cost of accounts receivable

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markowitzman

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An MBA friend said to me that if an item I sell is one euro and if I do not get paid for 60days that the real value of the euro at day 60 is circa 85cents and less than 70cents at day 120.
How do they work this out? Is this based on the fact that I could have used this money to pay down mortgage or business loan?
 
Very strange one, i haven't heard this before, is it possible that it's more to do with the longer it is that your have not received payment for your goods that there is a higher risk that your Debtor is more likely to become a Bad Debtor and therefore you are building this risk into the real value of your Sales?
 
Yes this could also be a factor but there is an opportunity cost for me of not being able to invest the money or pay down debt and the interest costs of being overdrawn as a result.
 
It depends on your cost of capital. On the face of it, if your cost of capital was 7.5 percent x 12 months = 90 percent, this would be true.

This is why people offer discounts for prompt payment.

However, if your cost of capital is 90 percent, you probably have other problems beside late payment.

I fear your MBA friend has mixed up annual and monthly interest rates. At 7.5 percent per year, an extra sixty days will cost you 7.5 percent/12 months * 2 months * 1 euro = 1.25 cents (a bit more, because I haven't taken account of the compounding of interest).

If you just can't get credit or investment for some reason, then obviously the extra thirty days would cripple you. Then it's not a matter of a particular amount of money, the problem is that you just can't trade.
 
The simple answer is do to the time value of money-where money received in the future is worth less than money received now, although for 60 days, the discount factor applied to future cash flows is likely to be close to 1.

Time value of money

The discount rate will depend on your cost of capital.
 
Agree with CCOVICH it just relates to the time value of money, although a reduction of 15% over 60 days would seem a bit excessive.

Again it does not take a MBA graduate to figure this out, this sort of thing would be though to first year undergraduates.

Ask him/her what rate they are using?
 
Your MBA friend as eluded to above has made some miscalculations

More importantly............... pay great attention to discounts!!

If you are being offered a 2.5% for 60 days discount take it. If you are getting a 5% discount for 30 days take it and take the hand and all. It is like going into the bank and putting it on deposit at 6-20% depending on how long you normally take to pay.

Likewise be very careful about giving discounts as it it like borrowing at 6-20% depending on how much faster you get you money in.
 
I reckon that discount rate is too high to be realistic. Chances are the MBA was just using random figures to explain that present values and future values are not the same thing. A bird in the hand is worth two in the bush and all that.
 
I don't think present values etc. are ever really an issue in this kind of calculation, unless the client takes a very long time (e.g. more than a year) to pay.

The point is that offering discounts for prompt payment can be very expensive way of improving cash flow.
 
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