Receivables Management

Prof. Prapti Paul

Introduction
• The receivables (including the debtors and the bills) is an asset to the firm as it represents a claim of the firm against its customers, expected to be realized in near future. Since credit sales assumes a sizeable proportion of total sales in any firm, the receivable management becomes an area of attention. • Every firm has a set of credit terms and policies under which goods are sold on credit, and every policy has a cost and benefit associated with it. • A careful analysis of various aspects of the credit policy is required. This is known as Receivables Management (RM). The term RM maybe defined as collection of steps and procedure required to properly weigh the costs and benefits attached with the credit policies. • The RM consists of matching the cost of increasing sales (particularly credit sales) with the benefits arising out of increased sales with the objective of maximizing the return on investment for the firm.

Costs and benefits of receivables
Costs: Cost of financing Administrative cost Delinquency cost Benefits: Increase in sales Increase in profits Extra profit

Cost of default by customers

If a firm takes its credit policy towards making more and more liberal, its liquidity decreases whereas profitability increases. On the other hand, if the firm makes its credit policy more and more stringent, the liquidity may increase but the profitability will go down. This is referred to as Tradeoff In Receivables. The firm should try to frame its credit policy in such a way as to attain the best possible combination of profitability and liquidity.

• RM must be attempted by adopting a systematic approach and considering the following aspects of receivables management: 1) The Credit Policy 2) The Credit Evaluation 3) The Credit Control. • CREDIT POLICY: defined as set of parameters and principles that govern the extension of credit to the customers. This requires the determination of (i) the credit standard, and (ii) the credit terms . i. The credit standards: the conditions that the customer must meet before being granted credit . The credit standard will help set the level which must be satisfied by a customer before being selected for making credit sales. However even after selecting the customers, all of them need not be necessarily be offered same terms and conditions. The credit policy also should set out clearly the terms of credit being offered to different types of customers.

ii. Credit terms: refers to the set of stipulations under which the credit is extended to the customers. While the custom of the market frequently dictate the nature of the credit terms and conditions offered by the firm, the firm can design its own credit terms as dynamic instruments in its overall sales efforts. The credit terms specify how the credit will be offered, including the length of the period for which the credit will be offered, interest rate on credit and the cost of default. The credit terms may relate to the following:  Credit period: length of time over which the customers are allowed to delay the payment. It generally varies from 3 days to 60 days. In some cases credit period may be zero and only cash sales are made.  Discount terms: the customers are generally offered cash discount to induce them to make prompt payments. Both the discount rate and the period within which it is available are reflected in the credit terms., e.g. 3/10, 2/20, net 30 means that 3% cash discount if payment made within 10 days; 2% cash discount if payment made within 20 days; otherwise full payment by the end of 30 days from the date of sale.

• There is always a cost of cash discount. If a firm has an average collection period of 40 days, and in order to reduce the avg. collection period, it offers a cash discount of 3% if payment is made in 10 days. A customer having a balance of Rs.100 who was paying in 40 days now avails the discount of 3% and pays Rs.97 on the 10th day. So the firm will be receiving Rs.97 for a period of 30 days (i.e. 4010) and the cost is Rs.3. The annual cost of this discount maybe calculated as follows: Annual financing cost = discount 365 100 100- disc credit period- disc period = Rs.3 365 100 = 37.6% 97 30 • So the annual cost of offering cash discount is 37.6%. This maybe compared with the cost of financing from other sources to decide whether to offer discount to the customers or not.

• CREDIT EVALUATION: involves determination of the type of customers who are going to qualify for the trade credit. Several costs are associated with extending credit to less credit worthy customers. As the probability of default increases, it becomes more important to identify which of the possible new customers would be risky. When more time is spent investigating the less credit worthy customers, the cost of credit investigation increases. Default costs also vary directly with the quality of customers. • Assessment of credit worthiness of a customer is subjective matter and a lot depends upon the experience and judgement of the person taking the decision. There are 3 basic factors of credit worthiness of a customer: 1) the character i.e. willingness and the practice of the customer to honor his obligations by paying as agreed. 2) the capacity i.e. the financial ability of the customer to pay as agreed. 3)the collateral i.e. the security offered by the customer against the credit. • Evaluation of credit worthiness of a customer is a two step procedure: (i) collection of information ,(ii) analysis of information. 1) Collection of information: (a) bank reference, (b) credit agency report, (c) published information (d) credit scoring. 2) Analysis of information: evaluation on 5 C’s character: character, capacity, capital, collateral and conditions .

