Factoring) 是銷售商（Seller）將其因銷貨、提供勞務等而
取得的應收帳款（Accounts Receivables）之債權，全部轉讓予應收帳款管理
商（Factor），由應收帳款管理商來承擔買方(Buyer)倒帳之信用風險，並提
供帳款管理、催收及資金融通的服務。)

The company can choose some or all of the following three services offered by the
factor:
(a) debt collection and administration (recourse or non-recourse) – the factor
takes over the whole of the company’s sales ledger, issuing invoices and
collecting debts.

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(b) financing – the factor will advance up to 80% of the value of the debt to
the company; the remainder (minus finance costs) being paid when the
debts are collected. The factor becomes a source of finance. Finance costs
are usually 1.5% to 3% above bank base rate and charged on a daily basis.
(c) credit insurance – the factor agrees to insure the irrecoverable debts of the
client. The factor would then determine to whom the company was able to
offer credit.

3.1.3 Factoring is most suitable for:

(a) small and medium-sized firm which often cannot afford sophisticated credit
and sales accounting systems, and
(b) firms that are expanding rapidly. These often have a substantial and growing
investment in inventory and receivables, which can be turned into cash by
factoring the debts. Factoring debts can be a more flexible source of financing
working capital than an overdraft or bank loan.
3.1.4 Factoring can be arranged on either a ‘without recourse” basis or a “with recourse”
basis.
(a) 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.
(b) 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.
(c) Credit protection is provided only when the service is non-recourse and
this is obviously more costly.

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3.1.5 Typical factoring arrangements

(a) Administration and debt collection

(b) Including financing

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3.1.6 Advantages and disadvantages of factoring

(Dec 11)
Advantages Disadvantages
(a) Saving in administration costs – not (a) Likely to be more costly than an
incur the costs of running its own efficiently run internal credit control
sales ledger department. department.
(b) Reduction in the need for (b) Factoring has a bad reputation
management control, i.e. slow associated with failing companies;
paying accounts receivable. using a factor may suggest your
(c) Particularly useful for small and company has money worries.
fast growing businesses where the (c) Customers may not wish to deal with
credit control department may not be a factor.
able to keep pace with volume (d) Once you start factoring it is difficult
growth. to revert easily to an internal credit
(d) Growth can be financed through control system.
sales rather than by injecting fresh (e) The company may give up the
external capital. opportunity to decide to whom credit
may be given (non-recourse factoring).

3.1.7 Determine whether factoring is financially acceptable

(Dec 08, Dec 11, Jun15)
3.1.8 Example 8
A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but
its debt administration has been poor and the average collection period has been 45
days with 0.5% of sales resulting in bad debts which are written off.

A factor would take on the task of debt administration and credit checking, at an
annual fee of 2.5% of credit sales. The company would save $30,000 a year in
administration costs. The payment period would be 30 days.

The factor would also provide an advance of 80% of invoiced debts at an interest
rate of 14% (3% over the current base rate). The company can obtain an overdraft
facility to finance its accounts receivable at a rate of 2.5% over base rate.

Should the factor’s service be accepted? Assume a constant monthly turnover.

Solution:

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It is assumed that the factor would advance an amount equal to 80% of the invoiced
debts, and the balance 30 days later.

(a) The current situation is as follows, using the company’s debt collection
staff and a bank overdraft to finance all debts.

Credit sales $1,500,000 pa

Average credit period 45 days
The annual cost is as follows: $
45/365 × $1,500,000 × 13.5% (11% + 2.5%) 24,966
Bad debts 0.5% × $1,500,000 7,500
Administration costs 30,000
Total cost 62,466

(b) The cost of the factor. 80% of credit sales financed by the factor would be
80% of $1,500,000 = $1,200,000. For a consistent comparison, we must
assume that 20% of credit sales would be financed by a bank overdraft. The
average credit period would be only 30 days. The annual cost would be as
follows.

