Introduction
One of the most fundamental concepts in finance is the relationship between risk and return, also known as the risk-return trade-off. In essence, an investment that bears greater risk is likely to yield higher returns. That is because firms and individuals do not want to accept the additional risk without being financially compensated. For example, a corporate bond with a lower credit score (i.e., more likely to default) will pay a higher coupon to compensate investors for the added risk. That is also the case for managers responsible for drafting and implementing companies’ working capital management policies.
Because a large inventory or substantial amount of cash in hand reduces the risk by increasing the company’s ability to meet short-term liabilities and financial obligations, thus decreasing the likelihood of going bankrupt. At the same time, however, cash in hand or bank does not earn a profit. Investment in inventories can be significant, and therefore, its level should be kept to a minimum with the excess cash being used for revenue-generating activities. However, in this article, we focus on trade receivables, one of the three main areas of working capital management.
Many companies tend to offer trade credit, i.e., the practice of extending credit to customers, allowing for deferred payment [1]. Businesses provide credit facilities to their customers as one strategy to increase sales. The timing of cash flows is a fundamental factor contributing to the success of any company. Therefore, offering credit to customers can have some significant disadvantages. Companies may get into serious financial trouble if a customer takes a long time to settle their outstanding bill. Firms will often take an overdraft or a medium-term loan from a bank to finance their trade receivables. In some cases, customers may fail to make a payment for the goods or services received. As a result, a company will incur losses, often referred to as bad debts.
Therefore, every business should have clear policies concerning its trade receivables management. When a customer is considered creditworthy, the following factors will be applied in the decision-making process [2]:
- how much credit should the customer receive;
- the length of time offered to repay the bill;
- discounts offered to encourage customers to make prompt payments; or
- how to manage the risk of customers failing to pay on time or at all (bad debts).
Credit periods and discounts
Watson and Head (2019) imply that a company must set up a credit analysis system, a credit control system, and a trade receivables collection system to operate its trade receivables policy [3]. In some cases, cash discounts are offered to encourage customers to pay earlier. A form of cost-benefit analysis is necessary to establish whether such discounts would be financially viable. Case Study I illustrates the importance and benefits of offering discounts.
‘Cash discounts may encourage early payment, but the cost of such discounts must be less than the total financing savings resulting from lower trade receivables balances, any administrative or financing savings arising from shorter trade receivables collection periods and any benefits from lower bad debts’.
Watson and Head (2019): Corporate Finance (8th edition). Pearson
Discounts for prompt payment can be an effective means of improving the company’s liquidity by closely managing the timings of trade receivables payments. Case Study I is an example of a fictitious company illustrating the benefits of introducing such discounts. The reduction in trade receivables allowed the company to save over £1.4m in financing costs. In a nutshell, the longer the credit period allowed and taken, the more funding is needed to finance the trade receivables.
Factoring
According to the Oxford Dictionary of Finance and Banking, factoring is defined as the buying of the trade debts of a manufacturer, assuming the task of debt collection and accepting the credit risk, thus providing the manufacturer with working capital [4]. In other words, factoring is the outsourcing of credit control to a third party, known as a factor.
Factoring is a legal agreement between the factor, usually a bank or financial institution, and a company willing to find a competent firm to manage its trade receivables. When a company sends an invoice to its customers, a copy is also sent to the factor. The factor will then pay an agreed percentage of the invoice value to the company. Arnold and Lewis (2019) suggest that up to 90% of the invoice value can be made available to the firm immediately [5]. The remaining amount is transferred to the company once the customer has paid the total amount to the factor.
An Exhibit 12.7 in the book Corporate Financial Management 6th edition (Part 4 Sources of Finance) explains the stages in a factoring deal. The supplying firm or the seller provides the customer with goods and the factor with the rights to receive the payment on sold invoices. The factor will usually pay the supplying firm 80% of the invoice value immediately, after which the customer or the buyer will have to pay the debt to a factor a few weeks after the delivery of goods. The remaining 20%, less factor’s fees and interest are paid to the seller by the factor.