• CONTROL OF RECEIVABLES: merely setting of standards and framing a credit policy is not sufficient; equally important is their effective implementation to control the receivables. Efforts may be required in 2 directions: 1) The collection procedure: once a firm decides to extend credit and defines the terms of credit sales, it must develop a policy for dealing with delinquent or slow paying customers. There is a cost of both: delinquent customers create bad debts and other costs associated with repossession of goods, whereas the slow paying customers cause more cash being tied up in receivables and the increased interest cost. The overall collection procedure of the firm should neither be too lenient( resulting in mounting receivables) nor too strict (resulting sometimes even in loss of customers). A strict collection policy can affect the goodwill and damage the growth prospects of the sales. If a firm as a lenient credit policy, the customers with a natural tendency towards slow payment, may become even slower to settle his accounts. Thus the objective of collection procedure and policies should be to speed up the slow paying customer and reduce the incidence of bad debts.

2) Monitoring of receivables: in order to control the level of receivables, the firm should apply regular checks and there should be a continuous monitoring system. The financial managers should keep a watch on the credit worthiness of all the individual customers as well as on the total credit policy of the firm. For this no. of measures are available as follows: i. By calculating Average Collection period = avg. receivables/ credit sales per day ii. Aging schedule: the quality of the receivables of a firm can be measured by looking at the age of receivables. The older the receivable, the lower is the quality and greater the likelihood of a default. In an ageing schedule, the total outstanding receivables on a particular days (at the end of a month or a year) are classified into different age groups (age being no. of days since becoming outstanding) together with percentage of total receivables that fall in each age group. Ex: the receivables of a firm, having a normal credit period of 30 days, maybe classified as follows:
Age group (no. of days) Less than 30 days % of total outstanding receivables 60%

31-45 days
46-60 days 61 and above

20%
10% 10%

• A firm has a credit period of 30 days and 60% of the total receivables are less than 30 days old. 20% of the receivables are over due by 15 days, 10% are over due by 30 days and 10% are over due by more than 30 days. This type of aging schedule can provide a kind of an early warning suggestions (i) deterioration of receivables quality and (ii) where to emphasize the appropriate corrective actions. • When compared with the past ageing schedule done by the same firm or done by other comparable firms, this may provide an indication of whether the firm should start worrying about its collection procedure. However a basic shortcoming of the ageing schedule is that it is influenced by the change in sales volume. 3) Lines of credit: refers to the maximum amount a particular customer may have as due to the firm at any time. Different lines of credit may be allowed to different customers. As long as the customer’s unpaid balance remains within this maximum limit, the account maybe routinely handled. However if a new order is going to increase the indebtedness of a customer beyond his line of credit, then the case must be taken for an approval for a temporary increase in the line of credit.

4) ACCOUNTING RATIOS: (i) receivable turnover ratio, (ii) average collection period. Both the ratios should be calculated on a continuous basis to monitor the receivables. The ratios calculated for a firm should be compared to the industry averages or with the past ratios of the firm. • Evaluation of credit policies: a firm may face a situation when it has several alternative credit policies before it and has to select one such policy which is most profitable to the firm. Every credit policy will result in a particular sales level. Normally, longer the credit period higher will be the sales, and therefore larger would be the profit of the firm. Does it mean that the firm should go on increasing the credit period.??? No. • There is no doubt that increase in sales will increase the contribution (SalesVariable cost). But simultaneously the firm will face the risk of increase in other costs also. There costs maybe: a) Increase in investment in debtors b) Increase in bad debts c) Other costs • The firm should select that proposal which is expected to give highest net profit ( benefits- costs). This comparison of costs and benefits maybe attempted as: (i) Total profit under different proposals (ii) Incremental profit under different proposals.

• Illustration 1:
A co. has prepared the foll projections for a year: Sales 21,000 units Selling price p.u Rs.40 Variable cost p.u Rs. 25 Total cost p.u Rs.35 Credit period allowed One month The co. proposes to increase the credit period allowed to its customers from one month to two months. It is envisaged that the change in the policy as above will increase the sales by 8%. The co. desires a return of 25% on its investment. You are required to examine and advice whether the proposed credit policy should be implemented or not.

