Ch 28: Accounts Receivable Management & Factoring

CHAPTER 28

ACCOUNTS RECEIVABLE MANAGEMENT

AND FACTORING

Problem 1

Current Policy Policy Policy

policy X Y Z
A. Credit period 25 40 50 60
B. Annual sales (Rs lakh) 3,000 3,012 3,027 3,047
C. Inc. sales (Rs lakh), [B - 3,000] - 12 27 47
D. Cost of sales (Rs lakh), [B/10 x 8+600] 2,400 2,407 2,416 2,428
E. Receivable invst. at cost (Rs cr), [D/360 x A] 167 267 336 405
F. Inc. receivable invst. at cost (Rs cr), [E - 167] - 101 169 238
G. Inc. contribution (Rs lakh), [B x (10-6)/10] - 4.8 10.8 18.8
H. Expected rate of return (%), [G/F] - 4.8% 6.4% 7.9%
I. Required rate of return (%) - 12% 12% 12%
Note: Cost of sales includes variable cost plus fixed cost.
None of the new policies is desirable since the required rate of return is higher than the expected rate of
return.

Cost calculations:
Average cost (Rs) 8
Unit variable cost (Rs) 6
Price (Rs) 10
Total cost of sales (Rs lakh) 2,400
Total variable cost (Rs lakh) 1,800
Total fixed cost (Rs lakh) 600

Problem 2

Current sales (Rs cr) 300

Current level of receivable (Rs cr) 30
Bad debts losses (%) 3%
Incremental cost(%) 80%
Current collection period (days) (30/300) x 36
360
New collection period (days) 36 + 30 66
New levels of sales (Rs cr) 360
New levels of receivable (Rs cr) (360/360) x 66
66
Incremental receivable invst. (Rs cr) 66 - 30 36
Contribution from addl. sales (Rs cr) 60 x 0.20 12
Bad debts on addl. sales (Rs cr) 60 x 0.03 1.8
Net contribution (Rs cr) 12 - 1.8 10.2
Rate of return (%) 10.2/(66-30) 28.3%
Required rate of return (%) 15%
Net surplus return (%) 28.3% - 13.3%
15.0%
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 3

Policy Policy Policy Policy

A B C D
A. Collection period (days) 40 45 55 70
B. Incremental sales (Rs) 300,000 400,000 500,000 600,000
C. Inc. invst. in receivable (Rs cr), [D x 0.20] 33,333 50,000 76,389 116,667
D. Inc. contribution (Rs cr), [D x (1 - 0.85)] x (1 - .35) 29,250 39,000 48,750 58,500
E. Expected return (%), D/E 88% 78% 64% 50%
F. Required rate of return (%) 20% 25% 32% 40%
Assuming that there are no other costs (bad debt, collection charges etc.) involved, the company will benefit if it
liberalises credit period to 70 days.

Problem 4

Current Policy Policy Policy Policy

policy 1 2 3 4
A. Credit period (days) 30 45 60 75 90
B. Annual sales (Rs cr) 60 64 64.5 65.3 66.5
C. Cost of sales (Rs cr), [B x 0.8 + 6] 54.00 57.20 57.60 58.24 59.20
D. Inc. sales (Rs cr), [C - 54] 4 4.5 5.3 6.5
E. Level of receivable (Rs cr), [C/360 x A] 4.50 7.15 9.60 12.13 14.80
F. Inc. receivable invst. (Rs cr), [E - 4.50] 2.65 5.10 7.63 10.30
G. Inc. contribution (Rs cr), [D x 0.20] 0.80 0.90 1.06 1.30
H. Bad-debt loss (%) 1.5% 1.5% 1.7% 2.0% 2.5%
I. Bad-debt loss (Rs cr), [D x H] 0.06 0.08 0.11 0.16
J. Inc. expected profit (Rs cr), [G - I] 0.74 0.82 0.95 1.14
K. Expected return (%), [J/F] 27.9% 16.1% 12.5% 11.0%
L. Required rate of return (%) 18% 18% 18% 18%
The firm should shift to credit policy 1. Other policies are not desirable since the expected rates are lower than the
required rates of return.

Cost calculation:
Sales (Rs cr) 60
Total cost (Rs cr), [0.90 x 60] 54
Variable cost (Rs cr), [0.80 x 60] 48
Fixed cost (Rs cr), [54 - 48] 6

Problem 5

Required rate of return (%) 15

Credit sales (Rs cr) 120
Current collection period (days) 60
Current level of receivable (Rs cr),[120/360x60] 20
New collection period (days) 40
New level of receivable (Rs cr), [120/360x40] 13.33
Discount rate (%) 0.02
Cost of cash discount (Rs cr), [120 x 0.6 x 0.02] -1.44
Decrease in receivable invst. (Rs cr),[13.33-20] -6.67
Expected return (%), [-1.44/-6.67] 21.6%
Required rate of return (%) 15.0%
Net gain (%) 6.6%
Ch 28: Accounts Receivable Management & Factoring

Problem 6

(Rs)
A. Current sales 7,200,000
B. New credit period 45
C. New collection period 45
D. Bad-debt losses 3%
E. Increased sales 360,000
F. Variable cost 70%
G. Tax rate 35%
H. Required rate of return 15%

I. Incremental sales 360,000

J. Contribution from incr. sales, I × (1 - 0.70) 108,000
K. Bad-debt losses on incr. sales (I × D) 10,800
L. Profit before tax, J - K 97,200
M. Less: tax, L × G 34,020
N. Profit after tax, L - M 63,180
O. Incr. receivable investment (at selling price) 345,000
P. Expected return, N/O 18.3%
Q. Net gain (%), P - H 3.3%

Incremental investment in receivable includes 15 days increase collection period for existing sales.
Investment in receivables = 7,200,000 × (45-30)/360 + 360,000 × 45/360 = Rs 345,000.

