Business finance : theory and practice

Chapter 13 • Management of working capital
Nissan Motors UK Ltd, the UK manufacturing arm of the Japanese car manufacturer,
has a plant in Sunderland in the north-east of England. Here it used to operate
a well-developed JIT system for virtually all of its inventory items. However, by using
only local suppliers it had cut itself off from the opportunity to exploit low-cost
suppliers, particularly ones in China. More recently it has drawn back from its total
adherence to JIT but this has led the business to feel that it now needs to hold buffer
inventories to guard against disruption of supply arising from transport problems of
sourcing parts from the Far East.
13.8 Trade receivables (trade debtors or accounts receivable)
With the exception of the retail trade, where immediate cash settlement predominates,
most commercial sales are made on credit. When the goods or services pass to the customer
business, that business becomes one of the supplier’s trade receivables until
such time as it settles its obligation by paying cash.
It appears that attitudes to the granting of credit vary from trade to trade, with timehonoured
credit policies being perpetuated by virtue of the fact that individual businesses
find it hard to break patterns with which their competitors intend to continue.
In determining credit policy the financial manager must try to strike a balance
between the costs and risks of granting credit and those associated with denying or
restricting credit.
The costs and risks of granting credit
The costs and risks of granting credit are outlined below.
Financing cost
Granting credit is equivalent to making interest-free loans. Since trade receivables
are not usually secured, they tend to be fairly risky loans. Thus the interest lost is at
a fairly high rate.
For Associated British Foods plc for 2007, the cost of funding trade receivables was
£59 million, an amount equal to about 11 per cent of the business’s operating profit for
that year. In other words, had the business been able to trade without the necessity to
offer trade credit, the shareholders would be £59 million better off. As with inventories,
ABF would, in practice, find it impossible to avoid financing some level of trade
receivables, but it is nevertheless a costly matter. See page 355 for an explanation of
how the cost of financing ABF’s working capital is derived.
Loss of purchasing power
When price inflation is present, which in the UK (and most of the developed world)
has been the case for much of the twentieth century and, so far, all of the twenty-first,
including every single year since the Second World War, value transfers from lender
to borrower. This is because the borrower (credit customer in this context) settles in £s
of lower value than those that were borrowed. To some extent this point is covered in
the previous one, but fairly recent experience of very high inflation rates showed that,
at such times, interest rates do not necessarily increase fully to compensate lenders for
the erosion of their money’s purchasing power. Those granting trade credit should be
aware that they are likely to be forgoing more than just the basic cost of finance in
times of inflation.
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