$
Factor’s finance 30/365 × $1,200,000 × 14% 13,808
Overdraft 30/365 × $300,000 × 13.5% 3,329
17,137
Cost of factor’s services: 2.5% × $1,500,000 37,500
Total cost of the factor 54,637

(c) Conclusion. The factor is cheaper. In this case, the factor’s fees exactly equal
the savings in bad debts ($7,500) and administration costs ($30,000). The
factor is then cheaper overall because it will be more efficient at collecting
debts. The advance of 80% of debts is not needed, however, if the company
has sufficient overdraft facility because the factor’s finance charge of 14% is
higher than the company’s overdraft rate of 13.5%.

An alternative way of carrying out the calculation is to consider the changes that
using a factor will mean.

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$
Effect of reduction in collection period
8,322

Extra interest cost of factor finance 30/365 × $1,200,000 ×

(14 – 13.5)% (493)
Cost of factor’s services 2.5% × $1,500,000 (37,500)
Savings in bad debts 0.5% × $1,500,000 7,500
Savings in company’s administration costs 30,000
Net benefit of using factor 7,829

3.2 Invoice discounting

3.2.1 Invoice Discounting (Jun 08, Dec 13)

(a) Invoice discounting is a method of raising finance against the security of
receivables without using the sales ledger administration services of a
factor.
(b) A number of good quality invoices may be discounted, rather than all
invoices, and the service is usually only offered to companies meeting a
minimum turnover criterion.
(c) With invoice discounting, the business retains control over its sales
ledger, and confidentiality in its dealings with customers.

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Multiple Choice Questions

24. Consider the following two statements:

1. Invoice discounting requires the discounter to take responsibility for collecting

all the trade debts outstanding.
2. An operating lease agreement transfers most of the risks and rewards associated
with the leased asset to the lessee.

Which one of the following combinations relating to the above statements is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

25. Consider the following two statements concerning invoice discounting:

An invoice discounter will take on:

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1. the administration of receivables of the client business.

2. responsibility for any bad debts relating to discounted invoices.

Which one of the following combinations (true/false) relating to the above statements
is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

26. Which of the following services may be provided by a debt factor?

1 Bad debt insurance

2 Advancement of credit
3 Receivables ledger management
4 Management of debt collection processes

A 1, 2 and 4 only
B 1 and 4 only
C 1, 2 and 3 only
D 1, 2, 3 and 4

27. The main aspects of debt factoring include

(1) Administration of the client's invoicing, sales accounting and debt collection
service
(2) Making payments to the client in advance of collecting the debts
(3) Credit protection when the service is nonrecourse

A (1) only
B (1) and (2) only

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C (2) and (3) only

D All of the above

28. Which of the following statements is/are correct?

(1) Factoring with recourse provides insurance against bad debts

(2) The expertise of a factor can increase the efficiency of trade receivables
management for a company

A 2 only
B 1 only
C Neither 1 nor 2
D 1 and 2
(ACCA F9 Financial Management June 2015)

Question 10 – Factoring, invoicing discounting, EOQ and bulk purchase discount

FLG Co has annual credit sales of $4·2 million and cost of sales of $1·89 million. Current
assets consist of inventory and accounts receivable. Current liabilities consist of accounts
payable and an overdraft with an average interest rate of 7% per year. The company gives
two months’ credit to its customers and is allowed, on average, one month’s credit by trade
suppliers. It has an operating cycle of three months.

Other relevant information:

Current ratio of FLG Co 1·4
Cost of long-term finance of FLG Co 11%

Required:

(a) Discuss the key factors which determine the level of investment in current assets.
(6 marks)
(b) Discuss the ways in which factoring and invoice discounting can assist in the
management of accounts receivable. (6 marks)
(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company
and the total cost of financing its current assets. (6 marks)

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(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material
costing $12 per unit is 60,000 units per year. Inventory management costs for this raw
material are as follows:

Ordering cost: $6 per order

Holding cost: $0·5 per unit per year
The supplier of this raw material has offered a bulk purchase discount of 1% for orders
of 10,000 units or more. If bulk purchase orders are made regularly, it is expected that
annual holding cost for this raw material will increase to $2 per unit per year.

