ICAI Notes- Unit 5: Management of Working Capital | Financial Management & Strategic Management for CA Intermediate PDF Download

 Page 1


 
 
 
FINANCIAL MANAGEMENT 
 
9.98 
UNIT - V   
MANAGEMENT OF PAYABLES (CREDITORS) 
23. INTRODUCTION 
There is an old age saying in business that if you can buy well then you can sell 
well. Management of your creditors and suppliers is just as important as the 
management of your debtors.  
Trade creditor is a spontaneous / short term source of finance in the sense that it 
arises from ordinary business transaction. But it is also important to look after your 
creditors - slow payment by you may create ill-feeling and your supplies could be 
disrupted and also create a bad image for your company.  
Creditors are a vital part of effective cash management and should be managed 
carefully to enhance the cash position. 
24. COST AND BENEFITS OF TRADE CREDIT 
(a) Cost of Availing Trade Credit 
 Normally it is considered that the trade credit does not carry any cost. 
However, it carries the following costs: 
(i) Price: There is often a discount on the price that the firm undergoes 
when it uses trade credit, since it can take advantage of the discount 
only if it pays immediately. This discount can translate into a high 
implicit cost. 
(ii) Loss of goodwill: If the credit is overstepped, suppliers may 
discriminate against delinquent customers if supplies become short. As 
with the effect of any loss of goodwill, it depends very much on the 
relative market strengths of the parties involved. 
(iii) Cost of managing: Management of creditors involves administrative 
and accounting costs that would otherwise be incurred.    
(iv) Conditions: Sometimes most of the suppliers insist that for availing the 
credit facility the order should be of some minimum size or even on regular 
basis. 
@The Institute of Chartered Accountants of India
Page 2


 
 
 
FINANCIAL MANAGEMENT 
 
9.98 
UNIT - V   
MANAGEMENT OF PAYABLES (CREDITORS) 
23. INTRODUCTION 
There is an old age saying in business that if you can buy well then you can sell 
well. Management of your creditors and suppliers is just as important as the 
management of your debtors.  
Trade creditor is a spontaneous / short term source of finance in the sense that it 
arises from ordinary business transaction. But it is also important to look after your 
creditors - slow payment by you may create ill-feeling and your supplies could be 
disrupted and also create a bad image for your company.  
Creditors are a vital part of effective cash management and should be managed 
carefully to enhance the cash position. 
24. COST AND BENEFITS OF TRADE CREDIT 
(a) Cost of Availing Trade Credit 
 Normally it is considered that the trade credit does not carry any cost. 
However, it carries the following costs: 
(i) Price: There is often a discount on the price that the firm undergoes 
when it uses trade credit, since it can take advantage of the discount 
only if it pays immediately. This discount can translate into a high 
implicit cost. 
(ii) Loss of goodwill: If the credit is overstepped, suppliers may 
discriminate against delinquent customers if supplies become short. As 
with the effect of any loss of goodwill, it depends very much on the 
relative market strengths of the parties involved. 
(iii) Cost of managing: Management of creditors involves administrative 
and accounting costs that would otherwise be incurred.    
(iv) Conditions: Sometimes most of the suppliers insist that for availing the 
credit facility the order should be of some minimum size or even on regular 
basis. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.99 
 
(b) Cost of Not Taking Trade Credit 
 On the other hand, the costs of not availing credit facilities are as under:  
(i) Impact of Inflation: If inflation persists then the borrowers are favored 
over the lenders as they were better off to pay the fixed outstanding 
amount later than sooner. Also, the subsequent transactions shall be at 
higher prices.  
(ii) Interest: Trade credit is a type of interest free loan, therefore failure to 
avail this facility has an interest cost. This cost is further increased if 
interest rates are higher. 
(iii) Inconvenience: Sometimes it may also cause inconvenience to the 
supplier if the supplier is geared to the deferred payment.    
25. COMPUTATION OF COST OF PAYABLES 
By using the trade credit judiciously, a firm can reduce the effect of growth or 
burden on investments in Working Capital. 
Now question arises how to calculate the cost of not taking the discount.  
The following equation can be used to calculate nominal cost, on an annual basis 
of not taking the discount: 
t
days 365
d 100
d
×
-
 
However, the above formula does not take into account the compounding effect 
and therefore, the cost of credit shall be even higher. The cost of lost cash discount 
can be estimated by the formula: 
1
d 100
100 t
365
- ?
?
?
?
?
?
-
 
Where, 
 d =  Size of discount i.e. for 6% discount,  d = 6 
 t  =  The reduction in the payment period in days, necessary to obtain the 
  early discount or Days Credit Outstanding – Discount Period. 
@The Institute of Chartered Accountants of India
Page 3


 
 