• Solution 1:
Evaluation of credit policy: Present Sales (units) Contribution per unit Total contribution Variable cost @Rs.25 Fixed cost Total cost Credit period Avg. debtors at cost 21,000 Rs.15 Rs.3,15,000 Rs.5,25,000 2,10,000 7,35,000 1 month Rs.61,250 Proposed 22,680 Rs.15 Rs.3,40,200 Rs.5,67,000 2,10,000 7,77,000 2 months Rs.1,29,500 100 Incremental 1,680 Rs.15 Rs.25,200 Rs.42,000 42,000 Rs.68,250

Incremental return = increased contribution extra funds blocked

= 25,200 100 = 36.92% 42,000 The return due to change in credit policy is 36.92% which is more than 25% as desired hence proposal shd be accepted.

• Illustration 2:
Super sports co. dealing in sports goods, have an annual sale of Rs.50,00,000 and are currently extending 30 days credit to the dealers. It is felt that the sales can pick up considerably if the dealers are willing to carry increased stock, but the dealers have difficulty in financing their inventory. Super sports co. is considering a shift in its credit policy. The foll info is available : Avg. collection period now is 30 days. Costs: variable costs 80 % of sales fixed cost Rs. 6 lacs per annum. Required pre tax return on investment =20% Credit policy A B C Avg. collection period 45 days 60 days 75 days Annual sales (Rs. In lacs) 56 60 62

D 90 days 63 Determine which policy should be adopted by the co. on the basis of (1) total profit, and (2) incremental profit.

• Solution 2:
Sales V.Cost@80% Fixed cost Total cost Profit (A) Credit period Avg. debtors at cost (cost/360)* credit period

Evaluation of credit policies (total profit)
Present A B C D 50,00,000 56,00,000 60,00,000 62,00,000 63,00,000 40,00,000 44,80,000 48,00,000 49,60,000 50,40,000 6,00,000 4,00,000 30 days 6,00,000 5,20,000 45 days 6,00,000 6,00,000 60 days 6,00,000 6,40,000 75 days 6,00,000 56,40,000 6,60,000 90 days 46,00,000 50,80,000 54,00,000 55,60,000

3,83,333

6,35,000

9,00,000

11,58,333

14,10,000

Cost of investment in debtors @20% (B) 76,667 Net profit (A-B) 3,23,333

1,27,000 3,93,000

1,80,000 4,20,000

2,31,667 4,08,333

2,82,000 3,78,000

• The firm may adopt Policy B as its giving the highest profit of Rs.4,20,000.

Evaluation of credit policies ( incremental profit) Present Sales Incremental sales Incr. V.cost Incr.Profit (A) T. Cost Avg. debtors at cost Incr. debtors Required return @20%(B) Net Incr. benefits(A-B) 6,00,000 4,80,000 1,20,000 10,00,000 8,00,000 2,00,000 12,00,000 9,60,000 2,40,000 13,00,000 10,40,000 2,60,000 56,40,000 14,10,000 10,26,667 2,05,334.4 54,667 A B C D 50,00,000 56,00,000 60,00,000 62,00,000 63,00,000

46,00,000 50,80,000 54,00,000 55,60,000 3,83,333 6,35,000 2,51,777 50,333 69,667 9,00,000 5,16,667 1,03,333 96,667 11,58,333 7,75,000 1,55,000 85,000

• The firm should select Policy B in this case as it gives the highest incremental profit of Rs.96,667.

• Question: A trader whose current sales are Rs.15 lakhs per annum and average collection period is 30 days wants to pursue a more liberal credit policy to improve sales. A study made by a consultant firm reveals the following information: Credit policy Increase in collection period 15 days 30 days 45 days 60 days Increase in sales Rs. 60000 90000 150000 180000

A B C D

E 90 days 200000 • The selling price per unit is Rs.5. Average cost per unit is Rs.4 and variable cost per unit is Rs.2.75 paise per unit. The required rate of return on additional investments is 20 per cent. Assume 360 days a year and also assume that there are no bad debts. Which of the above policies would you recommend for adoption?

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