Required:

(i) Calculate the total cost of inventory for the raw material when using the
economic order quantity. (4 marks)
(ii) Determine whether accepting the discount offered by the supplier will minimise
the total cost of inventory for the raw material. (3 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2008 Q3)

Question 11 – Cash operating cycle and factoring

Extracts from the recent financial statements of Bold Co are given below.

$000 $000
Turnover 21,300
Cost of sales 16,400
Gross profit 4,900

$000 $000
Non-current assets 3,000
Current assets
Inventory 4,500
Trade receivables 3,500 8,000
Total assets 11,000

Current liabilities
Trade payables 3,000
Overdraft 3,000 6,000

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Equity
Ordinary shares 1,000
Reserves 1,000 2,000

Non-current liabilities
Bonds 3,000
11,000

A factor has offered to manage the trade receivables of Bold Co in a servicing and factor-
financing agreement. The factor expects to reduce the average trade receivables period of
Bold Co from its current level to 35 days; to reduce bad debts from 0·9% of turnover to
0·6% of turnover; and to save Bold Co $40,000 per year in administration costs. The factor
would also make an advance to Bold Co of 80% of the revised book value of trade
receivables. The interest rate on the advance would be 2% higher than the 7% that Bold Co
currently pays on its overdraft. The factor would charge a fee of 0·75% of turnover on a
with-recourse basis, or a fee of 1·25% of turnover on a non-recourse basis. Assume that
there are 365 working days in each year and that all sales and supplies are on credit.

Required:

(a) Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship
between the cash operating cycle and the level of investment in working capital. Your
answer should include a discussion of relevant working capital policy and the nature
of business operations. (7 marks)
(b) Calculate the cash operating cycle of Bold Co. (Ignore the factor’s offer in this part of
the question). (4 marks)
(c) Calculate the value of the factor’s offer:
(i) on a with-recourse basis;
(ii) on a non-recourse basis. (7 marks)
(d) Comment on the financial acceptability of the factor’s offer and discuss the possible
benefits to Bold Co of factoring its trade receivables. (7 marks)
(25 marks)
(ACCA F9 Financial Management December 2011 Q2)

4. Management of Trade Accounts Payable

4.1 Problems of delaying payment

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4.1.1 Trade credit is the simplest and most important source of short-term finance for many
companies. Again it is a balancing act between liquidity and profitability.

4.1.2 By delaying payment to suppliers companies face possible problems:

(a) supplier may refuse to supply in future
(b) supplier may only supply on a cash basis
(c) there may be loss of reputation
(d) supplier may increase price in future.

4.2 Early settlement discount (Jun 08, Jun 11, Dec 13, Sep 16)

4.2.1 Trade credit is normally seen as a ‘free’ source of finance. Whilst this is normally
true, it may be that the supplier offers a discount for early payment. In this case
delaying payment is no longer free, since the cost will be the lost discount.

4.2.2 Example 9
One supplier has offered a discount to Box Co of 2% on an invoice for $7,500, if
payment is made within one month, rather than the three months normally taken to
pay. If Box’s overdraft rate is 10% pa, is it financially worthwhile for them to
accept the discount and pay early?

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Solution:

Discount saves 2% of $7,500 = $150

Financed by overdraft for extra two months in order to pay early:
Cost = 10% × 2/12 × $7,500 = $125
Net saving = $150 – $125 = 25

Alternatively:
Discount as a percentage of amount paid = 150 / 7,350 = 2.04%
Saving is 2 months, i.e. 6 periods (12/2) in a year
Annualised cost of not taking the discount = (1 + 0.0204)6 – 1 = 12.88%
The overdraft rate is 10%.
It would be cheaper to borrow the money from the bank to pay early and accept the
discount.

