If granting credit to ship owners and managers is considered an occupational hazard by the maritime industry it is hardly surprising. A glance at the accounts of a typical small ship supply company illustrates the extent to which profitability is damaged by late payment and bad debts.
This article looks at how the cost of credit can be measured and describes ways the Directors of a fictional ship supplier will improve the profitability and cash flow of their company this year. Although XYZ Ship Supply Co. does not exist, the accounts for 1996 are based on those of an amalgam of several companies. Figures have been rounded up or down to ease calculations but otherwise accurately reflect the financial results of a ship supply business.
Figure 1.
As at Estimated
31-Dec-96 31-Dec-97
$ 90,000 Fixed Assets $ 90,000
Current Assets
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$ 120,000 Stocks $ 120,000
$ 380,000 Debtors $ 235,000
$ 10,000 Cash at Bank $ 25,000
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$ 510,000 $ 380,000
Current Liabilities
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$ 200,000 Creditors $ 180,000
$ 150,000 Bank overdraft nil
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$ 350,000 $ 180,000
$ 160,000 Net Current Assets $ 200,000
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$ 250,000 TOTAL ASSETS $ 290,000
$ 50,000 Issued Share Capital $ 50,000
$ 200,000 Retained Profits $ 240,000
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$ 250,000 TOTAL CAPITAL EMPLOYED $ 290,000
$1,400,000 Sales $1,400,000
$ 950,000 Cost of Goods $ 930,000
$ 368,000 Operating costs $ 368,000
$ 12,000 Bad Debts w/off $ 6,000
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$1,330,000 $1,304,000
$ 70,000 Trading Profit $ 96,000
$ 15,000 Interest paid nil
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$ 55,000 PROFIT BEFORE TAX $ 96,000
Firstly, it is helpful to examine the results for
the year to 31st December 1996. You can use the calculations below to
compare the results of your own company and possibly identify areas
for improvement.
Bad debts have a direct effect on profit. Although XYZ Ship Supply Co. wrote off less than 1% of sales, i.e. $12,000, the effect was to reduce Profit before tax by 18% (from $67,000 to $55,000). As profit before tax was only 3.9% ($55,000 on sales of $1.4 million), annual sales would have to increase by over $300,000 ($12,000 divided by 3.9%) to replace the profit lost to bad debts. Put another way, even a 20% increase in sales would not compensate for 1% of bad debts.
At the end of the year 'debtors' totalled $380,000 or 63% of the total assets of the company. Such a percentage is not unusual but naturally causes some concern, particularly if it includes large amounts due from only a few customers. The default of one such company would cause considerable difficulties for the supplier. In 1995 companies were forced into bankruptcy due to over exposure to Adriatic Tankers Shipping Co. S.A.
Debt turn is especially important since it links the amount due from 'debtors' to sales. The Days Sales Outstanding (DSO) can be calculated by dividing 'debtors' ($380,000) by sales ($1.4 million) and multiplying by 365 days per year. In this case customers take an average of 99 days to pay. If standard payment terms are 30 days, this means customers are paying an average of 69 days late. This figure assumes all sales are on a credit basis. If some sales are on cash basis, the period must be recalculated after excluding cash sales.
It is clear that the company was only able to cope with this level of 'debtors' by making use of a bank overdraft and because profits had been retained in the company.
The overdraft necessary to finance 'debtors' cost the company $15,000 in interest paid. Again, this came directly from the bottom line. Interest charges had the effect of reducing profit before tax by more than 20% (from $70,000 to $55,000).
Such figures are not unusual. The report 'Getting Paid' produced by Intrum Justitia in 1989 found that it was not uncommon for credit costs caused by late payment to wipe out up to 50% of a company's profits.
Often companies focus their attention solely on bad debts. Yet, as this example shows, interest typically accounts for a higher proportion of credit costs than bad debts. The NUTEK report carried out in Sweden in 1993, showed that the cost of tying up capital can be ten times higher than credit losses. Therefore, concentrating on cash flow and reducing credit days will usually have a bigger effect on profitability than just trying to avoid bad debts.
In many cases it is not just profitability, but a company's survival that is at stake - too many ship suppliers have gone bust because, although profitable on paper, they experienced severe cash flow problems due to late payers.
After reviewing the results for 1996, the Directors of XYZ Ship Supply Co. revised their strategy for 1997. At the existing level of profitability it did not make sense to put a lot of effort into increasing sales. Obtaining higher turnover would require increased marketing expenditure, reducing prices and accepting higher risk customers. All these would be likely to depress profits further. Therefore, the Directors agreed it would be better to retain the present level of sales, whilst concentrating on improving profitability by exercising better credit management.
The main cause for concern was the average time taken by customers to pay. Firstly the Directors agreed that the DSO should be calculated on a monthly basis in future, so that it could be closely monitored.
The aged breakdown of 'debtors' at end of 1995 is set out below:-
0-30 days $ 76,000 20%
31-60 days $ 114,000 30%
61-90 days $ 95,000 25%
91-120 days $ 57,000 15%
over 120 days $ 38,000 10%
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$380,000 100%
This confirmed that the payment performance of accounts less than 120 days old had a far greater impact on the DSO and cash flow than the oldest debts.
The Directors set about improving the payment time of their largest customers. They found out who authorised payments and who processed them. They asked if there was anything they could do to make sure their invoices were processed quickly, for example by presenting Purchase Order details in a particular way.
New collection procedures were put in place, so that any customer delaying payment was contacted at an early stage and closely followed. This ended up saving time over the previous, irregular actions taken only after debts had become long overdue.
Many larger ship owners and managers make batch payments on particular dates each month. Invoices not received in time have to wait an extra month. Internal investigations revealed that XYZ's own poor practices were contributing to payment delays. In particular, the average time between delivery of goods and dispatch of invoices was 10 days. Indeed, invoices relating to supplies to vessels in the local dry-dock were not normally dispatched until after the vessels had sailed. Care is now taken taken to fit in with customers' payment processing deadlines. The target is to dispatch all invoices within 24 hours of supply.
The Directors aim to reach a DSO of 60 by the end of 1996. They know that for every day by which they reduce the DSO they gain a reduction in total 'debtors' of almost $4,000. The resulting saving in annual interest payments of nearly $400 corresponds to an increase in company profitability of 0.7%. So far, sales have been maintained by building better relations with existing customers. Small clients who always paid late have been put on C.O.D. terms. The time saved has been put to good use and, as a result, the company has gained new good quality customers.
Bad debts cannot be eliminated and no bad debts probably indicates a too cautious approach. However, the general improvement in credit management practice is expected to reduce bad debts by 50% compared to last year.
In addition to the reduced risk of bad debts the most obvious benefit to the company has been the improved cash flow. The overdraft is no longer needed, so no interest is paid. Prompt payment discounts offered XYZ's supplies are always taken. Goods are purchased in bulk quantities when this is economic. The Directors estimate the resultant savings will reduce their overall cost of goods by $20,000 a year.
The estimated figures for 31st December 1996 show profit before tax of $94,000, an improvement of more than 70%. The company also has a healthy cash flow which will be used to develop the business in 1998 and beyond. Further steps will be needed to improve profitability but at least the cost of credit is now under control.
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(c) Marine Debt Management Ltd. 2006