CHAPTER – 4

RECEIVABLES MANAGEMENT

Accounts Receivables constitute a significant portion of total current assets next after inventories.
When a firm sells goods for cash, payments are received immediately and therefore, no
receivables are created. However, when a firm sells goods or services on credit, the payments are
postponed to future dates and receivables are created. Usually credit sales are made on open
account which means that no formal acknowledgements of debt obligations are taken from the
buyers. The only documents evidencing the same are a purchase order, shipping invoice or even a
billing statement. The policy of open account sales facilities business transactions and reduces to
a great extent the paper work required in connection with credit sales.

Meaning of Accounts Receivables:

Receivables are asset accounts representing amount owed to the firm as a result of sale of
goods or services in the ordinary course of business.

Meaning of Accounts Receivables Management:

Management of accounts receivables is defined as “the process of making decisions relating to
the investment of funds in accounts receivables which will result in maximizing the overall
return on investment of the firm.”
Thus, the objective of receivable management is to promote sales and profits until that
point is reached where the return on investment in future funding of receivables is less than the
cost of funds raised to finance that additional credit.
Receivables are a direct result of credit sales. Credit sales are resorted to by a firm to
push up its sales which ultimately result in pushing up its profits earned by the firm. At same
time, selling goods on credit results in blocking funds in accounts receivable. Additional funds
are, therefore, required for the operating needs of the business which involve extra costs in terms
of interest. Moreover increase in receivables also increase changes of bad debts. Thus, creating
of accounts receivables are beneficial as well as dangerous. The financial manager has to follow
a policy which uses cash funds ad economically as possible in extending receivables without
adversely affecting the changes of increasing sales and making more profits.

Objectives of Receivables
Achieving Growth in Sales and Increasing Profits
If a firm sells goods credit, it will generally be in a position to sell more goods than if it insisted
on immediate cash payment. This is because many customer are either not prepared or not in a
position to pay cash when they purchased the goods. The firm can sell goods to such customers
in case it resorts to credit sales. Increase in sales results in higher profit for the firm.
Meeting Competition:
A firm may have to resort to granting of credit facilities to its customers because similar facilities
being granted by the competing firms to avoid the loss of sales from customers who would buy
elsewhere if they did not received expected credit.

Costs of Maintaining Receivables

Capital Costs
Maintance of accounts receivables results in blocking of the firm’s financial resources in them.
This is because there is a time gap between the sales of goods to customers’ and the payment by
them. The firm has therefore to arrange for addition funds to meet its own obligations such as
payment to employees, suppliers of raw materials etc., which waiting for payments from
customers. Additional funds may either be raised from outside or out of profits retained in the
business. In the both cases the firm incurs cost is interest cost.
Administrative Costs
The firm has to incur additional administrative costs for maintaining accounts receivables in the
form of salaries to the staff kept for maintaining accounting records relating to customers, cost of

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conducting investigations regarding potential credit customers to determine their credit worthiness
etc.,
Collection Costs
The firm has to incur costs for collecting the payments from its credit customers. Sometimes,
additional steps may have to be taken to recover money from defaulting customers.
Default Costs
Finally, the firm may not be able to recover the over dues because of the inability of the
customers. Such debts are treated as uncollectible and have to be written off as they cannot be
realized. Such costs are known as default costs associated with credit sales and accounts
receivables.

