LG 2 16.1 Spontaneous Liabilities

LG 1 LG 2 16.1 Spontaneous Liabilities

spontaneous liabilities Spontaneous liabilities arise from the normal course of business. For example,

Financing that arises from the

when a retailer orders goods for inventory, the manufacturer of those goods usu-

normal course of business; the

ally does not demand immediate payment but instead extends a short-term loan

two major short-term sources

to the retailer that appears on the retailer’s balance sheet under accounts payable.

of such liabilities are accounts payable and accruals.

The more goods the retailer orders, the greater will be the accounts payable bal- ance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addi-

unsecured short-term tion, both are forms of unsecured short-term financing—short-term financing financing

obtained without pledging specific assets as collateral. The firm should take

advantage of these “interest-free” sources of unsecured short-term financing without pledging specific assets whenever possible.

Short-term financing obtained

as collateral.

ACCOUNTS PAYABLE MANAGEMENT Accounts payable are the major source of unsecured short-term financing for

business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser.

Role in the Cash Conversion Cycle The average payment period is the final component of the cash conversion cycle

introduced in Chapter 15. The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In the preceding chapter, we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of

accounts payable raw materials and its mailing payment to the supplier. This activity is accounts management

payable management.

Management by the firm of the

When the seller of goods charges no interest and offers no discount to the

time that elapses between its

buyer for early payment, the buyer’s goal is to pay as slowly as possible without

purchase of raw materials and

damaging its credit rating. This means that accounts should be paid on the last

its mailing payment to the supplier.

day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, then the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addi- tion, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically

643 Example 16.1 3 In 2009, Hewlett-Packard Company (HPQ), the world’s largest technology com-

CHAPTER 16

Current Liabilities Management

pany, had annual revenue of $114,552 million, cost of revenue of $87,524 million, and accounts payable of $14,809 million. HPQ had an average age of inventory (AAI) of 29.2 days, an average collection period (ACP) of 53.3 days, and an average payment period (APP) of 60.4 days (HPQ’s purchases were $89,492 million). Thus, the cash conversion cycle for HPQ was 22.1 days (29.2 + 53.3 - 60.4) .

The resources HPQ had invested in this cash conversion cycle (assuming a 365-day year) were

= $ 87,524 million * (29.2 , 365) = $ 7,001,920,000 + Accounts receivable = 114,552 million * (53.3 , 365) = 16,727,730,411 - Accounts payable =

Inventory

89,492 million * (60.4 , 365) = 14,809,087,123 = Resources invested

= $ 8,920,563,288 Based on HPQ’s APP and average accounts payable, the daily accounts

payable generated by HPQ is $245,183,562 ($14,809,087,123 , 60.4). If HPQ were to increase its average payment period by 5 days, its accounts payable would increase by about $1,226 million (5 * $245,183,562). As a result, HPQ’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $1,226 million. Clearly, if this action did not damage HPQ’s credit rating, it would be in the company’s best interest.

Analyzing Credit Terms The credit terms that a firm is offered by its suppliers enable it to delay payments

for its purchases. Because the supplier’s cost of having its money tied up in mer- chandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment.

Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date.