Multiple Choice Questions

29. Tourmaline Ltd pays its major credit supplier 40 days after receiving the goods and
receives no settlement discount. The supplier has recently offered the company revised
credit terms of 3/10, net 40. (i.e. 3% discount allowed if payment is made within 10
days, otherwise payment in full within 40 days).

If Tourmaline Ltd refuses the settlement discount and pays in full after 40 days, what
is the approximate, implied, interest cost that is incurred by the company per year?

A 10·3%
B 27·4%
C 28·2%
D 37·6%

30. A product has an annual demand of 9,600 units, which is even throughout the year.
The product costs $50 per unit and the cost of holding one unit is $60 per year. The
order costs are $5 per order. The supplier offers a 4% discount for orders of at least 80

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units.

What is the minimum annual total cost that can be incurred in trading in this product?

A $460,800
B $463,800
C $466,200
D $482,400

31. Which of the following is NOT a potential hidden cost of increasing credit taken from
suppliers?

A Damage to goodwill
B Early settlement discounts lost
C Business disruption
D Increased risk of bad debts

32. Swap Co is due to receive goods costing $2,500. The terms of trade state that payment
must be received within three months. However, a discount of 1·5% will be given for
payment within one month.

Which of the following is the annual percentage cost of ignoring the discount and
paying in three months?

A 6·23%
B 9·34%
C 6·14%
D 9·49%
(ACCA F9 Financial Management December 2016)

Question 12 – Formulation of working capital policy, early settlement and bulk

purchase discount
ZPS Co places monthly orders with a supplier for 10,000 components that are used in its
manufacturing processes. Annual demand is 120,000 components. The current terms are

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payment in full within 90 days, which ZPS Co meets, and the cost per component is $7·50.
The cost of ordering is $200 per order, while the cost of holding components in inventory is
$1·00 per component per year.

The supplier has offered either a discount of 0·5% for payment in full within 30 days, or a
discount of 3·6% on orders of 30,000 or more components. If the bulk purchase discount is
taken, the cost of holding components in inventory would increase to $2·20 per component
per year due to the need for a larger storage facility.

Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 4·5%
per year.

Required:

(i) Discuss the factors that influence the formulation of working capital policy; (7 marks)
(ii) Calculate if ZPS Co will benefit financially by accepting the offer of:
(1) the early settlement discount;
(2) the bulk purchase discount. (7 marks)
(ACCA F9 Financial Management June 2011 Q4(b))

Question 13 – EOQ, early settlement discount, invoice discounting, factoring and

objectives of working capital management
Plot Co sells both Product P and Product Q, with sales of both products occurring evenly
throughout the year.

Product P
The annual demand for Product P is 300,000 units and an order for new inventory is placed
each month. Each order costs $267 to place. The cost of holding Product P in inventory is 10
cents per unit per year. Buffer inventory equal to 40% of one month’s sales is maintained.

Product Q
The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product
at $1 per unit on 60 days credit. The supplier has offered an early settlement discount of 1%
for settlement of invoices within 30 days.

Other information

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Plot Co finances working capital with short-term finance costing 5% per year. Assume that
there are 365 days in each year.

Required:

(a) Calculate the following values for Product P;

(i) The total cost of the current ordering policy; (3 marks)
(ii) The total cost of an ordering policy using the economic order quantity; (3 marks)
(iii) The net cost or saving of introducing an ordering policy using the economic
order quantity. (1 mark)
(b) Discuss how invoice discounting and factoring can aid the management of trade
receivables. (6 marks)
(c) Identify the objectives of working capital management and discuss the central role of
working capital management in financial management. (7 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2013 Q3)

Question 14 – Early settlement discount, EOQ and receivables management

Nesud Co has credit sales of $45 million per year and on average settles accounts with trade
payables after 60 days. One of its suppliers has offered the company an early settlement
discount of 0·5% for payment within 30 days. Administration costs will be increased by
$500 per year if the early settlement discount is taken. Nesud Co buys components worth
$1·5 million per year from this supplier.