Benefits of Receivables
Apart from the cots, another factor that has a bearing on accounts receivable management is
“benefit originating” form credit sales. The benefits are the increased sales and anticipated
profits because of a more liberal policy. When firms extend trade credit, that is, invest in
receivables, they intend to increase the sales. The impact of a liberal trade credit policy is likely
to take two forms.
First, it is oriented to sales expansion. In other words, a firm may grant trade credit either to
increase sales to existing customers or attract new customers. This motive for investment in
receivables is growth-oriented.
Secondly, the firm may extend credit to protect its current sales against emerging competitions.
Here, the motive is sales-retention. As a result of increased sales, the profits of the firm will
increase.
From the above, it is clear that investment in receivables involve both benefits and costs.
The extension of trade credit has a major impact on sales, costs and profitability. Other things
being equal, a relatively liberal policy and therefore, higher investment in receivables, will
produce larger sales. However costs will be higher with liberal policies than with more stringent
(rigid) measures. Therefore, accounts receivables management should aim at a trade-off between
profit (benefit) and risk (cost). That is to say, the decision to commit funds to receivables (or the
decision to grant credit) will based on a comparison of the benefits and costs
involved, while determining the optimum level of receivables. The cost and benefits to be
compared are marginal costs and benefits. The firm should only consider the incremental benefits
and costs that result from a change in the receivables or trade credit policy.
Factors Affecting the Size of Receivables
Level of Sales
This is the most important factor in determining the size of accounts receivables. Generally in the
same industry, a firm having in a large volume of sales will be having a large level of receivables
as compared a firm with a small volume of sales.
Credit Policies
The term credit policy refers to those decisions variables that influence the amount of trade credit
i.e., the investment of receivables. These variables include the quality of accounts receivables
trade accounts to be accepted, the length of the credit period to be extended cash discounts to be
given and any special term to be offered depending upon particular circumstances of the firm and
the customers.
A firm’s credit policy, as a matter of fact determines the amount of risk the firm is willing
to undertake in tits sales activities. If a firm has a eminent or relatively liberal credit policy it will
experience a higher level of receivables as compared to a firm with a more rigid credit policy.
Terms of Credit
The size of receivables is also affect by the terms of trade offered by the firm. The two important
components of the credit terms are credit period and cash discount.
Credit Period, in terms of the duration of time for which trade credit is extended – during this
period over due amount must be paid by the customers.
Cash discount, if any, which the customer can take advantage, of that is, the overdue amount will
reduce by this amount.

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Optimum Size (Level) of Receivables

Profitability
Costs & Benefits

Liquidity

0 Rigid Credit Policy Liberal

The Optimum investment in receivables will be at a level where there is a trade-off between costs
(risk) and benefits (profitability). When a firm resorts to a liberal credit policy the profitability of
the firm increases on account of higher sales. However, such a policy results in increased
investment in accounts receivables, increases chance of uncollectible debts and more collection
charges. The total investment in receivables increases and thus the problem of liquidity is
created. On the other hand, a stringent credit policy reduces the profitability but increases the
liquidity of the firm. Thus, Optimum Credit Policy occurs at a point where there is a “Trade-Off”
between liquidity and profitability as shown in the chart above.

Credit Policies - Managing the Accounts Receivables

The success or failure of a business depends primarily on the demand for its products – as a rule,
the higher its sales, the larger its profits and the higher its stock price. Sales, in turn, depend on a
number of factors, some exogenous but others under the firm’s control. The major controllable
determinants of demand are sales prices, product quality, advertising, and a firms’ Credit Policy.
“Credit Policy is a set of decisions that include a firm’s credit period, credit standards,
collection procedures and discounts offered.
Credit Policy, in turn, consists of these four variables:
1. Credit Period, which is the length of time buyers are given to pay for their purchases.
2. Discounts, given for early payment, including the discount percentage and how rapidly
payment must be made to qualify for the discount.
3. Credit Standards, which refer to the required financial strength of acceptable credit
customers.
4. Collection Policy, which is measured by its toughness or laxity (negligence) in attempting to
collection on slow-paying accounts.

Credit Standards
The term credit standard represents the basic criteria for extension credit to customers. Credit
Standard refers to the financial strength and creditworthiness a customer must exhibit in order
to qualify for credit. If a customer does not qualify for the regular credit terms, it can still
purchase from the fir, but the under more restrictive terms. The firm’s credit standards would be
applied to determine which customer qualified for the regular credit terms, and how much credit
each should receive.
The level of sales and receivables are likely to be high if the credit standards are relatively
loose, as compared to a situation when they are relatively tight (rigid or restrictive). The firms
credit standards generally determined by the five “C “s – Character, Capacity, Capital,
Collateral and Conditions.
Character – Character denotes the integrity of the customers i.e., his willingness to pay for the
goods purchased.
Capacity – Capacity denotes high ability to manage business.
Capital – Capital denotes high financial soundness.

