Financing of

Working Capital UNIT 9 PAYABLES MANAGEMENT

Objectives
The objectives of this unit are to:
• Explain the significance of payables as a source of finance
• Identify the factors that influence the payables quantum and duration
• Highlight the advantages of payable and provide hints for effective
management of payables.

Structure
9.1 Introduction
9.2 Payables: Their Significance
9.3 Types of Trade Credit
9.4 Determinants of Trade Credit
9.5 Cost of Credit
9.6 Advantages of Payables
9.7 Effective Management of Payables
9.8 Summary
9.9 Key Words
9.10 Self-Assessment Questions
9.11 Further Readings

9.1 INTRODUCTION
A substantial part of purchases of goods and services in business are on
credit terms rather than against cash payment. While the supplier of goods
and services tend to perceive credit as a lever for enhancing sales or as a
form of non-price instrument of competition, the buyer tends to look upon it
as a loaning of goods or inventory. The supplier’s credit is referred to as
Accounts Payable, Trade Credit, Trade Bill, Trade Acceptance, Commercial
Draft or Bills Payable depending on the nature of credit provided. The extent
to which this ‘buy-now, pay-later’ facility is provided will depend upon a
variety of factors such as the nature, quality and volume of items to be
purchased, the prevalent practices in the trade, the degree of competition and
the financial status of the parties concerned. Trade credits or Payables
constitute a major segment of current liabilities in many business enterprises.
And they primarily finance inventories which form a major component of
current assets in many cases.

9.2 PAYABLES: THEIR SIGNIFICANCE

Payables constitute a current or short term liability representing the buyer’s
obligation to pay a certain amount on a date in the near future for value of
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goods or services received. They are short term deferments of cash payments Theories and
Approaches
that the buyer of goods and services is allowed by the seller. Trade credit is
extended in connection with goods purchased for resale or for processing and
resale, and hence excludes consumer credit provided to individuals for
purchasing goods for ultimate use and instalment credit provided for
purchase of equipment for production purposes. Trade credits or payables
serve as non-interest bearing source of funds in most cases. They provide a
spontaneous source of capital that flows in naturally in the course of business
in keeping with established commercial practices or formal understandings.

9.3 TYPES OF TRADE CREDIT

Trade Credits or Payables could be of three types: Open Accounts,
Promissory Notes and Bills Payable.

Open Account or open credit operates as an informal arrangement wherein

the supplier, after satisfying himself about the credit-worthiness of the buyer,
despatches the goods as required by the buyer and sends the invoice with
particulars of quantity despatched, the rate and total price payable and the
payment terms. The buyer records his liability to the supplier in his books of
accounts and this is shown as payables on open account. The buyer is then
expected to meet his obligation on the due date.
The Promissory note is a formal document signed by the buyer promising to
pay the amount to the seller at a fixed or determinable future time. Where the
client fails to meet his obligation as per open credit on the due date, the
supplier may require a formal acknowledgement of debt and a commitment of
payment by a fixed date. The promissory note is thus an instrument of
acknowledgement of debt and a promise to pay. The supplier may even
stipulate an interest payment for the delay involved in payment.

Bills Payable or Commercial Drafts are instruments drawn by the seller and
accepted by the buyer for payment on the expiry of the specified duration. The
bill or draft will indicate the banker to whom the amount is to be paid on the
due date, and the goods will be delivered to the buyer against acceptance of
the bill. The seller may either retain the bill and present it for payment on the
due date or may raise funds immediately thereon by discounting it with the
banker. The buyer will then pay the amount of the bill to the banker on the
due date.

Activity 9 .1.
Try to ascertain from a Finance Manager:

i) What forms of credit is the firm obtaining?

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Financing of ii) Which of these forms is most economical from the purchasing firm’s
Working Capital
point of view and why?
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iii) How does the company organize itself to negotiate effectively with the
suppliers for obtaining the best possible credit terms?
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9.4 DETERMINANTS OF TRADE CREDIT

Size of the Firm
Smaller firms have increasing dependence on trade credit as they find it
difficult to obtain alternative sources of finance as easily as medium or large
sized firms. At the same time, larger firms that are less vulnerable to adverse
turns in business can command prompt credit facility from the supplier, while
smaller firms may find it difficult to sustain credit worthiness during periods
of financial strain and may have reduced access to credit due to weak
financial position.