A with recourse agreement indicates that the liability for bad debts lies with the company, while in non-recourse factoring, the factor bears the loss of bad debts [6]. For example, if a customer fails to pay the outstanding debt, the factor cannot reclaim the money from the company. Nonetheless, the company will still be obliged to pay any interest and fees relating to the invoice. The fee collection is well described by the following passage retrieved from the ACCA technical paper [6]:
‘When a factoring agreement is in place, customers must pay 100% of each invoice directly to the factor. Each invoice must clearly show the factor’s remittance details on it. Having received the money, the factor will then deduct its fees, its interest, and its advance from the remittance before paying the balance to the company.’
ACCA: Factoring and Invoice Discounting: Relevant to CAT Paper 10
To summarise the concept of factoring, it is fair to say that the factor essentially provides three services: the provision of finance, sales ledger administration, and credit insurance [5]. Factors provide cash essential in improving the company’s cash flows. The immediate availability of cash from trade receivables may be used to fund the working capital, e.g., inventory purchase, pay suppliers, or cover any other short-term expenses, such as wages and salaries. The debt collection and sales ledger administration are part of the factor’s services offered. Arnold and Lewis (2019) imply that particularly young and fast-growing companies prefer to outsource the functions of recording credit sales, evaluating customer’s creditworthiness, sending invoices, or chasing late payers, so that those companies can focus on the core business. Finally, insurance provision against any unpaid amount owed by a customer is another service offered by a factor. The charge for this service may oscillate between 0.3% and 0.5% of the invoice value [5].
Invoice discounting
It is essential to clarify that invoice discounting is not a form of discount offered by a company to its customers. Invoice discounting is similar to factoring. However, the fundamental difference is that the sales administration and the responsibility of debt collection remain with the business. The invoice discounting services are still usually provided by the subsidiaries of commercial banks and other financial institutions. Invoice discounting is cheaper than factoring, mainly because it is the company’s responsibility to run the sales ledger administration. Fees are typically between 0.2% and 0.8% of sales plus interest. The charges are comparable with overdraft rates offered by the banks [5]. As with factoring arrangements, invoice discounting arrangements can be with recourse or without recourse.
Any thoughts?
Arnold and Lewis (2019) claim that trade credit is perhaps the simplest and the most important source of short-term finance, and it has become a regular part of the business in most markets. An effective trade receivables management will ensure a company’s better cash position and enhance its liquidity to meet the short-term financial obligations as and when they fall due. Offering trade credit to customers is one method of increasing sales and attracting new business. Therefore, robust trade credit policies must be in place to ensure long-term growth and expansion.
To cement your understanding of the topic, we recommend reading the article published by the financial services firm Deloitte: Make your working capital work for you: Strategies for optimizing your accounts receivable.
References
[1] Foerster, S. (2015). Financial Management: Concepts and Applications, Global Edition (1st ed.). Pearson. Available at https://www.perlego.com/book/811300/financial-management-concepts-and-applications-global-edition-pdf
[2] Atrill, P., McLaney, E. (2018). Accounting and Finance for Non-Specialists (11th ed.). Pearson. Available at https://www.perlego.com/book/859641/accounting-and-finance-for-nonspecialists-11th-edition-pdf
[3] Watson, D.; Head, A. (2019). Corporate Finance (8th ed.). Pearson. Available at: https://www.perlego.com/book/877520/corporate-finance-pdf
[4]. Oxford Dictionary (2018). A Dictionary of Finance and Banking (6th ed.). Oxford University Press: Oxford
[5] Arnold, G., & Lewis, D. (2019). Corporate Financial Management (6th ed.). Pearson. https://www.perlego.com/book/871263/corporate-financial-management-6th-edition-pdf
[6] ACCA (n.d.). Factoring and Invoice Discounting: Relevant to CAT Paper 10. Available at: https://www.accaglobal.com › sa_oct08_factoring
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