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Trade credit works as a quite effective mode of financing variable working capital for a business entity for the period falling between the point goods, raw materials, etc. are purchased from the suppliers and the point when payment is made. The longer this period, the more advantageous it becomes for the organisation to avoid efforts of seeking finance for holding inventories or receivables. Similarly, it should be borne in mind that payment to trade creditors, domestic and overseas, has to be made within the stipulated period of time for avoiding interest payments, penalties, etc. Trade credit received by businesses on purchases reduces the working capital fund requirements and has to be taken into account for a correct assessment of funds.
There is a prolonged belief in business, trade and industrial world that if you can buy well, then you can sell well. The management of your suppliers and creditors is just as crucial as the management of your customers and debtors.
Trade creditors represent a spontaneous source of short-term finance in the sense that they arise from the course of ordinary business transactions. But it is important for businesses to diligently to look after their creditors. The main reason being, slow and sluggish payments by a business enterprise may create ill-feeling amongst creditors, which may even cause the supplies to be disrupted. Such delay in payments could also create a bad image for the company. In addition, creditors form a vital part of effective cash management and should be managed carefully to enhance an entity’s cash position.
A sound management policy to plan and control the accounts payables or trade credit in a business organisation is imperative due to the following reasons:
It is usually conceived by people that the trade credit does not carry any cost. However, this is not true, and trade credit carries the following costs:
Not only does trade credit come with some implicit costs, but it offers many benefits to business firms also. In fact, it is considered as one of the most effective sources of obtaining short-term finance by business entities. The benefits offered by trade credit or the cost of not taking trade credit cover the following:
It is extremely important to analyse the benefits offered by the suppliers via credit extension on the one hand and the cost involved in taking the credit extension provided by suppliers (i.e., the cost of discount foregone) on the other hand. In simple words, a risk-return trade-off has to be put into due consideration before accepting credit offers or discount offers by suppliers. There has to be judicious use of trade credit by a business in order to maximise its returns.
Suppose a company has been offered credit terms from its major supplier of “2/10, net 45”. The amount of the purchase invoice is Rs. 20,000. Hence, the company has the choice of paying Rs. 20,000 at 45th day by accepting trade credit or else paying Rs. 19,600 at the 10th day by accepting the discount offer. With the first option, the company can invest Rs. 19,600 for an additional 35 days and eventually pay the supplier Rs. 20,000 at the end of 45 days. The decision as to whether the discount should be accepted or not depends on the opportunity cost of investing Rs. 19,600 for 35 days. The company can invest additional cash and can obtain an annual return of 25%.
For analysing the cost of payables, the two alternatives, in this case, are as follows:
|Particulars||Refuse discount and take credit (Rs.)||Accept discount and refuse credit (Rs.)|
|Payment to suppliers||20,000 (on 45th day)||19,600 (on 10th day)|
|Return generated from investing Rs. 19,600 between day 10 and day 45 (Rs. 19,600 × 35/365 × 25%)||(470)||–|
|Net cost payable||19,530||19,600|
Thus, it is better for the company to refuse the discount, as return on cash retained is more than the saving on account of the discount. Had the annual rate of return on investment been 20%, it would have been more favourable to accept the discount offer of 2%. In that case, the net cost payable would have been Rs. 19,624.
Another aspect to consider here is calculating the annualised cost of taking credit, i.e., the cost of not taking the discount and delaying the payment for a term of 35 days. Such annualised cost of trade credit is computed with the help of below formula:
The company can compare its cost of funds or short-term investment rate with the cost of trade credit to make a decision regarding availing the discount. Generally, in most cases, if the cost of funds or short-term investment rate is lower than the cost of trade credit, then the company will benefit by paying its invoices within the discount period.
On the other hand, if the business could borrow at a rate which is less than the annualised cost of trade credit, then it would be preferable to do so and take the early payment discount offered by the supplier.
In the example given above, the cost of trade credit comes out to 23.45%, with discount% = 0.02 and Days after discount period = 35. Thus, when the company delays suppliers’ payment, it incurs an annualized cost of 23.45% per annum. Now, let’s assume that the company can borrow a bank overdraft at an interest rate of 18% p.a.; here it would be preferable for the company to borrow money from bank instead of availing the supplier’s credit.
Some of the techniques which may be employed by the finance manager for effective management of accounts payables are:
Timing of payments is crucial: When it comes to the optimization of working capital, increasing payables should be a main strategy. To ensure this, many organisations follow this strategy by extending payables as long as possible in order to maximize free cash flow. But, this approach is not always the correct one. In some instances, delaying payments can erode suppliers’ confidence/trust, resulting in slower delivery times, less willingness to fix defects, slower responses to address post-purchase queries and more troublesome payment terms. On the other hand, paying early can often yield substantial benefits in situations where suppliers offer bulk discounts or rebates for making an early payment.
Maintain the Invoicing and Reporting Process: To improve liquidity, properly managing the invoicing process is essential. This involves setting up a centralized processing office, processing invoices on a timely basis and including a date stamp, etc. To boost accounting and reporting process for proper management of payables, companies must apply payments to every invoice on the date they are made to assure system accuracy, post journal entries before cut-off dates of the reporting period, and follow up on and resolve un-reconciled items on a timely basis.
Proper Invoice to Purchase Order Matching: Before issuing payments, companies must confirm if order deliveries tally contractual terms by accessing vendor contracts. Purchase orders should be issued for every fresh order so that the company can validate any orders received, lock in payment terms well in advance and track invoices against current purchase orders to ensure that vendors are billed in conformity with agreed-upon terms. Such standards should be adhered to across the organization.
Prevent the occurrence of Accounts Payable Errors and Fraud: For the management of payables, it should be ensured that the risk of manual errors and frauds is minimal by using automated mechanisms, strengthening internal controls around accounts payable processing, and accurate contract review.
Refinement of accounts payable processes: For effective management of payables, a business should streamline its accounts payable transactions. These involve the company’s ability to process bills on a timely basis, take advantage of available discounts, rely on automated systems to approve purchase requisitions and issue payments, feed accurate supplier or contract information into master data files, and set either longer or shorter payment terms with suppliers depending on which are most favourable. Improving the systems of accounts payable can help increase the accuracy of cash flow budgets, ultimately positioning the business to enhance liquidity, reduce funding gaps and realize higher profits.
The accounts payable team of an entity, together with the material and purchasing departments; should coordinate with top management to implement a sound payables’ policy or working capital culture throughout the organisation. It comprises much more than just seeing that purchase invoices are procured and processed in a timely manner. The overall goal should be to adopt a management focus that emphasizes the significance of optimizing payables and freeing up working capital to fuel growth.
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