Industrial Categories
Different categories of industries or Commercial enterprises show varying
degrees of dependence on trade credit. In certain lines of business the
prevailing commercial practices may stipulate purchases against payment in
most cases. Monopoly firms may insist upon Cash on delivery. There could
be instances where the firm’s inventory, turns over every fortnight but the
firm enjoys thirty days credit from suppliers, whereby the trade credit not
only finances the firm’s inventory but also provides part of the operating
funds or additional working capital.

Nature of Product
Products that sell faster or which have higher turnover may need shorter term
credit. Products with slower turnover take longer to generate cash flows and
will need extended credit terms.

Financial Position of Seller

The financial position of the seller will influence the quantities and period of
204 credit he wishes to extend. Financially weak suppliers will have to be strict
and operate on higher credit terms to buyers. Financially stronger suppliers, Theories and
Approaches
on the other hand, can dictate stringent credit terms but may prefer to extend
liberal credit so long as the transactions provide benefits in excess of the
costs of extending credit. They can afford to extend credits to smaller firms
and assume higher risks. Suppliers with working capital crunch will be
willing to offer higher cash discounts to encourage early payments.

Financial Position of the Buyer

Buyer’s creditworthiness is an important factor in determining the credit
quantum and period. It may be logical to expect large buyers not to insist on
extended credit terms from small suppliers with weak bargaining power.
Where goods are supplied on a consignment basis, the supplier provides extra
finance for the merchandise and pays commission to the consignee for the
goods sold. Small retailers are thus enabled to carry much larger levels of
stocks than they will be able to finance by themselves. Slow paying or
delinquent accounts may be compelled to accept stricter credit terms or higher
prices for products, to cover risk.

Terms of Sale
The magnitude of trade credit is influenced by the terms of sale. When a
product is sold, the seller sends the buyer an invoice that specifies the goods
or services, the price, the total amount due and the terms of the sale. These
terms fall into several broad categories according to the net period within
which payment is expected. When the terms of sale are only on cash basis,
there can be two situations, viz., Cash On Delivery (COD) and Cash Before
Delivery (CBD). Under these two situations, the seller does not extend any
credit.

Cash Discount
Cash discount influences the effective length of credit. Failure to take
advantage of the cash discount could result in the buyer using the funds at an
effective rate of interest higher than that of alternative sources of finance
available. By providing cash discounts and inducing good credit risks to pay
within the discount period, the supplier will also save on the costs of
administration connected with keeping records of dues and collecting overdue
accounts.

Degree of Risk
Estimate of credit risk associated with the buyer will indicate what credit
policy is to be adopted. The risk may be with reference to buyer’s financial
standing or with reference to the nature of the business the buyer is in.

Nature and Extent of Competition

Monopoly status facilitates imposition of tight credit term whereas intense
competition will promote the tendency to liberalise credit. Newly established
companies in competitive fields may more readily resort to liberal trade credit
for promoting sales than established firms which are more formal in deciding
on credit policies.
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Financing of Datings
Working Capital
In seasonal industries, sellers frequently use datings to encourage customers
to place their orders before a heavy selling period. For many consumer
durables, the demand will be of this type. The need for an air-conditioner is
felt in the summer, leading to heavy ordering at a particular point of time.
This has double advantages. For manufacturer, he can schedule production
more conveniently and reduce the inventory levels. Whereas, the buyer has
the advantage of not having to pay for the goods until the peak, of the selling
period. Under this arrangement, credit is extended for a longer period than
normal.

9.5 COST OF CREDIT

Billing methods can vary. The payment of invoices may be stipulated as a
number of days after the date of the invoice or after the receipt of the goods.
In instances of seasonal business, when the supplier wishes to induce
customers to acquire and hold inventories in advance of the peak sales period,
he may resort to dating. The supplier, under this arrangement, extends longer
duration credit to the buyer and allows him to pay for the goods when the
peak period sales pick up. In some cases, a series of despatches effected
during a period, say, a month, are bunched together for invoicing and the
credit term is reckoned from the invoice date.

When the credit does not cover cash discount for early payment, the trade
credit is considered to be a cost free source of financing for the buyer. It is
not uncommon for some of the buyers to delay payments beyond the due
date, thus extending the period of use of costless trade credit.

Trade credit is a built-in source of financing that is normally linked to the

production cycle of the purchasing firm. If payments are made strictly in
accordance with credit terms, trade credit can be regarded as a cost free, non-
discretionary source of financing. But where the buyer takes the privilege of
delaying payment beyond the due date, it assumes the form of discretionary
financing and if this becomes a regular feature resulting in delinquency, trade
credit will cease to be cost free. The supplier may stop credit or may charge a
higher price for the product, to cover the risk.

The supplier may offer cash discount for payment within a specified number
of days after the invoice or after the receipt of goods. Generally such
concessions for expedited settlement are given to select customers on
informal basis. Where the aim is to induce earlier payment wherever possible,
cash discounts are provided for in the credit terms. The quantum of discount
offered will vary for different categories of business and clients.

Cash discount is to be distinguished from the other categories of discount that

may be offered by the seller, namely, the trade discount and the quantity
discount. The trade discount is a reduction from the invoice or list price
offered to the dealer or trader in the channel of distribution. Quantity
discounts are given when purchases are made insizeable lots.

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When the cash discount is allowed for payment within a specified period, we Theories and
Approaches
can compute the cost of credit. For instance, if 30 days’ credit is offered with
the stipulation of a 2 per cent cash discount for payment within 10 days, it
means that the cost of deferring payment by 20 days is 2 per cent. If payment
is made 20 days earlier than the due date, 2 per cent of the amount due can be
saved, which amounts to an attractive annual saving rate of 36 per cent.
If cash discount is not availed, the effective rate of interest of the funds held
will work out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a period of
20 days, and the rate of interest will be:
2/98 × 360/20 = 36.7 per cent.

If 60 days’ credit is extended, with a cash discount of 2 per cent for payment
within 10 days, there is a saving of Rs. 2 for paying 50 days ahead. The
effective rate of interest is 2/98 × 360/50 = 14.7 per cent. For 90 days’ credit,
with 2 per cent cash discount for payment within 10 days, the effective
interest works out to 9.2 per cent. Thus the more liberal the credit terms, the
saving from cash discount declines and so does the effective rate of interest
for using the funds till the due date. If, however, the discounts are not taken
and the settlement is made earlier than the due date, the effective rate of
interest will vary. For a firm that resists from taking the cash discount, its
cost of trade credit declines the longer it is able to delay payment.

The rationale for availing trade credit should be its savings in cost over the
forms of short term financing, its flexibility and convenience. Stretching
trade credit or accounts payable results in two types of costs to the buyer.
One is the cost of cash discount foregone and the other is the consequence of
a poor credit rating.
The contention that there is no explicit cost to trade credit if the payment is
made during the discount period or if the payment is made on the due date
when no cash discount is offered, is not totally tenable. The supplier who is
denied the use of funds during the credit period may bear the cost fully or
pass on part of it to the buyer through higher prices. This will depend on the
nature of demand for the product. If the demand is elastic, the supplier may
opt to bear the cost himself and refrain from charging higher prices to recover
part of it. The buyer should satisfy himself that the burden of trade credit is
not unduly loaded on him through disguised price revisions.

Repeated delinquency and deterioration in credit reputation do involve an

opportunity cost though it is difficult to measure. Some suppliers may be more
tolerant to delayed payments at some times than on other occasions. A policy
of delayed payments is bad business practice and in the long run can prove
very expensive or may even lead to freezing of credit source. Credit
reputation is a precious asset that needs to be preserved with utmost care. The
long run policy should be to avail discounts, if offered, utilize credit periods
to the full and discharge obligations on schedule.

The following formula can be used for determining the effective rate of
return: R = C (360)/D (100-C), where

R = Annual interest rate for the use of funds C = Cash discount 207
Financing of D = Number of extra days the customer has the use of supplier’s funds.
Working Capital
Let us take an illustration.

A firm wants to hold additional inventory but does not have the cash to
finance it. If the credit term is 2 per cent discount for payment within 10 days
with 60 days credit period, and the bank rate is 9 per cent, should the firm
take the discount?

If the discount is not taken by the 10th day, the effective rate of interest on
the funds held and utilized for the remaining 50 days will be:

2/98 × 360/50 = 14.7 per cent.

The bank rate is 9 per cent only. Therefore it is advisable to take the discount
offered, even if it involves utilizing bank borrowing for effecting early
payment for availing the cash discount.

Stretching Accounts Payable

It is normally assumed that the payment to the supplier is made at the end of
due date. However, a firm may postpone payment beyond this period. This
type of postponement is called stretching or Leaning on the trade. The cost of
stretching accounts payable is two fold : the cost of cash discount foregone
and the possible deterioration in the credit rating. If a firm stretches its
payables excessively, so that its payables are significantly delinquent, its credit
rating will suffer. Suppliers will view the firm with apprehension and may
insist on rather strict terms of sale. Although it is difficult to measure, there is
certainly an opportunity cost to a deterioration in the firms quality of
payment.

Activity 9 .2
i) Do the suppliers change their trade credit policy from time to time or are
they consistent irrespective of customer’s shifting fortunes?
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ii) Compare Manufacturing companies against Service Firms in terms of

Credit Policies.
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 Theories and
9.6 ADVANTAGES OF PAYABLES Approaches

Easy to obtain
Payable or Trade Credit is readily obtainable, in most cases, without extended
procedural formalities. During periods of credit crunch or paucity of working
capital, trade credit from large suppliers can be a boon to small buyers.

Suppliers assume the risk

Where the suppliers have the advantage of high gross margins on their
products, they would be able to assume greater risks and extend more liberal
credit.

Informality
In trade credit, there is no rigidity in the matter of repayment on scheduled
dates, occasional delays are not frowned upon. It serves as an extendable,
convenient source of unsecured credit.

Continuous Financing
Even as the current dues are paid, fresh credit flows in, as further purchases
are made. It is a continuous source of finance. With a steady credit term and
the expectation of continuous circulation of trade credit-backing up repeat
purchases, trade credit does in effect, operate as long term source.

9.7 EFFECTIVE MANAGEMENT OF PAYABLES

The salient points to be noted on effective management of payables are:

• Negotiate and obtain the most favourable credit terms consistent with the
prevailing commercial practice pertaining to the concerned product line.
• Where cash discount is offered for prompt payment, take advantage of
the offer and derive the savings there from.
• Where cash discount is not provided, settle the payable on its date of
maturity and not earlier. It pays to avail the full credit term.
• Do not stretch payables beyond due date, except in inescapable
situations, as such delays in meeting obligations have adverse effects on
buyer’s credibility and may result in more stringent credit terms, denial of
credit or higher prices on goods and services procured.
• Sustain healthy financial status and a good track record of past dealings
with the supplier so that it would maintain his confidence. The quantum
and the terms of credit are mainly influenced by suppliers’ assessment of
buyer’s financial health and ability to meet maturing obligations promptly.
• In highly competitive situations, suppliers may be willing to stretch credit
limits and period. Assess your bargaining strength and get the best
possible deal.
• Avoid the tendency to divert payables. Maintain the self-liquidating
character of payables and do not use the funds obtained there from for
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Financing of acquiring fixed assets. Payables are meant to flow through current assets
Working Capital
and speedily get converted into cash through sales for meeting maturing
short term obligations.
• Provide full information to suppliers and concerned credit agencies to
facilitate a frank and fair assessment of financial status and associated
problems. With fuller appreciation of client’s initiatives to honor his
obligations and the occasional financial strains which he might be
subjected to for a variety of reasons, the supplier will be more
considerate and flexible in the matter of credit extension.
• Keep a constant check on incidence of delinquency. Delays in settlement
of payables with reference to due dates can be classified into age groups
to identify delays exceeding one month, two months, three months, etc.
Once overdue payables are given priority of attention for payment, the
delinquencyrate can be minimized or eliminated altogether.
• Managers shall not think that payables management is a back-office
function. In view of the competing uses for materials, advancements in
the technology and the growing significance of Supply Chain
Management (SCM), this function also needs to be viewed as priority.
• Coordination between the Purchase department and Accounts department
is very much necessary.
• In the light of the EFTS and RTGS practices becoming widespread and
moving towards paperless processing, the issue shall be not about
delaying the payments, but it is about effective ‘scheduling of purchase
orders and payments’. Continuous monitoring of suppliers portals may
help schedule them properly and efficiently.
• Finally, it is the command of the company on the Data Flow about
suppliers, shortages, market trends that would greatly contribute in
designing newer and innovative ways in the management of payables.

In an interesting study done on ‘Accounts Payable Optimisation’, the

Institute of Finance and Management (IOFM), Geneva, Switzerland has
identified 17 ways to optimize investment in payables. They are:
• Self-Service Web Portal for vendors.
• Travel & Expense (T&E) Automation.
• Spend Analysis for Vendor Consolidation.
• Electronic Data Interchange (EDI).
• Automated Clearing House (ACH).
• Migrating Suppliers to e-invoicing.
• Document imaging as and when invoices are received (Front-end
processing).
• Automated Workflows for invoice approval.
• Automated workflows for Exceptions handling.
• Automated Data Capture (ADC).
210 • Cash forecasting with payables data.
• Recovery Audits. Theories and
Approaches
• Outsourcing/Off-shoring.
• P-cards (purchasing/procurement cards).
• Evaluated Receipt Settlement (ERS).
• Web Invoicing.
• Dynamic Discounting.

After having surveyed the practices of firms, the study found that the
following three methods are very popular among the companies:
a) Automated Clearing House.
b) P-cards.
c) Document Imaging and e-invoicing.

Advancements in the technology have really changed the way the corporate
affairs are handled across the globe. Many multinational companies like
ABB, Canon, Oracle, etc., are increasingly adopting many of the above
methods.

9.8 SUMMARY
Payables or trade credit is a self liquidating, easy-to-obtain, flexible source of
short term finance. Buyer’s credit reputation, as reflected in evidences of his
willingness and ability to meet maturing obligations will determine the
quantum and period of credit he can command. Factors like competition,
nature of the product and size of the supplier’s firm also influence terms of
credit, besides relevant commercial practices or conventions. It will be
prudent to take advantage of cash discount facilities when available and avoid
over-stretching payables by frequent delays in payments. If good credit
relations are maintained with suppliers, payables can be a ready and
expanding source of short term finance that will correspond to the needs of a
growing firm.

Payables are not altogether cost-free but if managed well, the costs can be
substantially lower than the alternative sources of short term finance.

9.9 KEY WORDS

Accounts Payable: is a liability arising from the purchase of goods or
services on credit.
Trade Acceptance: is a bill or instrument drawn by the seller on the buyer,
the amount which the buyer accepts to pay at an agreed future date.
Promissory Note: is a formal document signed by the buyer promising to
pay the amount thereof to the seller on demand or at a certain future date.
Delinquency: is the failure to meet the obligation on the due date.
Datings: A practice of encouraging buyers to place orders before a heavy
selling period.
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Financing of Stretching : Postponement of payment beyond due date.
Working Capital

9.9 SELF ASSESSMENT QUESTIONS

1) Why is trade credit used extensively by firms?
2) What are the different forms of trade credit? Explain.
3) Trade credit is regarded as a spontaneous source of short term finance.
Comment.
4) Distinguish between trade discount, quantity discount and cash discount.
5) What are the factors that influence the availability of trade credit?
6) What are the principal advantages of trade credit or payables?
7) Over extension of trade credit is a major factor in the financial difficulties
of most companies that fail. Explain.
8) A company has regularly been obtaining 90 days’ credit, with a cash
discount of 2 per cent for payment within 10 days and has found that it
can let the account slide for an extra 30 days without injuring its credit
rating or losing its source of supply. Will it pay the firm to borrow from a
finance agency at a rate of 7 per cent to take advantage of cash discount?
9) Compute the cost of not availing the following discounts on a purchase of
Rs. 10lakh a year.
a) 2/10, net 30
b) 3/10, net 40
c) 2/5, net 25
d) 1/10, net 46

10) You receive a bill from a supplier with the term 2/15, net 45.

a) If you can borrow funds from your bank at 12% per annum, should
you avail discount?
b) Suppose the terms are 1/5, net 15, and you can borrow at 12%, should
you avail discount?

9.10 FURTHER READINGS

Satish B. Mathur, 2002, Working Capital Management and Control, New
Age International (P) Ltd., New Delhi.

R.M. Srivastava, 1986, Essentials of Business Finance, Himalaya Publishing

House, Bombay (Chapter 20),
Van Horne, James C, 1985, Fundamentals of Financial Management,
Prentice Hall of India, New Delhi.

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