CreditTermsAndCashFlow

Credit Terms & Cash Flow

Cash-flow management is one of the four responsibilities of the Financial Manager. The mechanics of managing the cash that flows in (accounts receivable) and out (accounts payable, inventory) are exam-targetable in their own right — credit terms, factoring vs. pledging, and inventory categories all show up as terminology questions.

graph TD
    CFM["Cash-Flow Management"]
    CFM --> AP["Accounts Payable<br/>What we owe"]
    CFM --> AR["Accounts Receivable<br/>What's owed to us"]
    CFM --> INV["Inventory<br/>Goods on hand"]
    AR --> CP["Credit Policy<br/>Who gets credit, on what terms"]
    CP --> CT["Credit Terms<br/>e.g., 2/10 net 30"]
    AR --> SOL{"Need cash now?"}
    SOL -->|Yes| F["Factoring<br/>Sell AR for less than face value"]
    SOL -->|No, just borrow| P["Pledging<br/>Use AR as loan collateral"]
    INV --> RM["Raw-Materials Inventory"]
    INV --> WIP["Work-in-Process Inventory"]
    INV --> FG["Finished-Goods Inventory"]

How It Appears Per Course

ADMN 201

LO2 distinguishes short-term (operating) from long-term (capital) expenditures. The cash-flow detail comes in three places: how AR is created and managed (credit policy), how AR can be turned into cash early (factoring vs. pledging), and how inventory is categorized for production tracking.

Accounts Payable, Accounts Receivable, and Inventory

The three line items the financial manager watches every day:

Item	What it is	Cash-flow direction
Accounts Payable	Unpaid bills owed to suppliers + wages and taxes due within a year	Cash out (eventually)
Accounts Receivable	Funds due from customers who bought on credit	Cash in (eventually)
Inventory	Materials and goods held that will be sold within the year	Cash tied up until sold

Key tension: AR represents revenue you’ve earned but haven’t collected. Inventory represents money you’ve spent but haven’t recovered. Both eat working capital.

Credit Policy

Credit Policy = the rules governing a firm’s extension of credit to customers.

Two questions every credit policy answers:

1. Who gets credit? (Standards: which buyers are eligible)
2. On what terms? (Discount for early pay, deadline for full pay)

Customers with strong payment histories get credit. Customers with poor histories are denied or required to prepay.

Reading Credit Terms: “2/10, net 30”

The most common short-hand format. It means:

• 2 = a 2% discount…
• /10 = …if paid within 10 days
• net 30 = otherwise the full amount is due in 30 days

Example on a $1,000 invoice:

• Days 1–10: Pay $980 (2% discount)
• Days 11–30: Pay $1,000 (full price)
• Day 31+: Late — penalties or collection action

Why offer a discount at all? It pulls cash in faster. The seller would rather have $980in10daysthan$1,000 in 30 — because that $980 can immediately fund operations or earn interest.

The buyer’s calculation: Skipping the 2% discount to delay payment by 20 days is the equivalent of paying ~37% annualized interest. For most buyers, taking the discount is the financially correct move.

Higher discounts → faster collections

Sellers can adjust the terms to influence cash flow:

• “5/10, net 30” → much stronger incentive to pay early
• “1/15, net 60” → weaker incentive, slower collections, gentler on the buyer

Turning AR into Cash Early

Sometimes a firm needs cash now and can’t wait for customers to pay. Two mechanisms:

Factoring AR

Factoring = selling accounts receivable to a third party (the Factor) for less than face value.

• Example: A firm sells $50,000ofARtoaFactorfor$40,000 (80%). The Factor then collects from the customers and keeps whatever they recover.
• Factor’s profit is typically 2–4% — depends on AR quality, collection cost, and interest rates.
• Factoring = outsourcing the collection process and getting paid early.
• $4 billion of AR is factored each year in Canada.

Pledging AR

Pledging accounts receivable = using AR as collateral on a secured loan, without actually selling the AR.

• The AR stays on your books; you collect from customers as normal.
• The lender holds a claim on the AR if you default.
• Important for service firms (accounting, law) that have no inventory — AR is their main collateral.

Factoring vs. Pledging — the key distinction

	Factoring	Pledging
Who collects?	The Factor	The original firm
Who owns the AR?	The Factor (sold)	The original firm (collateral only)
Cash now?	Yes — receive 80% immediately	Only if drawn on the loan
AR shows on balance sheet?	No (sold off)	Yes (still owned)

Exam trap: Factoring is a sale; pledging is collateral. They feel similar — both let you get cash from AR — but legally they are different transactions.

Inventory Categories

The textbook explicitly distinguishes three types of inventory in a manufacturing context:

Category	What it is	Example (Furniture Maker)
Raw-Materials Inventory	Basic supplies used in production	Lumber, fabric, screws, glue
Work-in-Process Inventory	Goods partway through production	Half-assembled couches, sanded but unstained tables
Finished-Goods Inventory	Items ready for sale	Boxed sofas in the warehouse

Why this categorization matters:

• Each category has different storage, financing, and obsolescence risk
• A spike in work-in-process inventory may signal production bottlenecks
• A spike in finished-goods inventory may signal slowing sales or over-production
• Raw-materials shortages stop production cold even when finance and labour are fine

Inventory Risk: Too Little vs. Too Much

Too little inventory	Too much inventory
Lost sales (can’t fulfill orders)	Funds tied up that could earn elsewhere
Production stoppages	Storage costs + obsolescence risk
Customer dissatisfaction	Forced to sell at low prices to clear

JIT and lean production (see OperationsPlanning) are the operational answer: shrink inventory toward zero without breaking the supply chain.

Cross-Course Connections

FinancialManager — cash-flow management is one of the four responsibilities
ShortTermFinancing — trade credit, secured loans (using AR/inventory as collateral), unsecured loans (line of credit, revolving, commercial paper)
AccountingEquation-FinancialStatements — AR, AP, and inventory are all current asset/liability line items on the balance sheet
FinancialRatios — inventory turnover, AR turnover, days sales outstanding all measure how well these are being managed
OperationsPlanning — JIT and materials management directly target inventory reduction

Deeper Reference (ACC 926 — archived)

• CashAndReceivables — IFRS treatment of factoring vs. pledging (sale vs. secured borrowing test)
• Inventory — FIFO/weighted-average cost methods, LCNRV, inventory ratios

Key Points for Exam/Study

• Three cash-flow line items: Accounts Payable (out), Accounts Receivable (in), Inventory (tied up)
• Credit Policy = rules for who gets credit and on what terms
• “2/10, net 30” = 2% discount if paid in 10 days; full amount due in 30 days
• Higher discount % → faster customer payments
• Factoring = SELLING AR to a Factor for <face value (Factor collects)
• Pledging = using AR as COLLATERAL on a loan (you still collect)
• Three inventory categories: Raw Materials → Work-in-Process → Finished Goods
• Too little inventory loses sales; too much ties up cash
• Service firms with no inventory rely on AR as their main collateral

Open Questions

• How does a small firm without strong financial statements actually qualify for factoring?
• Is JIT inventory always cheaper, or can supply-chain disruptions make a buffer worth its cost?