Problem 7

(Rs)
Current sales 720,000
Increase in sales 20,000
New level of sales 740,000
Current collection period (days) 30
Current level of receivables 60,000
New level of receivables 41,111
Cash discount 2%
Discount period (days) 10
Percentage customers taking discount 50%
Bad debt losses 2%
Variable cost 70%
Corporate tax rate 50%
Opportunity cost of capital 10%

A. Increased sales 20,000

B. Contribution from increased sales, A × (1-0.70) 6,000
C. Bad debt loss, A × 2% 400
D. Cost of cash discount: 740,000 × 0.02 ×0.5 7400
E. After-tax profit, (B - C -D)×(1-0.5) -900
F. Decrease receivable investment, 41,111 - 60,000 -18,889
G. Expected return, E/F 4.8%
H. Net gain %, 10% -G 5.2%
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

The investment in receivables is the difference between new level of receivables and the current level of receivables.
Since the average collection period for 50 per cent sales is 10 days and for remaining 50 per cent 30 days, the new level
of receivables is calculated as follows:
New level of receivables = 740,000 × 0.50 × 10/360 + 740,000 × 0.50 ×30/360 = Rs 41,111
Decrease in receivables investment = 41,111 – 60, 000 = - Rs 18,889
In decline in after-tax profit is –Rs 900 which translates to 4.8 per cent loss of return while the company can earn 10
per cent on its investment. Hence, there is a gain of 5.2 per cent, or -900 – 0.10 × -18,889 = + Rs 989.

Problem 8

(Rs crore)
Good Slow-
paying
Total accounts accounts
A. Sales 22.00 17.60 4.40
B. Variable costs:
a. Cost of goods sold, [0.85xA] 18.70 14.96 3.74
b. Selling, [0.026xA] 0.57 0.46 0.11
c. Administration, [0.016xA] 0.35 0.28 0.07
d. Warehousing, [0.014xA] 0.31 0.25 0.06
e. Bad debts. [0.004x22] 0.09 0.09
f. Collection charges, [0.002x22] 0.04 0.04
C. Total variable costs, [a +b + c + d + e +f] 20.06 15.95 4.12
D. Contribution, [A-C] 1.94 1.65 0.28
E. Fixed costs:
g. Selling, [0.02x22] 0.44 0.44
h. Administration, [0.008x22] 0.18 0.18
i. Warehousing, [0.01x22] 0.22 0.22
F. Total fixed costs, [g + h + i] 0.84 0.84
G. Profit before tax, [D-F] 1.10 0.82 0.28
H. Pre-tax profit margin (%), [G/A] 5.0% 4.7% 6.4%

Consequences of not selling to slow-paying customers:

Lost contribution (excluding bad debts and
collection charges), [4.4 x 0.094] 0.41
Less bad debt and collection charges avoided 0.13
Net loss 0.28
Decrease in receivable investment 0.885
Expected return (%) 31.8%

If the company does not sell to slow-paying customers, it shall avoid the outstanding receivable balance of Rs 0.885
crore (Rs 88.5 lakh).
Ch 28: Accounts Receivable Management & Factoring

Problem 9

Current Alternate Alternate

policy policy 1 policy 2
A. Sales (Rs cr) 60 60 60
B. Collection period (CP) 45 20 14
C. Percentage taking discount 60% 80% 95%
D. Discount rate (%) 1% 2% 3%
E. Default percentage 0.50% 1% 1.50%
F. Cost of discount (Rs cr), [A x C x D] 0.36 0.96 1.71
G. Cost of default (Rs cr), [A x C x E] 0.18 0.48 0.86
H. Total loss (Rs cr), [F + G] 0.54 1.44 2.57
I. Incremental loss, [H - 0.54] - 0.90 2.03
J. Receivable invst. (Rs cr), [(A/360) x B] 7.50 3.33 2.33
K. Inc. receivable invst. (Rs cr), [J - 7.50] - 4.17 5.17
L. Expected return (%), [I/J] - 21.6% 39.2%
M. Required rate of return (%) 18% 18% 18%

Problem 10

Annual sales (Rs cr) 200

Credit sales, 80% (Rs cr) 160
Average collection period (days) 80
Level of receivable (Rs cr): (160/360) x 80 35.56
Factoring commission (Rs cr): 1.75% x 35.56 0.62
Reserve (Rs): 10% x 35.56 3.56
Available advance (Rs cr): 35.56 - 3.56- 0.62 31.38
Upfront interest on advance (Rs cr): (16.5% x 1.15
31.38)/360/80
Net available advance (Rs cr): 31.38 - 1.15 30.23