From a different supplier, Nesud Co purchases $2·4 million per year of Component K at a
price of $5 per component. Consumption of Component K can be assumed to be at a
constant rate throughout the year. The company orders components at the start of each
month in order to meet demand and the cost of placing each order is $248·44. The holding
cost for Component K is $1·06 per unit per year.

The finance director of Nesud Co is concerned that approximately 1% of credit sales turn
into irrecoverable debts. In addition, she has been advised that customers of the company

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take an average of 65 days to settle their accounts, even though Nesud Co requires
settlement within 40 days.

Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are
360 days in a year.

Required:

(a) Evaluate whether Nesud Co should accept the early settlement discount offered by its
supplier. (4 marks)
(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to
ordering Component K. (6 marks)
(c) Critically discuss how Nesud Co could improve the management of its trade
receivables. (10 marks)
(20 marks)
(ACCA F9 Financial Management September 2016 Q31)

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5. Managing Foreign Trades

(Jun 09, Dec 15)
5.1 Overseas accounts receivable and payable bring additional risks that need to be
managed:
(a) Export credit risk
(b) Foreign exchange risk
5.2 Export credit risk is the risk of failure or delay in collecting payments due from
foreign customers. It may be caused by:
(a) insolvent customers
(b) bank failure
(c) unconvertible currencies
(d) political risk
5.3 When credit is granted to foreign customers, two problems may become especially
significant.
(a) The longer distances over which trade takes place and the more complex
nature of trade transactions and their elements means foreign accounts
receivable need more investment than their domestic counterparts. Longer
transaction times increase accounts receivable balances and hence the level
of financing and financing costs.
(b) The risk of bad debts is higher with foreign accounts receivable than with
their domestic counterparts. In order to manage and reduce credit risks,
therefore, exporters seek to reduce the risk of bad debt and to reduce the level
of investment in foreign accounts receivable.
5.4 Many foreign transactions are on ‘open account’, which is an agreement to settle the
amount outstanding on a predetermined date. Open account reflects a good business
relationship between importer and exporter. It also carries the highest risk of non-
payment.
5.5 How to manage and reduce?
(a) One way to reduce investment in foreign accounts receivable is to agree early
payment with an importer, for example by payment in advance, payment on
shipment, or cash on delivery. These terms of trade are unlikely to be
competitive, however, and it is more likely that an exporter will seek to receive
cash in advance of payment being made by the customer.
(b) One way to accelerate cash receipts is to use bill finance. Bills of exchange
with a signed agreement to pay the exporter on an agreed future date,
supported by a documentary letter of credit, can be discounted by a bank to
give immediate funds. This discounting is without recourse if bills of exchange
have been countersigned by the importer’s bank.

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Documentary letters of credit are a payment guarantee backed by one or more

banks. They carry almost no risk, provided the exporter complies with the
terms and conditions contained in the letter of credit. The exporter must
present the documents stated in the letter, such as bills of lading, shipping
documents, bills of exchange, and so on, when seeking payment. As each
supporting document relates to a key aspect of the overall transaction, letters of
credit give security to the importer as well as the exporter.
(c) Companies can also manage and reduce risk by gathering appropriate
information with which to assess the creditworthiness of new customers,
such as bank references and credit reports.
(d) Insurance can also be used to cover some of the risks associated with giving
credit to foreign customers. This would avoid the cost of seeking to recover
cash due from foreign accounts receivable through a foreign legal system,
where the exporter could be at a disadvantage due to a lack of local or
specialist knowledge.
(e) Export factoring can also be considered, where the exporter pays for the
specialist expertise of the factor as a way of reducing investment in foreign
accounts receivable and reducing the incidence of bad debts.
5.6 Foreign exchange risk is a risk that the value of the currency will change between the
date of the contract and the date of settlement. This will be discussed in later chapters

Multiple Choice Questions

33. Which of the following methods may be used by a company to reduce the credit risk
of foreign trades?

1 Open account
2 Early payment
3 Bills of exchange
4 Insurance

A 1, 2 and 4 only
B 1, 2 and 3 only
C 1, 3 and 4 only
D 2, 3 and 4 only

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34. Which of the following is least likely to be used in the management of foreign
accounts receivable?

