Chapter 16

Examining Cash Inflow and Outflow

In This Chapter

Finding out how fast customers pay

Considering slow-paying customers

Making sure companies pay bills quickly

Digging into discount offers

Is the money flowing? That’s the million-dollar, and sometimes multimillion-dollar, question. Measuring how well a company manages its inflow and outflow of cash is crucial.

In this chapter, we review the key ratios for gauging cash flow and show you how to calculate them. In addition, we explore how companies use their internal financial reporting to monitor slow-paying customers and discuss whether paying bills early or on time is better and how you can test that issue.

Assessing Trade-Receivable Turnover and Average Collection Period

Sales are great, but if customers don’t pay on time, the sales aren’t worth as much to a business: late payers mean that companies have to borrow money to finance customer debt or miss out on opportunities for future investment because they don’t have the cash the customers owe them. In fact, someone who doesn’t pay at all for the products they take is no better for business than a thief. When you’re assessing a company’s future prospects, one of the best ways to judge how well it’s managing its cash flow is to calculate the trade-receivable turnover ratio and from that the average collection period. When you calculate the trade receivable turnover ratio, you’re testing how fast the customers are actually paying those bills.

A balance sheet lists customer credit accounts under the line item ‘Trade and other receivables’. Any company that sells its goods on credit to customers must keep track of to whom it extended credit and whether or not those customers paid their bills in a reasonable time.

What you’re trying to calculate here is the amount of time that customers take to pay normal bills issued in the normal course of business. You therefore have to find the ‘Trade receivables’ item in the notes to the accounts to separate them from other types of receivables – such as prepayments when a company has paid in advance for products or services that it will receive in the next year. Sometimes it’s not so straightforward and when there’s no actual line saying ‘Trade receivables’ you may have to study the note and eliminate items that are obviously not trade receivables to find the figure you’re looking for.

Financial transactions involving credit-card sales aren’t figured into accounts receivable but are handled like cash. The type of credit we’re referring to here is in-store credit or company credit, which is when the bill the customer receives comes directly from the store or company where the customer purchased the item.

When a store or a company makes a sale on credit, it enters the purchase on the customer’s credit account. At the end of each billing period, the store or company sends the customer a bill (often called an invoice) for the purchases that the customer made on credit. The customer usually has between 10 and 30 days from the billing date to pay the bill.

Calculating trade-receivable turnover

Here’s the two-step formula for testing trade-receivable turnover:

1. Find the trade-receivable turnover ratio.

Here’s how:

sales (or revenue) ÷ trade receivables = trade-receivables turnover ratio

If you work inside the company, an even better test is to use annual credit sales rather than sales as shown in the financial statements, because sales includes both cash and credit sales. But if you’re an outsider reading the financial statements, you can’t find out the credit sales number.

2. Find the average collection period (the time it takes customers to pay their bills).

Here’s how:

365 days ÷ trade-receivables turnover ratio = average collection period

This ratio is very industry dependent. For example, if a computer company sells a complex product and has a problem with implementation, the customer may not pay their bill until the problem is solved. Such companies are bound to have much longer collection periods than the two retailers we are studying.

Think about the retail business. We cannot tell how much of their sales are on credit and how much in cash by reading the income statement; but we know that the vast amount of their customers will pay their bills in cash or its equivalent at the checkout. We should expect them, therefore to have a very short collection period. As a comparison we will also give the ratios for a company called Molins who sell machinery for making cigarettes and for packaging. This illustrates the difference between such a company and the retailers.

Here’s how to test trade receivables turnover by using Marks and Spencer’s and Tesco’s 2007 income statements and balance sheets.

To find Tesco’s turnover:

1. Find Tesco’s trade-receivables turnover ratio for 2007.

£42,641 (net sales) ÷ £771 (trade receivables) = 55

2. Find the average credit collection period.

365 days ÷ 55 (trade-receivables turnover ratio) = 7 days

Tesco’s customers, cash and credit, averaged about 7 days to pay their bills.

Comparing this data with the previous year’s is a good idea to see whether the situation is getting better or worse. If you use the same process to calculate Tesco’s 2006 average credit collection period, you find the answer is 6 days, meaning that the company took slightly longer in 2007 to collect than it did the year before. In order to understand the significance of this, look at what is happening with similar companies as well as within the industry. The longer credit collection period may be an internal company problem, or an industry-wide problem related to changes in the economic situation. In the case of Tesco, with its very short collection period, the difference is probably insignificant.

