Question

Zhou Enterprises has approximately $10m of accounts receivable. Because of the pandemic, Zhou is in need of cash to help keep the business operating.

Required:

1. Briefly describe some ways that Zhou could use its accounts receivable to obtain cash faster than it would by waiting to collect all of the receivable amounts from customers.

2. Suppose Zhou successfully arranges with Sarmatina Financial Corp to transfer half of their receivables in exchange for approximately $5m in cash. Why might Zhou prefer to structure (for accounting/reporting purposes) the exchange as a sale vs. as a secured borrowing? Be specific about the differential effects on the income statement, balance sheet, and/or some key financial ratios.

3. What key aspects of the arrangement would Zhou need to consider in deciding whether to appropriately account for the arrangement as a sale or as a secured borrowing?

Answer 1

Given:

• Zhou Entreprises has Accounts Recievables = $10m
• Accounts Receivables increased due to - Pandemic (World-wide situation)
• Option to Exchange Receivables to cash with Samartina FInancial Corp = $5m (half of receivables).

Required:

• Ways to materialise Accounts Receivables as fast as possible.
• Why prefer exchange as a sale over borrowing?
• Effect on Financial Statements and ratios.
• Key aspects of arrangement that will help in decision making.

Answer:

Zhou Entreprises is in need of cash that may help in maintaining the Working Capital or other payments. Accounts Receivables have increased due to global pandemic. It is clear that, Zhou Entreprises may be doing good otherwise. It is due to pandemic it has done less business and is suffering from no-cash status. Therefore, there is clear understanding that entreprise's efficiency and operating ratio is higer.  

Accounts Receivables are the money owed by clients to the business. Proper management of A/R is necessary to avoid bad-debts. There are various ways to materialise Accounts Receivables when they are stuck into market.

Following are the ways:

• Factoring: Factoring is one such financial service in the market which deals with debtor fianance. Factoring is mainly done at a discount and within a country.
• Forfaiting: Forfaiting is another example of debt finance that deals with international business.
• Bank Loan: Bank loan will give immediate cash to the busiess. But it has certain limitations. One, bank loans are always secured with business assets. Second, higher interest rate. Third, bank loan is not easy to avail as they involve greater documentation.

Why prefer exchange as a sale over borrowing?

From above three, first one - factoring is as good as selling the accounts receivables at discount to another business which gives cash immediately. This is best way to save time and effort. This also saves the assets falling into mortgage.

Thus, exchange of accounts recievables is better than borrowing loan by securing assets. Following three are reasons:

• Saves time and effort to collect receivables.
• Business assets are not mortgaged i.e., 100% ownership is retained.
• Cash availability is certain and fast.
• Not much documentation and compliance costs are involved.
• Certainly, discount amount is lesser than interest charged by banks/ financial institutions.
• Risk is avoided. Interest rate is usually connected with markets. Rate hike will affect entreprise.

Effect on Financial Statements and ratios:

Status when accounts receivables are more following are the effects on Financial Statements:

• Income Statement: Profit is shown higher. This is because, sales are higher but cash sales are lower. There is no clear effect on sales. But, when cash is unavailable, payments are less made and thus, Non-operating expenses reduce substantially. Salary, Rent, Premiums etc. are paid less. This increases the balancing figure - 'Profit' which is shown in Balance Sheet.
• Balance Sheet: Profits are shown higher as stated above. This is added in shareholder's income that includes Credit Sales as well. Also, Cash is shown less on assets side. This imbalance is balanced by 'Debtors' in Balance Sheet. Overall picture is clear - Accounts Receivables is shown higher. Accounts receivables is shown on assets side in Balance sheet and on the other side similar dollar value is adjusted with the liabilities. Cash flow is affected negatively.

Key Financial Ratios:

• Debt-to-Assets Ratio: Most often, investors see this ratio. This ratio speaks about the firm's ability to save the assets from pushing into debts.
• Accounts Receivables Turnover Ratio: This ratio speaks how quickly the entreprise convert receivables into cash. Higher is better. If the Accounts receivables are higher, the ratio result will be lower. This ratio shows how how many times the receivables are collected in an accounting period.
• All cash related ratios will be affected negatively as there is no or less cash left in the entreprise.

Key aspects of arrangement that will help in decision making:

Zhou must consider following aspects while deciding whether to go for Receivables sales or borrowing cash:

• Short-term or Long Term: Zhou has to see if there is a need of cash in short term or long term. For short term or very short term requirements, borrowing is better as it involes less risk and less interest rate. Also, discountin (in factoring) amount can be saved. For long-term requirement, better to sell the accounts recevables.
• Duration of Receivables: If the receivables are pending since long, it is better to sell them off.
• Availability of other options: If there are other options to get cash, it is always suggested to go for it. This will reduce the loss caused due to discounting.

Thumbs-up if this answer helps!

Feel free to comment below if more clarification or explanation is required.

All the best !!