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Collateral – Collateral denotes to assets which the customers can offer by way of security
(pledge).
Conditions – Conditions refers to the impact of general economic trends on the firm or to special
development in certain areas of economy that may affect the customer’s ability to meet his
obligations.
Although a great deal of credit information is available, it must still be processed in a judgment
manner. Computerized information systems can assist in making better credit decisions.
Table – 1 – Effect of Relaxation of Credit Standards
Items Direction of Change Effect on Profits
Sales Volume Increase Increase (Positive)
Average Collection period Increase Decrease (Negative
Uncollectible Expenses Increase Decrease (Negative
The effect of Tighten Credit Standards is likely to have an opposite effect.
Case Study 1:
A firm is considering pushing up its sales extending credit facilities to the following categories of
customers (A) Customers with a 10% risk of non-payment and (B) Customers with a 30% risk of
non-payment. The incremental sales expected in the case of categories (A) Br. 40,000 while (B)
Br. 50,000. The cost of production and selling costs are 60% of sales while the collection costs
amount to 5% of sales in case of category (A) and 10% of sales in case of Category (B). You are
required to advise the firm about the extending credit facilities to each of the above categories of
customers.
[Hint: Incremental Sales – Collection costs = Net Sales Realized – Production and Selling
Costs = Incremental Income]

Case Study 2:
A firm is currently selling a product at Br. 10 per unit. The most recent annual sales (all credit)
were 30,000 units. The variable cost per unit is Br. 6 and the average cost per unit, given sales
volume of 30,000 units, is Br. 8. The total fixed cost is Br. 60,000. The average collection period
may be assumed to be 30 days.
The firm is contemplating a relaxation of credit standards that expected to result in a 15%
increase in units’ sales; the average collection period would increase to 45 days with not change
in uncollectible expenses. It is also expected that increased sales will result in additional
networking capital to the extent of Br. 10,000. The increase in collection expense may be assume
dot be negligible. The required return on investment is 15%.
Required: Should the firm relax the credit standard? What should be the Accounts receivable
turnover, Total Cost of Sales, Average investment in accounts receivables, the cost of marginal
investments in accounts receivable, and the Cost of Working capital in Present and Proposed
plans?

Credit Terms
The second decision area in accounts receivable management is the credit terms. After the credit
standards have been established and the credit-worthiness of the customers has been assessed, the
management of a firm must determine the terms and conditions on which trade credit will be
made available. The stipulations under which goods are sold on credit are referred to as a
credit terms. These relate to the repayment of the amount under the credit sale. Thus, credit
terms specify the repayment terms of receivables.
Credit terms have three components:
A. Credit Period, in terms of the duration of time for which trade credit is extended – during this
period over due amount must be paid by the customers.
B. Cash Discount, if any, which the customer can take advantage, of that is, the overdue amount
will reduce by this amount.
C. Cash Discount Period, which refers to the duration during which the discount can be availed
of. These terms are usually written abbreviations, for instance, 2/10, n/30.

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The credit terms, like credit standards, affect the profitability as well as the cost of a firm. A firm
should determine the credit terms on the basis of cost-benefit trade-off.

Table – 2 – Effect of Increase in Cash Discounts

Items Direction of Change Effect on Profits
Sales Volume Increases Increases (Positive)
Average Collection period Decreases Increases (Positive)
Uncollectible Expenses Decreases Increases (Positive)
Profit Per Unit Decreases Decreases (Negative)
Decease in Cash Discount is likely to have an opposite effect.
Table – 3 – Effect of Increase in Cash Period
Items Direction of Change Effect on Profits
Sales Volume Increases Increases (Positive)
Average Collection period Increases Decreases (Negative)
Uncollectible Expenses Increases Decreases (Negative)
A reduction in the credit period is likely to have an opposite effect.

Case Study 3:
Assume that the firm in our Case Study - 2 is contemplating to allow 2% cash discount for
payment within 10 days after a credit purchase. It is expected that if discounts are offered, sales
will increase by 15% and the average collection period will drop to 15 days. Assume
uncollectible expenses will not be affected; return on investment expected by the firm is 15%;
60% of the total sales will be on discount. Should the firm implement the proposal?