To find Marks and Spencer’s turnover:

1. Calculate Marks and Spencer’s trade-receivables turnover ratio for 2007.

£8,588.10 (net sales) ÷ £67.90 (trade receivables) = 126

2. Calculate the average sales credit period.

365 days ÷ 126 (trade-receivables turnover ratio) = 3 days

Marks and Spencer’s trade receivables turned over more often (at an average of 3 days) than Tesco’s (at an average of 7 days) in 2007.

Is that an improvement or step backward for Marks and Spencer? Using the 2006 numbers, you find that Marks and Spencer took 2 days to collect from its customers in 2006. That means that the company experienced a slight lengthening in its trade-receivables collection period.

Looking at heavy engineering company Molins, you find that its trade- receivables turnover ratio was 7 at about the same time giving it a collection period of 55 days. Most industries come somewhere within a range that has retailers at the fast end to engineering companies (who are bound to take longer) at the slow end.

Finding the right credit policy

Setting the right trade-receivables policy can have a major impact on sales. For example, a company could require customers to pay within ten days of billing or it will close their accounts. That may be too strict, and customers could end up walking out of the store or stopping doing business with the company because they can’t charge to an account. Another common credit policy that could be too strict would be one that requires too high a salary level to qualify, forcing too many customers to go elsewhere to buy the products they need.

Looking at the other side of the coin, a credit policy that is too loose may allow customers 60 days to pay their accounts. By the time the company realises that it has a non-paying customer, the customer could already have charged a large sum to the account. If the customer never pays the account, the company would have to write it off as a bad debt.

What do the numbers mean?

The higher a trade-receivables turnover ratio is, the faster a company’s customers are paying their bills. Usually, the trade-receivables collection is directly related to the credit policies set by the company. For example, a high turnover ratio may look very good, but that ratio may also mean that the company’s credit policies are too strict, and it’s losing sales because few customers qualify for credit. A low accounts-receivable turnover ratio usually means that a company’s credit policies are too loose, and the company may not be doing a good job of collecting on its accounts.

The retail companies that we are examining are unlikely to have major levels of bad debt – although both need to make some provision for possible bad debts in their personal finance arms. If the amount of bad debts is material to the financial statements, then the amount written off will be disclosed in the notes to the accounts.

As an investor, if a company has a longer collection period than its competitors you may want to call their investor-relations department to find out about its longer trade-receivables collections period and what the company is doing to improve these numbers.

Taking a Close Look at Customer Accounts

If you’re working inside a company and have responsibility for customer accounts, you get an internal financial report called the accounts-receivable aging schedule (or aged debtors). This schedule summarises the customers with outstanding accounts, the amounts they have outstanding, and the number of days that their bills are outstanding. Each company designs its own report, so they don’t have any required formats. Check out Table 16–1 to see an example of an accounts-receivable aging schedule.

After you get the aging schedule, you can quickly see which companies are significantly past the due date in their payments. Many firms begin cutting off customers whose accounts are more than 60 or 90 days past due date. Other firms cut off customers when they’re more than 120 days past due date. No set accounting rule dictates when to cut off customers who haven’t paid their bills; this decision depends on the internal control policies the company sets.

In the aging schedule example for ABC Company, the JK Company looks like its account needs some investigating. Although a company can carry past-due payments because of a dispute about a bill, after that dispute goes beyond 90 days, the company awaiting payment may put restrictions on the other company’s future purchases until its account gets cleaned up. HI Company seems to be another slow-paying company that may need a call from the accounts-receivable manager or collections department.

Many times, a company salesperson makes the first contact with the slow paying customer. If the salesperson is unsuccessful, the company initiates more severe collection methods, with the highest level being an outside collection agency or court action. Companies with strong collection practices do a gentle reminder call when an account is more than 30 days late and push harder as the account is more and more past its due date.

When a company decides that it probably will never collect on an account, it writes off the account as a bad debt in the Bad Debt Account. Each company sets its own policies about how quickly it will write off a bad debt. A company usually reviews its accounts for possible write-offs at the end of each accounting period. We talk more about accounts receivable and their impact on cash flow in Chapter 17.

Finding the Accounts-Payable Turnover Ratio

A company’s reputation for paying its bills is just as important as collecting from its own customers. If a company develops the reputation of being a slow payer, it can have a hard time buying on credit. The situation can get even more serious if a company is late paying its loans. In that case, a company can end up with increased interest rates while its credit rating becomes lower and lower. We discuss the importance of a good credit rating in Chapter 19.