 
FINANCIAL MANAGEMENT 
 
9.98 
UNIT - V   
MANAGEMENT OF PAYABLES (CREDITORS) 
23. INTRODUCTION 
There is an old age saying in business that if you can buy well then you can sell 
well. Management of your creditors and suppliers is just as important as the 
management of your debtors.  
Trade creditor is a spontaneous / short term source of finance in the sense that it 
arises from ordinary business transaction. But it is also important to look after your 
creditors - slow payment by you may create ill-feeling and your supplies could be 
disrupted and also create a bad image for your company.  
Creditors are a vital part of effective cash management and should be managed 
carefully to enhance the cash position. 
24. COST AND BENEFITS OF TRADE CREDIT 
(a) Cost of Availing Trade Credit 
 Normally it is considered that the trade credit does not carry any cost. 
However, it carries the following costs: 
(i) Price: There is often a discount on the price that the firm undergoes 
when it uses trade credit, since it can take advantage of the discount 
only if it pays immediately. This discount can translate into a high 
implicit cost. 
(ii) Loss of goodwill: If the credit is overstepped, suppliers may 
discriminate against delinquent customers if supplies become short. As 
with the effect of any loss of goodwill, it depends very much on the 
relative market strengths of the parties involved. 
(iii) Cost of managing: Management of creditors involves administrative 
and accounting costs that would otherwise be incurred.    
(iv) Conditions: Sometimes most of the suppliers insist that for availing the 
credit facility the order should be of some minimum size or even on regular 
basis. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.99 
 
(b) Cost of Not Taking Trade Credit 
 On the other hand, the costs of not availing credit facilities are as under:  
(i) Impact of Inflation: If inflation persists then the borrowers are favored 
over the lenders as they were better off to pay the fixed outstanding 
amount later than sooner. Also, the subsequent transactions shall be at 
higher prices.  
(ii) Interest: Trade credit is a type of interest free loan, therefore failure to 
avail this facility has an interest cost. This cost is further increased if 
interest rates are higher. 
(iii) Inconvenience: Sometimes it may also cause inconvenience to the 
supplier if the supplier is geared to the deferred payment.    
25. COMPUTATION OF COST OF PAYABLES 
By using the trade credit judiciously, a firm can reduce the effect of growth or 
burden on investments in Working Capital. 
Now question arises how to calculate the cost of not taking the discount.  
The following equation can be used to calculate nominal cost, on an annual basis 
of not taking the discount: 
t
days 365
d 100
d
×
-
 
However, the above formula does not take into account the compounding effect 
and therefore, the cost of credit shall be even higher. The cost of lost cash discount 
can be estimated by the formula: 
1
d 100
100 t
365
- ?
?
?
?
?
?
-
 
Where, 
 d =  Size of discount i.e. for 6% discount,  d = 6 
 t  =  The reduction in the payment period in days, necessary to obtain the 
  early discount or Days Credit Outstanding – Discount Period. 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.100 
ILLUSTRATION 20 
Suppose ABC Ltd. has been offered credit terms from its major supplier of 2/10, net 
45. Hence the company has the choice of paying ` 10 per ` 100 or to invest ` 98 for 
an additional 35 days and eventually pay the supplier ` 100 per ` 100. The decision 
as to whether the discount should be accepted depends on the opportunity cost of 
investing ` 98 for 35 days. ANALYSE what should the company do?  
SOLUTION 
If the company does not avail the cash discount and pays the amount after 45 days, 
the implied cost of interest per annum would be approximately:  
1 - ?
?
?
?
?
?
-
35
365
2 100
100
= 23.5% 
Now let us assume that ABC Ltd. can invest the additional cash and can obtain an 
annual return of 25% and if the amount of invoice is ` 10,000. The alternatives are 
as follows: 
Advise: Thus, it is better for the company to refuse the discount, as return on cash 
retained is more than the saving on account of discount. 
ILLUSTRATION 21 
The Dolce Company purchases raw materials on terms of 2/10, net 30.  A review of 
the company’s records by the owner, Mr. Gautam, revealed that payments are usually 
made 15 days after purchases are made.  When asked why the firm did not take 
advantage of its discounts, the accountant, Mr. Rohit, replied that it cost only 2 per 
cent for these funds, whereas a bank loan would cost the company 12 per cent. 
 Refuse  
discount 
Accept  
discount 
 `  `  
Payment to supplier 10,000 9,800 
Return from investing ` 9,800 between day 10 and day 45: 
`
35
×  9,800×25%
365
 
 
(235) 
 
Net Cost 9,765 9,800 
@The Institute of Chartered Accountants of India
Page 4


 
 