Case Study 4:
Suppose, a firm is contemplating an increase in the credit period from 30 to 60 days, the average
collection period which is at present 45 days is expected to increase to 75 days. It is also likely
that the uncollectible expenses will increase from the current level of 1% to 3% of sales. Total
credit sales re expected to increase from the level of 30,000 units to 34,500 units. The present
average cost per unit is Br. 8, the variable cost and sales per unit are Br. 6 and Br. 10 per unit
respectively. Assume the firm expects a rate of return of 15%. Should the firm extend the credit
period?

Collection Policies
Collection policies refers to the procedures the firm follows to collect past-due accounts. For
example, a letter might be sent to customers when a bill is 10 days past due; a more severe letter,
followed by a telephone call, would be sent if payment is not received within 30 days; and the
account would be turned over to a collection agency after 90 days.
The collection process can be expensive in terms of both out-of-pocket expenditures and
lost goodwill- customers dislike being turned over a collection agency. However, at least some
firmness is needed to prevent an undue lengthening of the collection period and to minimize
outright losses. A balance must be struck between the costs and benefits of different collection
policies.
Changes in collection policy influence sales, the collection period, and the uncollectible
loss percentage. All of this should be taken into account when setting a credit policy.

Table – 4 – Effect of Tight (Rigid) Collection Policies

Items Direction of Change Effect on Profits
Sales Volume Decrease Decreases (Negative)
Average Collection period Decrease Increase (Positive)
Uncollectible Expenses Decrease Increase (Positive)

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Collection Expenditure Increase Decrease (Negative)
The effect of lenient Collection Policy will be just the opposite effect.

Case Study 5:
A firm is contemplating stricter collection policies. The following details are available:
1. At present, the firm is selling 36,000 units on credit at a price of Br. 32 each; the variable
cost per unit is Br. 25 per unit the average cost per unit is Br. 29; average collection period is 58
days; and collection expenses amount to Br. 10,000; uncollectible are 3%.
2. If the collections procedures are tighten, additional collection charges amounting to Br.
20,000 would be required, uncollectible expenses will be 1 %; the collection period will be 40
days; sales volume is likely to decline by 500 units.
Assume a 20% rate of return on investment, what would be your recommendation? Should the
firm implement the decision?

Case Study 6:
Super sports dealing in spots goods, has an annual sale of Br. 5,000,000 and currently extending
30 days credit to the dealers. It is felt that sales can pick up considerably if the dealers are willing
to carry increased stocks, but the dealers have difficulty in financing their inventory. The firm is
therefore, considering shifts in credit policy. The following information is available:
The average collection period now is 30 days
Variable Costs 80% of sales
Fixed Costs Br. 600,000 per annum
Required rate of return on investment 20%
Credit Policy Average Collection Period Annual Sales (In Br.)
A 45 days Br. 5,600,000
B 60 days Br. 6,000,000
C 75 days Br. 6,200,000
D 90 days Br. 6,300,000
Determine which policy the company should adopt.

Case Study 7:
In order to increase sales from the normal level of Br. 240,000 per annum, the marketing
manager submits a proposal for liberalizing credit policy as under: Normal sales Br.
240,000; Normal credit period 30 days.
Proposed Increase in credit period beyond Increase in normal sales
normal 30 days
15 Br. 12,000
30 Br. 18,000
45 Br. 21,000
60 Br. 24,000
The contribution is 1/3rd of sales. The company expects a rate return of f20% on investment.
Evaluate the above alternatives and advise the management (assume 360 days a year)

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Case Study -8:
Star Limited, manufacturers of color TV sets, are considering the liberalization of existing credit
terms to three of their large customers. The credit period and likely quantity of TV sets that will
be lifted by the customers are as follows:

Credit Period Quantity lifted

A B C
0 Days 1,000 1,000 ---
30 days 1,000 1,500 ---
60 days 1,000 2,000 1,000
90 days 1,000 2,500 1,500
The selling price per TV set is Br. 9,000. The expected contribution is 20% of the selling price.
The cost of carrying accounts receivables averages 20% per annum.
You are required:k8
(A) To determined the credit period to allowed to each customer (Assume 360 days in a year)
(B) What other problems the company might face in allowing the credit period as determined
in (A) above?