FM : FIN AN CI AL MA N A GE ME N T

Credit assessment
In order to minimise the risk of irrecoverable debts, PNP plc should assess potential
customers as to their creditworthiness before offering them credit. The depth of the
credit check depends on the amount of business being considered, the size of the
client and the potential for repeat business. The credit assessment requires
information about the customer, whether from a third party as in a trade reference,
a bank reference or a credit report, or from PNP itself through, for example, its
analysis of a client’s published accounts. The benefits of granting credit must always
be greater than the cost involved. There is no point, therefore, in PNP plc paying for a
detailed credit report from a credit reference agency for a small credit sale.
Credit control
Once PNP plc has granted credit to a customer, it should monitor the account at
regular intervals to make sure that the agreed terms are being followed. An aged
receivables analysis is useful in this respect since it helps the company focus on those
clients who are the most cause for concern. Customers should be reminded of their
debts by prompt despatch of invoices and regular statements of account. Customers
in arrears should not be allowed to take further goods on credit.
Collection of amounts due
The customers of PNP plc should ideally settle their accounts within the agreed credit
period. There is no indication as to what this might be, but the company clearly feels
that a segmental analysis of its clients is possible given their payment histories, their
potential for irrecoverable debts and their geographical origin. Clear guidelines are
needed over the action to take when customers are late in settling their accounts or
become irrecoverable debts, for example indicating at what stage legal action should
be initiated.

17 PLOT CO

Key answer tips

Care must be taken in parts (a) and (b) due to the number of calculations necessary to fulfil
the various requirements. A clear and methodical approach to the Workings is vital.
Part (c) should be a straight forward repetition of knowledge in this small syllabus area.
The highlighted words are key phrases that markers are looking for.

(a) (i) Cost of current ordering policy

Ordering cost = 12 × 267 = $3,204 per year
Monthly order = monthly demand = 300,000/12 = 25,000 units
Buffer inventory = 25,000 × 0.4 = 10,000 units
Average inventory excluding buffer inventory = 25,000/2 = 12,500 units
Average inventory including buffer inventory = 12,500 + 10,000 = 22,500 units
Holding cost = 22,500 × 0.1 = $2,250 per year
Total cost = 3,204 + 2,250 = $5,454 per year

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(ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ = √(2 × 267 × 300,000/0.10) = 40,025 or 40,000 units per order
Number of orders per year = 300,000/40,000 = 7.5 orders per year
Order cost = 7.5 × 267 = $2,003
Average inventory excluding buffer inventory = 40,000/2 = 20,000 units
Average inventory including buffer inventory = 20,000 + 10,000 = 30,000 units
Holding cost = 30,000 × 0.1 = $3,000 per year
Total cost = $2,003 + $3,000 = $5,003 per year
(iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = $451 per year
(b) Product Q trade payables at end of year = 456,000 × 1 × 60/365 = $74,959
Product Q trade payables after discount = 456,000 × 1 × 0.99 × 30/365 = $37,105
Decrease in Product Q trade payables = 74,959 – 37,105 = $37,854
Increase in financing cost = 37,854 × 0.05 = $1,893
Value of discount = 456,000 × 0.01 = $4,560
Net value of offer of discount = 4,560 – 1,893 = $2,667
(c) The objectives of working capital management are usually taken to be profitability
and liquidity. Profitability is allied to the financial objective of maximising
shareholder wealth, while liquidity is needed in order to settle liabilities as they fall
due. A company must have sufficient cash to meet its liabilities, since otherwise it
may fail.
However, these two objectives are in conflict, since liquid resources have no return
or low levels of return and hence decrease profitability. A conservative approach to
working capital management will decrease the risk of running out of cash, favouring
liquidity over profitability and decreasing risk. Conversely, an aggressive approach to
working capital management will emphasise profitability over liquidity, increasing the
risk of running out of cash while increasing profitability.
Working capital management is central to financial management for several reasons.
First, cash is the life-blood of a company’s business activities and without enough
cash to meet short-term liabilities, a company would fail.
Second, current assets can account for more than half of a company’s assets, and so
must be carefully managed. Poor management of current assets can lead to loss of
profitability and decreased returns to shareholders.
Third, for SMEs current liabilities are a major source of finance and must be carefully
managed in order to ensure continuing availability of such finance.

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Errors that were made included:

• Treating the reduction in trade payables as a benefit
• Comparing annual benefit with monthly cost, and vice versa
• Including only a benefit, or including only a cost
• Calculating an annual percentage cost, when the question asked for net value in
dollars.
Some candidates, having calculated net value of the early settlement discount, went on to
discuss whether it should be accepted. No credit was given to such a discussion, however,
as the question asked only for calculation.
In part (c) better answers identified profitability and liquidity as the main objectives of
working capital management, perhaps briefly explaining the conflict between the two,
before focusing on a discussion of the central role of working capital management in
financial management, referring perhaps to the importance of cash and cash management,
the importance of currents assets to a company, the importance of current liabilities as a
source of finance, especially for SMEs, the need to have policies relating to the elements of
working capital such as trade receivables and inventory, and so on.