A Letters of credit
B Bills of exchange
C Invoice discounting
D Commercial paper

Question 15 – Granting credit to foreign customers

Discuss how risks arising from granting credit to foreign customers can be managed and
reduced. (8 marks)
(ACCA F9 Financial Management June 2009 Q3(c))

Question 16 – Early settlement discount and management of foreign customers

ZXC Co currently has income of $30 million per year, of which 80% is from credit sales,
and a net profit margin of 10%. Due to fierce competition, ZXC Co has lost market share
and is looking for ways to win back former customers and to keep the loyalty of existing
customers. The sales director has pointed out that a major competitor of ZXC Co currently
offers an early settlement discount of 0·5% for settlement within 30 days, while ZXC Co
itself does not offer an early settlement discount. He suggests that if ZXC Co could match
this early settlement discount, annual income from credit sales would increase by 20%.

Credit customers of ZXC Co take an average of 51 days to settle invoices. Approximately

0·5% of the company’s credit sales have historically become bad debts each year and
written off as irrecoverable. The finance director has been advised that offering an early
settlement discount of 0·5% for payment within 30 days would increase administration costs
by $35,000 per year, while 75% of credit customers would be likely to take the discount.
The credit controller believes that bad debts would fall to 0·375% of credit sales if the early
settlement discount were introduced.

ZXC Co has an average short-term cost of finance of 4% per year. Assume that there are 360
days in each year.

Required:

(a) Evaluate whether ZXC Co should introduce the early settlement discount. (6 marks)

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(b) Discuss TWO ways in which a company could reduce the risk associated with foreign
accounts receivable. (4 marks)
(Total 10 marks)
(ACCA F9 Financial Management September/December 2015 Q3)

Additional Examination Style Questions

Question 17 – Working capital management, EOQ and hedging

PKA Co is a European company that sells goods solely within Europe. The recently-appointed
financial manager of PKA Co has been investigating the working capital management of the
company and has gathered the following information:

Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units. The
cost of placing and processing an order is €250, while the cost of holding a unit in stores is
€0·50 per unit per year. Both costs are expected to be constant during the next year. Orders
are received two weeks after being placed with the supplier. You should assume a 50-week
year and that demand is constant throughout the year.

Accounts receivable management

Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show
that the average accounts receivable period in the last financial year was 75 days. The
financial manager also noted that bad debts as a percentage of sales, which are all on credit,
increased in the last financial year from 5% to 8%.

Accounts payable management

PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in
six months’ time. The financial manager is concerned that the cost of these supplies may rise
in euro terms and has decided to hedge the currency risk of this account payable. The
following information has been provided by the company’s bank:

Spot rate ($ per €): 1.998 ± 0.002

Six months forward rate ($ per €): 1.979 ± 0.004

Money market rates available to PKA Co:

Borrowing Deposit

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One year euro interest rates: 6.1% 5.4%

One year dollar interest rates: 4.0% 3.5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

(a) Identify the objectives of working capital management and discuss the conflict that may
arise between them. (3 marks)
(b) Calculate the cost of the current ordering policy and determine the saving that could be
made by using the economic order quantity model. (7 marks)
(c) Discuss ways in which PKA Co could improve the management of domestic accounts
receivable. (7 marks)
(d) Evaluate whether a money market hedge, a forward market hedge or a lead payment
should be used to hedge the foreign account payable. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2007 Q4)

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