76 ACCOUNTING FOR MANAGERS
comprise creditors and accruals. The other element of working capital isbank,
representing either surplus cash (a current asset) or short-term borrowing through
a bank overdraft facility (a creditor).
The working capital cycle is shown in Figure 6.1. Money tied up in debtors and
stock puts pressure on the firm, either to reduce the level of that investment or
to seek additional borrowings. Alternatively, cash surpluses can be invested to
generate additional income through interest earned.
Managing working capital is essential for success, as the ability to avoid a cash
crisis and pay debts as they fall due depends on:
žmanaging debtors through effective credit approval, invoicing and collec-
tion activity;
žmanaging stock through effective ordering, storage and identification of stock;
žmanaging trade creditors by negotiation of trade terms and through taking
advantage of settlement discounts; and
žmanaging cash by effective forecasting, short-term borrowing and/or invest-
ment of surplus cash where possible.
Managing debtors......................................
The main measure of how effectively debtors are managed is the number of days’
sales outstanding. Days’ sales outstanding is:
debtors
average daily salesUsing the previous example, the firm has sales of £2 million and debtors of
£300,000. Average daily sales are £5,479 (£2 million/365). There are therefore 54.75
average days’ sales outstanding (£300,000/£5,479).
The target number of days’ sales outstanding will be a function of the industry,
the credit terms offered by the firm and its efficiency in both credit approval
and collection activity. Management of debtors will aim to reduce days’ sales
outstanding over time and minimize bad debts.
Acceptance policies will aim to determine the creditworthiness of new cus-
tomers before sales are made. This can be achieved by checking trade and bank
references, searching company accounts and consulting a credit bureau for any
adverse reports. Credit limits can be set for each customer.
Collection policy should ensure that invoices and statements are issued quickly
and accurately, that any queries are investigated as soon as they are identified, and
that continual follow-up (by telephone and post) of late-paying customers should
take place. Discounts may be offered for settlement within credit terms.
Bad debts may occur because a customer’s business fails. For this reason,
firms establish a provision (see earlier in this chapter) to cover the likelihood of
customers not being able to pay their debts.