CP

600 CHAPTER 16 Working Capital Management

begins to show an increasing percentage of past-due accounts, then the firm’s credit

policy may need to be tightened.

Although a change in the DSO or the aging schedule should signal the firm to in-

vestigate its credit policy, a deterioration in either of these measures does not necessar-

ily indicate that the firm’s credit policy has weakened. In fact, if a firm experiences sharp

seasonal variations, or if it is growing rapidly, then both the aging schedule and the

DSO may be distorted. To see this point, note that the DSO is calculated as follows:

Since receivables at a given point in time reflect sales in the last month or so, but sales

as shown in the denominator of the equation are for the last 12 months, a seasonal in-

crease in sales will increase the numerator more than the denominator, hence will

raise the DSO. This will occur even if customers are still paying exactly as before.

Similar problems arise with the aging schedule if sales fluctuate widely. Therefore, a

change in either the DSO or the aging schedule should be taken as a signal to investi-

gate further, but not necessarily as a sign that the firm’s credit policy has weakened.

Explain how a new firm’s receivables balance is built up over time.

Define days sales outstanding (DSO). What can be learned from it? How is it af-

fected by sales fluctuations?

What is an aging schedule? What can be learned from it? How is it affected by

sales fluctuations?

Accruals and Accounts Payable (Trade Credit)

Recall that net operating working capital is equal to operating current assets minus

operating current liabilities. The previous sections discussed the management of op-

erating current assets (cash, inventory, and accounts receivable), and the following

sections discuss the two major types of operating current liabilities, accruals and ac-

counts payable.

Accruals

Firms generally pay employees on a weekly, biweekly, or monthly basis, so the bal-

ance sheet will typically show some accrued wages. Similarly, the firm’s own esti-

mated income taxes, Social Security and income taxes withheld from employee pay-

rolls, and sales taxes collected are generally paid on a weekly, monthly, or quarterly

basis, hence the balance sheet will typically show some accrued taxes along with ac-

crued wages.

These accruals increase automatically, or spontaneously, as a firm’s operations

expand. However, a firm cannot ordinarily control its accruals: The timing of wage

payments is set by economic forces and industry custom, while tax payment dates are

established by law. Thus, firms use all the accruals they can, but they have little con-

trol over the levels of these accounts.

Accounts Payable (Trade Credit)

Firms generally make purchases from other firms on credit, recording the debt as an

account payable. Accounts payable, or trade credit,is the largest single category of op-

erating current liabilities, representing about 40 percent of the current liabilities of

the average nonfinancial corporation. The percentage is somewhat larger for smaller

DSO

Accounts receivable

Sales/365

.

Working Capital Management 595