How to Analyze Trade Credit - Pt. 2

The collection time represents one of the most important indicators in the analysis of the temporal dimension of the balance sheet numbers.

It should not be forgotten, in fact, that in addition to the economic dimension (ability to produce income), the patrimonial dimension (composition of investments and related sources of financing) and the financial dimension (transformation of costs and revenues into monetary inflows and outflows), there is a fourth dimension, the temporal dimension that permeates all balance sheet schemes and that can be analysed through the following duration indicators:

• Average time to collect receivables (a)
• Average warehouse holding time (b)
• Average debt payment time (c)

These three indicators, appropriately added together (a + b – c), constitute the monetary cycle , or cash cycle , which represents the time that elapses between the first payment of money and the first collection of money, or in other words it is a measure of the company's ability to withstand a shortage of liquidity over time.

Shortage due to the fact that the economic dynamics (achieving revenues and sustaining costs) in most cases does not coincide with the financial dynamics (receipts and payments), but rather precedes it.

And it is precisely the extent of this deferral that must be carefully analysed, as this time lag is closely linked to short-term financial needs .

The financial requirement is therefore linked to the dynamics of the net working capital (credits + inventory – debts), of which the three rotation indices listed above represent an expression in terms of the speed of monetization of the related items.

The monetary cycle can be schematized as follows, within the representation of business management in operating cycles:

In the example in the figure, 54 days pass from the date of payment of raw materials to suppliers (May 28) to the date of collection from customers (July 21) of sales of finished products, which can also be calculated as follows:

This obviously applies to manufacturing companies .

As regards commercial enterprises , however, since the part relating to the production cycle and the storage times of raw materials and finished products is missing, the scheme is a little more simplified:

Here too the duration of the monetary cycle is identical, but the calculation is more streamlined:

It is very important to monitor the duration of the monetary cycle over time because, as already mentioned, this quantity has significant repercussions on financial requirements, since:

• an increase in the time taken to collect payments from customers leads to an increase in the need for cash ( liquidity absorption );
• an increase in the time of goods storage leads to an increase in the cash requirement ( liquidity absorption );
• an increase in the payment time of suppliers leads to a reduction in the cash requirement (failure to absorb, therefore generation of liquidity ).

After this brief review of the temporal dimension of the balance sheet, with particular attention to the dynamics of trade credits, in the next contributions we will focus on the indicator of the time to collect credits ( DSO ), trying to understand its calculation methods, its meaning and its possible uses in practice.

(continued in part 3 )