Annual cost of factoring:

Commission: 0.62 x (360/80) 2.80
Interest on advance: 1.15 x (360/80) 5.18
Total 7.98
Savings from factoring (Rs cr):
Bad debt avoided: 0.9% x 160 1.44
Cost of administration avoided 0.20
Total 1.64
Net cost of factoring 6.34
Effective cost of factoring: 6.34/30.23 (%) 21.0%
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASES

Case 28.1: Relax Pharmaceutical Limited

The case can be used to answer the following questions: (1) How to determine the investment in receivable? Increment
investment in receivable means additional investment (on new and current sales) caused by a change in the credit
policy. This investment may be measured in terms of selling price or cost – just the variable cost or total cost (including
both variable and fixed). (2) What are ‘marginal accounts’? What is their cost and contribution? Generally fixed costs
will not change whether a firm sells or does not sell to marginal accounts because all fixed costs are expected to be
recovered from sales to ‘good accounts’. Relaxing credit terms may increase sales to marginal accounts. There will be
trade-off between the increased revenue and the increased cost. (3) What does a credit policy involve? How does
change in a credit policy affect a firm’s sales revenue and profitability? (4) How can debtors (or receivable be
monitored)? Collection period or aging schedule will not be useful when sales show periodic fluctuations. In this
situation ‘collection experience matrix’ is an appropriate approach.
This case helps to explain most of issues with regard to a firm’s credit policy. The calculations are shown below.

Current Situation
Credit Cash Total
Sales to good customers (Rs million) 900 120 1,020
Sales to marginal customers (Rs million) 180 0 180
Current sales (Rs million) 1,080 120 1,200

Average collection period - good cusomers (days) 60

Average collection period - marginal cusomers (days) 70
Credit sales per day - good customers (Rs million) 900/360 2.5
Investment in receivables- good customers (Rs million) 2.5 × 60 150
Credit sales per day - marginal cuistomers (Rs million) 180/360 0.5
Investment in receivables - marginal customers (Rs million) 0.5 × 70 35
Total investment in receivables at selling price (Rs million) 185

Contribution from marginal accounts

Avoidable variable cost (excluding 1/4th collection costs of good
customers) 86.97%
Contribution ratio 13.03%
Contribution loss from marginal customers (Rs million) 180 x 13.03% 23.45
Tax (35% rate assumed) 8.21
After-tax contribution loss (Rs million) 15.25
Investment in receivables - marginal customers (Rs million) 35
Rate of return 43.6%
Required rate of return 15%
Marginal accounts are proftable. They should continue.

Proposed policy (without cash discount)

Credit period (days) 70
New sales (Rs million) 1,440

Credit Cash Total

Incremental sales to good customers 60 0 60
Incremental sales to marginal customers (Rs million) 180 0 180
Incremental sales (Rs million) 240 0 240
Average collection period - good cusomers (days) 75
Average collection period - marginal cusomers (days) 90
Ch 28: Accounts Receivable Management & Factoring

Bad-debt losses from sale to marginal customers 0.0550

Collection costs (marginal accounts) 0.0009

Collection charges (marginal accounts) (Rs million) 0.05

Contribution ratio 13.03%

Contribution from incremntal sales (rs million) 31.27
Incremental bad-debt losses and collection costs (Rs million) 10.11
Net contribution (Rs million) 21.16
After-tax contribution (Rs million) 13.75

Investment in receivables- good customers (Rs million) (900 + 60)/360*75 200

Investment in receivables - marginal customers (Rs million) (180 + 180)/360*90 90
Total investment in receivables (Rs million) 290
Rate of return 4.7%
Required rate of return 15%
It's not desirable to change the credit terms.

Proposed policy (with cash discount)

Credit period (days) 70
New sales (Rs million) 1,440

Credit Cash Total

Incremental sales to good customers 60 0 60
Incremental sales to marginal customers (Rs million) 180 0 180
Incremental sales (Rs million) 240 0 240
Cash discount 2%
Sales to customers availing cash discount (Rs million) (900 + 60)*0.3 288
Cash discount (Rs million) 5.76

Average collection period - good customers (days) 75

Average collection period - marginal customers (days) 90

Bad-debt losses from sale to marginal customers 0.0550

Collection costs (marginal accounts) 0.0009

Collection charges (marginal accounts) (Rs million) 0.05

Contribution ratio 13.03%

Contribution from incremental sales (Rs million) 31.27
Incremental bad-debt losses and collection costs (Rs million) 10.11
Incremental cash discount (Rs million) 5.76
Net contribution (Rs million) 15.40
After-tax contribution (Rs million) 10.01
I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Investment in receivables- good customers (Rs million) 0.3*(900 + 60)/360*75 164

Investment in receivables - marginal customers (Rs million) (180 + 180)/360*90 90
Total investment in receivables (Rs million) 254
Rate of return 3.9%
Required rate of return 15%
It's not desirable to change the credit terms.