The management of accounts receivable begins with calculating the average days of receivables and comparing this ratio to the firm's historical performance or to the average ratios for a group of comparable companies. More detail about the accounts receivable performance can be gained by using an aging schedules~chas that presented in Figure 1.
Study Session 11
Cross-Reference to CFA Institute Assigned Reading#46 - Working Capital Management Figure 1: Receivables Aging ($ ODD's)
Days Outstanding March April May
<31 days 200 212 195
31-60days 150 165 140
61-90days 100 90 92
>90 days 50 70 66
In March, $200,000 of accounts receivable were current, that is, had been outstanding less than31 days. $50,000 of the receivables at the end of March had been outstanding for more than 90days.
Presenting this data as percentages of total outstanding receivables can facilitate analysis of how the aging schedule for receivables is changing over time. An example is presented in Figure 2.
Figure2: Receivables Aging(% of totals)
Days Outstanding March April May
< 31 days 40% 39% 40%
31-60days 30% 31% 28%
61-90days 20% 17% 19%
>90 days 10% 13% 13%
Another useful metric for monitoring the accounts receivable performance is the weighted average collection period, which indicates the average days outstanding per dollar of receivables. As illustrated in Figure 3, the weights are the percentage of total receivables in each category, and these are multiplied by the average days to collect accounts within each aging category.
Figure3:Weighted Average Collection Period - March Days Outstanding Average Collection
% Weight Days x Weight Days
< 31 days 22 40% 8.8
31-60days 44 30% 13.2
61-90 days 74 20% 14.8
>90 days 135 10% 13.5
Weighted Average Collection Period 50.3days
The information necessary to compare a firm's aging schedule and weighted average collection period to other firms is not available. However, analysis of the historical trends and significant changes in a firm's aging schedule and weighted average collection days can give a clearer picture of what is driving changes in the simpler
Study Session 11 Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management between stricter credit terms (and borrower creditworthiness) and the ability to make
sales. Terms that are too strict will lead to less-than-optimal sales. Terms that are too lenient will increase sales at the cost of longer average days of receivables, which must be funded at some cost, and will increase bad accounts, directly affecting profitability.
Inventory Management
Inventory management involves a trade-off as well. Inventory levels that are too low will result in lost sales due to stock-outs, while inventory that is too large will have carrying costs because the firm's capital is tied up in inventory. Reducing inventory will free up cash that can be invested in interest-bearing securities or used to reduce debt or equity funding. Increasing average days inventory or a decreasing inventory turnover ratio can both indicate that inventory is too large. A large inventory can lead to greater losses from obsolete items and can also indicate that obsolete items that no longer sell well are included in inventory.
Comparing average days of inventory and inventory turnover ratios between industries, or even between two firms that have different business strategies, can be misleading.
The grocery business typically has high inventory turnover, while an art gallery's inventory turnover will typically be low. An auto parts firm that stocks hard-to-find parts for antique cars will likely have a low inventory turnover (and charge premium prices) compared to a chain auto parts store that does most of its business in standard items like oil filters, brake parts, and antifreeze. In any business; inventory
management is an important component of effective overall financial management.
Accounts Payable Management
Just as a company must manage its receivables because they require working capital and therefore have a funding cost, payables must be managed well because they represent a source of working capital to the firm. If the firm pays its payables prior to their due dates, cash is used unnecessarily and interest on it is sacrificed. If a firm pays its payables late, it can damage relationships with suppliers and lead to more restrictive credit terms or even the requirement that purchases be made for cash. Late payment can also result in interest charges that are high compared to other sources of short-term financing.
Typical terms on payables (trade credit) contain a discount available to those who pay quickly as well as a due date. Terms of "2/ I 0 net 60" mean that if the invoice is paid within 10 days, the company gets a 2% discount on the invoiced amount and that if the company does not take advantage of the discount, the net amount is due 60 days from the date of the invoice.
Srudy Session 11
Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management
Our primary quantitative measure of payables management is average days of payables
outstanding, which can also be calculated as: .
accounts payable number of days of payables= ---"----'---
average day's purchases where:
annual purchases average day's purchases = --~'---
365
A company with a short payables period (high payables turnover) may simply be taking advantage of discounts for paying early because it has good low-cost funds available to finance its working capital needs. A company with a long payables period may be such an important buyer that it can effectively utilize accounts payable as a source of short- term funding with relatively little cost (because suppliers will put up with it).
Monitoring the changes in days' payables outstanding over time for a single firm will, however, aid the analyst. An extension of days' payables may serve as an early warning of deteriorating short-term liquidity.