You can test a company’s bill-paying record with the accounts-payable turnover ratio. In addition, you can check how many days a company takes to pay its bills by using the days-in-accounts-payable ratio.

Calculating the ratio

The accounts-payable turnover ratio tests how quickly a company pays its bills. You calculate this ratio by dividing the cost of sales (you find this figure on the income statement) by the average accounts payable (you find the accounts-payable figures on the balance sheet). Using the average number rather than the closing figure on the balance sheet is a technique that some people use and we use it here for completeness.

Here’s the formula for the accounts-payable turnover ratio:

cost of sales ÷ average accounts payable = accounts-payable turnover ratio

We use Tesco and Marks and Spencer’s income statements and balance sheets for 2007 to compare their accounts-payable turnover ratios.

To calculate Tesco’s ratio:

1. Find the average accounts payable.

£2,832 (2006 accounts payable) + £3,317 (2007 accounts payable) ÷ 2 = £3,074.5 (average accounts payable)

2. Calculate Tesco’s accounts-payable turnover ratio.

£39,401 (cost of sales) ÷ £3,074 (average accounts payable) = 12.8

Tesco turns over its accounts payable 12.8 times per year.

To calculate Marks and Spencer’s ratio:

1. Find the average accounts payable.

£242.60 (2006 accounts payable) + £259.70 (2007 accounts payable) ÷ 2 = £251.15 (average accounts payable)

2. Use that number to calculate Marks and Spencer accounts-payable turnover ratio.

£5,246.90 (cost of sales) ÷ £251.15 (average accounts payable) = 20.9

Marks and Spencer turns over its accounts payable 20.9 times per year, which is a good bit faster than Tesco.

What do the numbers mean?

The higher the accounts-payable turnover ratio, the shorter the time is between purchase and payment. If a company has a low turnover ratio, this may indicate that it has a cash-flow problem.

Each industry has its own set of ratios. The only way to accurately judge how a company is doing with paying its bills is to compare it with similar companies and the industry.

Determining the Number of Days in Accounts-Payable Ratio

The number of days in accounts-payable ratio lets you test the average length of time a company takes to pay its bills. If a company is taking longer to pay its bills each year, or if it pays its bills over a longer time period than other companies in its industry, it may be having a cash-flow problem. Also, if a company pays its bills quicker than other companies in the same industry, that could be a problem, too: they could hang on to the cash for longer and save themselves interest on their short-term loans. We could have used the same method of calculation here as we did for the average collection period, but again for completeness we are using a different technique that will give the same answer.

Calculating the ratio

Use the following formula to calculate the number of days in accounts payable:

average accounts payable ÷ cost of sales × 365 days = days in accounts payable

We can use Tesco’s and Marks and Spencer’s balance sheets and income statements to find the number of days in accounts-payable ratio. Fortunately, we don’t have to calculate average accounts payable if you calculated the accounts-payable turnover ratio in the section ‘Finding the Accounts-Payable Turnover Ratio’ earlier in this chapter.

Tesco:

£3,074 (average accounts payable) ÷ £39,401 (cost of sales) × 365 = 28.5 days

Tesco takes about 28.5 days to pay its bills, or about 4 weeks, which is very different from the 7 days the company takes to collect from customers, as the accounts-receivable turnover ratio shows. Therefore, Tesco is receiving cash from its customers much faster than it’s paying out cash to its suppliers. That is a healthy financial sign and an indication that, because of the nature of its business, there’s no cash-flow problem. You could say that they are using their muscle to pass their cash-flow problems to their suppliers.

Marks and Spencer:

£251.20 (average accounts payable) ÷ £5,246.90 (cost of sales) × 365 = 17.5 days

Marks and Spencer takes about 17.5 days, or less than three weeks, to pay its bills. Marks and Spencer’s accounts-receivable turnover ratio showed that its customers take slightly more than 3 days to pay their bills. Therefore again, Marks and Spencer gets cash in much more quickly than its suppliers get paid.

Consider Molins, an engineering company, at the other end of the spectrum. Molins takes 55 days on average to get its cash in, while it has to pay its suppliers within 41 days. This means that it will have to have spare cash at all times to make sure it can pay its bills.

What do the numbers mean?

If the number of days a company takes to pay its bills increases from year-to-year, it may be a red flag indicating a possible cash-flow problem. To know for certain what’s happening, compare the company with similar companies and the industry averages.

