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Introduction

Effective management of trade payables involves seeking satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers.

8.1 Trade credit

Trade payables are those suppliers who are owed money for goods and services which they have supplied for the trading activities of the enterprise. For a manufacturing company, trade payables will be raw materials suppliers.

Question 4.9 ^Factoring

The management of trade payables involves:

• Attempting to obtain satisfactory credit from suppliers

• Attempting to extend credit during periods of cash shortage

• Maintaining good relations with regular and important suppliers

Learning outcome E1(f)

What might your firm have to do to obtain credit from a supplier?

Taking credit from suppliers is a normal feature of business. Nearly every company has some trade payables waiting for payment. Trade credit is a source of short-term finance because it helps to keep working capital down. It is usually a cheap source of finance, since suppliers rarely charge interest.

However, trade credit will have a cost, whenever a company is offered a discount for early payment, but opts instead to take longer credit.

8.1.1 Trade credit and the cost of lost early payment discounts

Trade credit from suppliers is particularly important to small and fast growing firms. The costs of making maximum use of trade credit include:

(a) The loss of suppliers' goodwill

(b) The loss of any available cash discounts for the early payment of debts The cost of lost cash discounts can be estimated by the formula:

d 1

t is the reduction in the payment period in days which would be necessary to obtain the early payment discount

X has been offered credit terms from its major supplier of 2/10, net 45. That is, a cash discount of 2%

will be given if payment is made within ten days of the invoice, and payments must be made within 45 days of the invoice. The company has the choice of paying 98c per $1 on day 10 (to pay before day 10 would be unnecessary), or to invest the 98c for an additional 35 days and eventually pay the supplier $1 per $1. The decision as to whether the discount should be accepted depends on the opportunity cost of investing 98c for 35 days. What should the company do?

If the company refuses the cash discount, and pays in full after 45 days, the implied cost in interest per annum would be approximately:

Suppose that X can invest cash to obtain an annual return of 25%, and that there is an invoice from the supplier for $1,000. The two alternatives are as follows.

Refuse Accept discount discount

$ $

Payment to supplier 1,000.0 980

Return from investing $980 between day 10 and day 45:

365 25%

$980× 35 × (23.5)

Net cost 976.5 980

It is cheaper to refuse the discount because the investment rate of return on cash retained, in this example, exceeds the saving from the discount.

Although a company may delay payment beyond the final due date, thereby obtaining even longer credit from its suppliers, such a policy would be inadvisable (except where an unexpected short-term cash shortage has arisen). Unacceptable delays in payment will worsen the company's credit rating, and additional credit may become difficult to obtain.

8.2 Other payables

There is usually less scope for flexibility with other types of short-term payables. Things like rent and tax and dividends have to be paid out in full on certain specific dates.

'Management' in such cases is a matter of ensuring that what is due gets paid on time and that the finance is available when needed.

Age analysis of payables

You will be able to appreciate what an age analysis of payables is, having looked at the age analysis of receivables earlier in the chapter.

Here is an age analysis of payables for Heath Co.

HEATH CO

AGE ANALYSIS OF TRADE PAYABLES AS AT 31.1.X2 Account

V001 Vitatechnology 3,284.00 2,140.00 1,144.00 – –

P002 Prendergast Tubes 1,709.50 1,010.50 699.00 – –

Various points of analysis and interpretation could arise from an age analysis of payables.

(a) Is the company paying its suppliers earlier than it needs to?

(b) Is the company taking advantage of suppliers' discounts where this is advantageous?

(c) Do older amounts represent disputes, disagreements or accounting errors that ought to be looked into?

(d) In the case of Heath Co, is it possible that the fact that there are two accounts for Plates of Derby has led to confusion, perhaps resulting in the older unsettled items?

Example: age analysis of payables

8.3 The purchasing cycle

The purchasing business is now the customer, which has its credit status checked, takes delivery of goods and invoice, and pays for the goods or services.

8.4 Payment terms as part of the order

The payment terms offered by or agreed with the supplier form part of the contract with the supplier.

8.5 Controls over purchasing

In the same way as controls are maintained over receivables, controls should also be in place over purchase commitments. The documentation in the diagram above is an important control. In addition, there should be restrictions on who is allowed to place an order; perhaps only a centralised purchasing function should be permitted to order goods. When goods arrive the goods received department should check they agree to the order and are of acceptable quality. The details of invoices should be carefully checked, and the purchasing department should confirm that the goods have been received.

Businesses with several sites should decide whether purchasing should be centralised in one location or devolved to each site. A central location may be able to co-ordinate inventory holdings better, obtain better prices or bulk discounts, and have access to a wider range of suppliers. Local ordering may be more flexible to individual locations' needs, and local purchasing managers may form stronger relationships with local suppliers.

Section summary

Effective management of trade payables involves seeking satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers.