Agreed on credit terms
When an organization sells on credit to a customer, it needs working capital to finance the credit to the customer. This money is intended to finance the cost of the product sold (product, raw materials, labor cost), or the costs of providing the service throughout the service period. The organization needs to finance the increase in working capital that results from each sale to a customer.
The working capital invested in the accounts receivable section has a cost to the organization and is referred to as the “cost of capital”. It does not matter if the organization pays for the financing (borrows funds) or uses the funds it has. In any case, the total financing costs of all the working capital required to finance the debtors section for the purpose of maintaining the business activity, amounts to the cost of the organization’s credit terms.
In practice, the cost of credit can be calculated by agreement as the average balance of the debtors throughout the year multiplied by the organization’s “cost of capital”.
Example: If the organization’s average total debtor balances is 1,000,000, and the price of capital paid by the organization (for example for a loan from its bank) is 9%, then the cost of the agreed credit will be 90,000 (9%). (In these funny days, the interest percentage in the example is just a number…).
Credit cost of arrears
In the realm of financial management, particularly within the context of credit and collections, the concept of the “credit cost of arrears” emerges as a significant factor. This concept pertains to the financial implications and burdens imposed on an organization due to the delay in receiving payments for credit extended to its customers. The underlying principle is that just as a business requires working capital to finance the extension of credit under agreed terms to its paying customers, it similarly necessitates additional working capital to manage and finance debts that are overdue.
The correlation between ongoing sales and the accumulation of arrears is noteworthy. In a typical business cycle, a company continues to generate new sales monthly, offering credit terms to its customers. If past debts are not settled within the stipulated period, the organization faces a cumulative effect. The unpaid debts from previous cycles add to the financial burden of the current cycle, creating a compounded need for additional working capital. This phenomenon essentially magnifies the financial strain on the organization, as it must now finance not just the current credit sales but also the unpaid ones from prior periods.
The cost associated with such arrears is multifaceted. On one level, there is a direct financial cost, often manifested in the form of interest expenses if the organization resorts to external borrowing to cover the shortfall in its working capital. Alternatively, if the organization uses its internal funds to bridge this gap, it encounters an opportunity cost, for these funds could have been otherwise employed in potentially profitable ventures or investments.
Moreover, the requirement to finance arrears impacts the cash flow and liquidity of the business. The delayed inflow of cash from receivables can hinder the company’s ability to meet its short-term obligations and can adversely affect its operational efficiency. Consequently, businesses must adopt robust credit management policies and practices. This includes performing diligent credit risk assessments, maintaining stringent follow-up procedures on receivables, and employing effective strategies to mitigate credit risks, such as offering early payment incentives or utilizing credit insurance.
In summary, the credit cost of arrears is a critical aspect that underscores the importance of efficient credit and collections management. It highlights the need for businesses to not only focus on extending credit as part of their sales strategy but also to vigilantly manage and finance the associated credit risks and delays in payments, thereby ensuring the overall financial health and stability of the organization.