Just like accounts receivable prepares an aging schedule for customer accounts, companies also prepare internal financial reports for accounts payable that show which companies they owe money to, the amount they owe, and the number of days for which they’ve owed that amount.

Deciding Whether Discount Offers Make Good Financial Sense

One common way that companies encourage their customers to pay early is to offer them a discount. When a discount is offered, a customer (in this case, the company that must pay the bill) may see a term such as ‘2/10 net 30’ or ‘3/10 net 60’ at the top of its bill. ‘2/10 net 30’ means that the customer can take a 2 per cent discount if it pays the bill within 10 days; otherwise, it must pay the bill in full within 30 days. ‘3/10 net 60’ means that if a customer pays the bill within 10 days, it can take a 3 per cent discount; otherwise, it can pay the bill in full within 60 days. Other terms are used to express the same idea. Frequently one company makes an agreement with another that covers all its purchases. The agreement states what their discount is and how quickly they must pay to get it. To encourage companies to take the discount the supplier often puts in big letters the amount they save by paying the invoice early.

Taking advantage of this discount saves the customers money, but if the customer doesn’t have enough cash to take advantage of the discount, it needs to decide whether to use its credit line to do so. Comparing the interest saved by taking the discount with the interest a company must pay to borrow money to pay the bills early can help a company decide whether or not using credit to get the discount is a wise decision.

The formula for calculating the annual interest rate is

[(% discount) ÷ (100 – % discount)] × (365 ÷ number of days paid early) = annual interest rate

We calculate the interest rate based on the early-payment terms stated earlier.

For terms of 2/10 net 30

You first must calculate the number of days that the company would be paying the bill early. In this case, it’s paying the bill in 10 days instead of 30, which means it’s paying the bill 20 days earlier than the terms require. Now calculate the interest rate, using the annual interest-rate formula:

[2 (% discount) ÷ (100 – 2 (% discount) = 98)] × (365 ÷ 20 (number of days paid early)) = 37.24%

That percentage is much higher than the interest rate the company may have to pay if it needs to use a credit line to meet cash-flow requirements, so taking advantage of the discount makes sense. For example, if a company has a bill for £100,000 and takes advantage of a 2 per cent discount, it has to pay only £98,000, and it saves £2,000. Even if it must borrow the £98,000 at an annual rate of 10 per cent, which would cost about £537 for 20 days, it still saves money provided it can borrow the money to pay the bill within 10 days.

For terms of 3/10 net 60

First, find the number of days the company would be paying the bill early. In this case, it’s paying the bill within 10 days, which means it’s paying 50 days earlier than the terms require. Next, calculate the interest rate, using this formula:

[3 (% discount) ÷ (100 – 3 (% discount) = 97] × (365 ÷ 50 (number of days paid early)) = 22.58%

Paying 50 days earlier gives the company an annual interest rate of 22.58 per cent, which is likely to be higher than the interest rate it’d have to pay if it needed to use a credit line to meet cash-flow requirements. But the interest rate isn’t nearly as good as the terms of 2/10 net 30. A company offered 3/10 net 60 terms will probably still choose to take the discount, as long as the cost of its credit lines carry an interest rate that’s lower than that available with these terms and, of course, if it has a credit facility that allows it to do so.

What do the numbers mean?

For most companies, taking advantage of these discounts makes sense, as long as the annual interest rate calculated using this formula is higher than the one they must pay if they borrow money to pay the bill early. This becomes a big issue for companies, because unless their inventory turns over very rapidly, 10 days probably isn’t enough time to sell all the inventory purchased before they must pay the bill early. Their cash wouldn’t come from sales but, more likely, from borrowing.

If cash flow is tight, a company would have to borrow funds using its credit line to take advantage of the discount. For example, if the company buys £100,000 in goods to be sold at terms of 2/10 net 30, the company could save £2,000 by paying within 10 days. If the company hasn’t sold all the goods, it would have to borrow up to £98,000 for 20 days, which wouldn’t be necessary if it didn’t try to take advantage of the discount. Assume that the annual interest on the credit line for the company is 9 per cent. Does it make sense to borrow the money?

A company would need to pay the additional interest on the amount borrowed only for 20 additional days (because that’s the number of days the company must pay the bill early). Calculating the annual interest of 9 per cent of £98,000 equals £8,820, or £24 per day. Borrowing that money would cost an additional £480 (£24 times 20 days). So even though the company must borrow the money to pay the bill early, the £2,000 discount would still save the company £1,520 more than the £480 interest cost involved in borrowing the money.