 
FINANCIAL MANAGEMENT 
 
9.98 
UNIT - V   
MANAGEMENT OF PAYABLES (CREDITORS) 
23. INTRODUCTION 
There is an old age saying in business that if you can buy well then you can sell 
well. Management of your creditors and suppliers is just as important as the 
management of your debtors.  
Trade creditor is a spontaneous / short term source of finance in the sense that it 
arises from ordinary business transaction. But it is also important to look after your 
creditors - slow payment by you may create ill-feeling and your supplies could be 
disrupted and also create a bad image for your company.  
Creditors are a vital part of effective cash management and should be managed 
carefully to enhance the cash position. 
24. COST AND BENEFITS OF TRADE CREDIT 
(a) Cost of Availing Trade Credit 
 Normally it is considered that the trade credit does not carry any cost. 
However, it carries the following costs: 
(i) Price: There is often a discount on the price that the firm undergoes 
when it uses trade credit, since it can take advantage of the discount 
only if it pays immediately. This discount can translate into a high 
implicit cost. 
(ii) Loss of goodwill: If the credit is overstepped, suppliers may 
discriminate against delinquent customers if supplies become short. As 
with the effect of any loss of goodwill, it depends very much on the 
relative market strengths of the parties involved. 
(iii) Cost of managing: Management of creditors involves administrative 
and accounting costs that would otherwise be incurred.    
(iv) Conditions: Sometimes most of the suppliers insist that for availing the 
credit facility the order should be of some minimum size or even on regular 
basis. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.99 
 
(b) Cost of Not Taking Trade Credit 
 On the other hand, the costs of not availing credit facilities are as under:  
(i) Impact of Inflation: If inflation persists then the borrowers are favored 
over the lenders as they were better off to pay the fixed outstanding 
amount later than sooner. Also, the subsequent transactions shall be at 
higher prices.  
(ii) Interest: Trade credit is a type of interest free loan, therefore failure to 
avail this facility has an interest cost. This cost is further increased if 
interest rates are higher. 
(iii) Inconvenience: Sometimes it may also cause inconvenience to the 
supplier if the supplier is geared to the deferred payment.    
25. COMPUTATION OF COST OF PAYABLES 
By using the trade credit judiciously, a firm can reduce the effect of growth or 
burden on investments in Working Capital. 
Now question arises how to calculate the cost of not taking the discount.  
The following equation can be used to calculate nominal cost, on an annual basis 
of not taking the discount: 
t
days 365
d 100
d
×
-
 
However, the above formula does not take into account the compounding effect 
and therefore, the cost of credit shall be even higher. The cost of lost cash discount 
can be estimated by the formula: 
1
d 100
100 t
365
- ?
?
?
?
?
?
-
 
Where, 
 d =  Size of discount i.e. for 6% discount,  d = 6 
 t  =  The reduction in the payment period in days, necessary to obtain the 
  early discount or Days Credit Outstanding – Discount Period. 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.100 
ILLUSTRATION 20 
Suppose ABC Ltd. has been offered credit terms from its major supplier of 2/10, net 
45. Hence the company has the choice of paying ` 10 per ` 100 or to invest ` 98 for 
an additional 35 days and eventually pay the supplier ` 100 per ` 100. The decision 
as to whether the discount should be accepted depends on the opportunity cost of 
investing ` 98 for 35 days. ANALYSE what should the company do?  
SOLUTION 
If the company does not avail the cash discount and pays the amount after 45 days, 
the implied cost of interest per annum would be approximately:  
1 - ?
?
?
?
?
?
-
35
365
2 100
100
= 23.5% 
Now let us assume that ABC Ltd. can invest the additional cash and can obtain an 
annual return of 25% and if the amount of invoice is ` 10,000. The alternatives are 
as follows: 
Advise: Thus, it is better for the company to refuse the discount, as return on cash 
retained is more than the saving on account of discount. 
ILLUSTRATION 21 
The Dolce Company purchases raw materials on terms of 2/10, net 30.  A review of 
the company’s records by the owner, Mr. Gautam, revealed that payments are usually 
made 15 days after purchases are made.  When asked why the firm did not take 
advantage of its discounts, the accountant, Mr. Rohit, replied that it cost only 2 per 
cent for these funds, whereas a bank loan would cost the company 12 per cent. 
 Refuse  
discount 
Accept  
discount 
 `  `  
Payment to supplier 10,000 9,800 
Return from investing ` 9,800 between day 10 and day 45: 
`
35
×  9,800×25%
365
 
 
(235) 
 
Net Cost 9,765 9,800 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.101 
(a) ANALYSE what mistake is Rohit making? 
(b) If the firm could not borrow from the bank and was forced to resort to the use 
of trade credit funds, what suggestion might be made to Rohit that would reduce 
the annual interest cost? IDENTIFY. 
SOLUTION 
(a) Rohit’s argument of comparing 2% discount with 12% bank loan rate is not 
rational as 2% discount can be earned by making payment 5 days in advance 
i.e. within 10 days rather 15 days as payments are made presently. Whereas 
12% bank loan rate is for a year. 
 Assume that the purchase value is `100, the discount can be earned by 
making payment within 10 days is `2, therefore, net payment would be `98 
only. Annualized benefit  
= 
365 days 2
× ×100
98 5 days
 
 
` 
` 
 = 149% 
This means cost of not taking cash discount is 149%. 
(b) If the bank loan facility could not be available, then in this case the company 
should resort to utilise maximum credit period as possible.  
 Therefore, payment should be made in 30 days to reduce the interest cost. 
 
  
@The Institute of Chartered Accountants of India