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Four: Summary and Conclusions

Review Exercises


The terms of sale that creditor firms provide for customers should represent dynamic components of their financial and marketing strategies. Based on the time value of money, late payment associated with the credit period and early payment for a discount both represent a form of price competition. They provide debtors with lower "effective" price options, defined by their annual opportunity cost of borrowing, compared to the original invoiced "cash" price.

If price is inversely related to demand, the availability of trade credit should increase the creditor firm's turnover. In theory (and hopefully practice) all parties to sales transactions should benefit.

Of course, how a company actually chooses an optimum combination of credit policy variables that also maximize profit, once a range of customer opportunity rates are established, involves a complex sequence of managerial decisions where the net gains require careful consideration.

A change in either the credit period or cash discount policy creates a unique level of demand, which results in a unique structure of costs and revenues associated with each debtor policy. As we observed in the previous Chapter, the optimum credit period should be set for a high opportunity rate (high-risk) clientele. Discount policy should be designed to attract low opportunity rate (quality) customers. However, as we also noted, when economic circumstances change, credit policy variables must be reviewed.

For example, if the structure of interest rates changes, the borrowing costs for each class of customer alters. Since these determine the monetary value of trade credit in present value (PV) terms and the creditor firm's "effective" price-demand function, ultimately they will redefine its total working capital requirements; not only debtors but also creditors, inventory, the need for precautionary cash balances and borrowing to support production.

The purpose of this Chapter is to review this credit related funds system with reminders of how a firm's working capital structure, underpinned by liquidity and cash flow, is determined by the level of debtors, optimum or otherwise.

Exercise 7.1: Working Capital: A Review

Having read the appropriate bookboon companions and Parts One and Two of this study, you will recall that the overall objective of working capital management is to ensure that operational (short-term) transactions, which are required to support the demand for a firm's products and services arising from either cash or credit sales, actually take place.

Chapter Two and Seven of "Working Capital and Strategic Debtor Management" and Chapter Three of "Strategic Debtor Management and the Terms of Sale" (2013) explained the whole procedure, which is summarized by the flow chart in Figure 7.1.

The Structure and Flow of Working Capital

Figure 7.1: The Structure and Flow of Working Capital


Produce a written commentary to explain the sequence of events illustrated by Figure 7.1.

An Indicative Outline Solution

If you have referenced my source material, the first points to note are the three square boxes and two dotted arrows.

- The cash balance at the centre of the diagram represents the total amount available on any particular day.

- This will be depleted by purchases of inventory, plus employee remuneration and overheads, which are required to support production.

- The receipt of money from sales to customers will replenish it.

- A cash deficit will require borrowing facilities.

- Any cash surplus can be retained for reinvestment, placed on deposit or withdrawn from the business.

If the cycle of events that defines the conversion of raw materials to cash was instantaneous, there would never be a cash surplus (or deficit) providing the value of sales matched their operational outlays, plus any allowances for capital expenditure, interest paid, taxation and dividends. For most firms, however, this cycle is interrupted as shown by the circles in the diagram.

On the demand side, we can identify two factors that affect cash transactions adversely. Unless the firm requires cash on delivery (C.O.D.) or operates on a cash and carry basis, customers who do not pay immediately represent a claim to cash from sales, which have already taken place. These define the level of debtors outstanding at a particular point in time. Similarly, stock purchases that are not sold immediately represent a claim to cash from sales, which have yet to occur. For wholesale, retail and service organizations these represent their stock of finished goods. For a manufacturing company there will also be raw materials, plus items of inventory at various stages of production that define work in progress.

On the supply side, these interruptions to cash flow may be offset by delaying payment for stocks already committed to the productive process. This is represented by creditors.

The net effect on any particular day may be a cash surplus, a deficit, or zero balance.

Surpluses may be re-invested or distributed as dividends.

Deficits will require financing.

Zero balances may require supplementing.

Thus, we can conclude that a firm's working capital structure defined by the terms of trade, determines a forecast of its overall cash requirements (the credit related funds system) which relate to:

- Debtor management

- Methods of inventory (stock) control

- Availability of trade credit

- Working capital finance

- Re-investment of short-term cash surpluses.

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