18 WQZ CO

Key answer tips

This question covers two popular areas of working capital management: inventory and
accounts receivable management. The calculations in part (a) give some early chances to
pick up some relatively easy marks. Part (b) and (d) are both discursive requirements that
should also prove relatively straightforward. The trickiest element is part (c) although the
requirement to calculate the maximum early settlement discount that could be offered is
only worth one mark: don’t let this put you off gathering the marks for the earlier parts of
the process. The highlighted words are key phrases that markers are looking for.

(a) Cost of the current ordering policy

Order size = 10% of 160,000 = 16,000 units per order
Number of orders per year = 160,000/16,000 = 10 orders per year
Annual ordering cost = 10 × 400 = $4,000 per year
Holding cost ignoring buffer stock = 5.12 × (16,000/2) = $40,960 per year
Holding cost of buffer inventory = 5.12 × 5,000 = $25,600 per year
Total cost of current policy = 4,000 + 40,960 + 25,600 = $70,560 per year
Cost of the ordering policy using the EOQ model
Order size = √(2 × 400 × 160,000/5.12) = 5,000 units per order
Number of orders per year = 160,000/5,000 = 32 orders per year
Annual ordering cost = 32 × 400 = $12,800 per year
Holding cost ignoring buffer stock = 5.12 × (5,000/2) = $12,800 per year
Holding cost of buffer inventory = 5.12 × 5,000 = $25,600 per year
Total cost of current policy = 12,800 + 12,800 + 25,600 = $51,200 per year

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Change in costs of inventory management by using EOQ model

Decrease in costs = 70,560 – 51,200 = $19,360

Tutorial note:
Since the buffer inventory is the same in both scenarios, its holding costs do not need
to be included in calculating the change in inventory management costs.

(b) 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. This approach to inventory management is called just-in-time
(JIT) procurement.
The benefits of a JIT procurement policy include a lower level of investment in
working capital, since inventory levels have been minimised: a reduction in inventory
holding costs; a reduction in materials handling costs, due to improved materials flow
through the production process; an improved relationship with suppliers, since
supplier and customer need to work closely together in order to make JIT
procurement a success; improved operating efficiency, due to the need to streamline
production methods in order to eliminate inventory between different stages of the
production process; and lower reworking costs due to the increased emphasis on the
quality of supplies, since hold-ups in production must be avoided when inventory
between production stages has been eliminated.
(c) Evaluation of changes in receivables management

Tutor’s top tips:

When asked to evaluate a proposed change in policy you should always focus on
quantifying the additional costs and benefits. Start by listing them out, and then
begin with the easier calculations first. You don’t need to complete the evaluation in
order to score reasonable marks.

The current level of receivables days = (18/87.6) × 365 = 75 days

Since 25% of credit customers will take the discount, 75% will not be doing so.
The revised level of receivables days = (0.25 × 30) + (0.75 × 60) = 52.5 days
Current level of trade receivables = $18m
Revised level of trade receivables = 87.6 × (52.5/365) = $12.6m
Reduction level of trade receivables = 18 – 12.6 = $5.4m
Cost of short-term finance = 5.5%
Reduction in financing cost = 5.4m × 0.055 = $297,000
Administration and operating cost savings = $753,000
Total benefits = 297,000 + 753,000 = $1,050,000

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Cost of early settlement discount = 87.6m × 0.25 × 0.01 = $219,000

Net benefit of early settlement discount = 1,050,000 – 219,000 = $831,000
The proposed changes in receivables management are therefore financially
acceptable, although they depend heavily on the forecast savings in administration
and operating costs.

Maximum early settlement discount

Tutor’s top tips:

To calculate this you must start with the awareness that the maximum discount that
could be offered is one where the cost equals the benefit. Anything above this, and it
wouldn’t be worth offering the discount.
You’ve already calculated the value of the benefit, so all that remains is to convert
this figure into a percentage of sales revenue, remembering that only 25% of
customers are expected to take up the offer.

Comparing the total benefits of $1,050,000 with 25% of annual credit sales of
$87,600,000, which is $21,900,000, the maximum early settlement discount that
could be offered is 4.8% (100 × (1.050k/21.9m)).
(d) Factors that should be considered when formulating working capital policy on the
management of trade receivables include the following:
The level of investment in trade receivables
If the amount of finance tied up in trade receivables is substantial, receivables
management policy may be formulated with the intention of reducing the level of
investment by tighter control over the way in which credit is granted and improved
methods of assessing client creditworthiness.
The cost of financing trade credit
If the cost of financing trade credit is high, there will be pressure to reduce the
amount of credit offered and to reduce the period for which credit is offered.
The terms of trade offered by competitors
In order to compete effectively, a company will need to match the terms offered by
its competitors, otherwise customers will migrate to competitors, unless there are
other factors that will encourage them to be loyal, such as better quality products or
a more valuable after-sales service.
The level of risk acceptable to the company
Some companies may feel that more relaxed trade credit terms will increase the
volume of business to an extent that compensates for a higher risk of bad debts. The
level of risk of bad debts that is acceptable will vary from company to company.
Some companies may seek to reduce this risk through a policy of insuring against
non-payment by clients.
The need for liquidity
Where the need for liquidity is relatively high, a company may choose to accelerate
cash inflow from credit customers by using invoice discounting or by factoring.

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