Receivable

management

The objectives of accounts receivable management

The optimum level of trade credit extended represents a balance between two
factors:
 Profit improvement from sales obtained by allowing credit
 The cost of credit allowed.

Credit control policy

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Management should consider several factors when a policy for credit control
is formulated. These include:

a) The administrative costs of debt collection

b) The procedures for controlling credit to individual customers and for debt
collection
c) The amount of extra capital required to finance an extension of total credit
there might be an increase in accounts receivable, inventories and
accounts payable, and the net increase in working capital must be
financed
d) The cost of the additional finance required for any increase in the volume
of accounts receivable (or the savings from a reduction in accounts
receivable) – this cost might be bank overdraft interest, or the cost of long-
term funds (such as loan inventory or equity)
e) Any savings or additional expenses in operating the credit policy (for
example the extra work involved in pursuing slow payers)
f) The ways in which the credit policy could be implemented

I. Credit could be eased by giving accounts receivable a longer period in

which to settle their accounts – the cost would be the resulting increase
in accounts receivable.
II. A discount could be offered for early payment – the cost would be the
amount of the discounts taken.

A credit policy has four key aspects:

1. Assess creditworthiness.
2. Credit limits.
3. Invoice promptly and collect over due debts.
4. Monitor the credit system.

Assessing creditworthiness
A firm should assess the creditworthiness of:
 All new customers immediately
 Existing customers periodically.

Information may come from:

 Bank references
 Trade references
 Competitors
 Published information
 Credit reference agencies
 Company sales records

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 Credit scoring.

Credit limits
Credit limits should be set to reflect both the:
• Amount of credit available
• Length of time allowed before payment is due.

The ledger account should be monitored to take account of orders in the

pipeline as well as invoiced sales, before further credit is given.

Invoicing and collecting overdue debts

A credit period only begins once an invoice is received so prompt invoicing is
essential. If debts go overdue, the risk of default increases, therefore a system
of follow-up procedures is required.

Techniques for ‘chasing’ overdue debts include the following:

1. Reminder letters
2. Telephone calls
3. Withholding supplies
4. Debt collection agencies
5. Legal action

Monitoring the system

Regular monitoring of accounts receivable is very important. Individual
accounts receivable can be assessed using a customer history analysis
and a credit rating system. The overall level of accounts receivable can be
monitored using an aged accounts receivable listing and credit utilisation
report, as well as reports on the level of bad debts.

Extension of credit
To determine whether it would be profitable to extend the level of total credit,
it is necessary to assess:
• The extra sales that a more generous credit policy would stimulate
• The profitability of the extra sales
• The extra length of the average debt collection period
• The required rate of return on the investment in additional accounts
receivable

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Test your understanding 1
Which of the following would not be a key aspect of a company’s
accounts receivable credit policy?
a) Assessing creditworthiness
b) Checking credit limits
c) Invoicing promptly and collecting overdue debts
d) Delaying payments to obtain a ‘free’ source of finance

Test your understanding 2

Russian Beard Co is considering a change of credit policy, which will result in
an increase in the average collection period from one to two months. The
relaxation in credit is expected to produce an increase in sales in each year
amounting to 25% of the current sales volume.
Selling price per unit $10
Variable cost per unit $8.50
Current annual sales $2,400,000

The required rate of return on investments is 20%. Assume that the 25%
increase in sales would result in additional inventories of $100,000 and
additional accounts payable of $20,000.
Advise the company on whether or not to extend the credit period offered to
customers, if:
a) All customers take the longer credit of two months
b) Existing customers do not change their payment habits, and only new
customers take a full two months' credit

Test your understanding 3

Enticement Co currently expects sales of $50,000 a month. Variable costs of
sales are $40,000 a month (all payable in the month of sale). It is estimated
that if the credit period allowed to accounts receivable were to be increased
from 30 days to 60 days, sales volume would increase by 20%. All customers
would be expected to take advantage of the extended credit. If the cost of
capital is 12.5 % a year, is the extension of the credit period justifiable in
financial terms?

Early settlement discounts

Early settlement discounts may be employed to shorten average credit
periods and to reduce the investment in accounts receivable and therefore
interest costs of the finance invested in trade receivables. The benefit in
interest cost saved should exceed the cost of the discounts allowed.

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Note that the annual cost calculation is always based on the amount left to
pay, i.e. the amount net of discount.

If the cost of offering the discount exceeds the rate of overdraft interest then
the discount should not be offered.

Test your understanding 4

A company is offering a cash discount of 2.5% to receivables if they agree to
pay debts within one month. The usual credit period taken is three months.

What is the effective annualised cost of offering the discount and should
it be offered, if the bank would loan the company at 18% pa?

Test your understanding 5

Paisley Co has sales of $20 million for the previous year, receivables at the
year-end are $4 million and the cost of financing receivables is covered by an
overdraft at the interest rate of 12% pa. It is now considering offering a cash
discount of 2% for payment of debts within 10 days. Should it be introduced if
40% of customers will take up the discount?

Test your understanding 6

Lowe and Price Co has annual credit sales of $12,000,000, and 3 months are
allowed for payment. The company decides to offer a 2% discount for
payments made within 10 days of the invoice being sent, and to reduce the
maximum time allowed for payment to 2 months. It is estimated that 50% of
customers will take the discount. If the company requires a 20% return on
investments, what will be the effect of the discount? Assume that the volume
of sales will be unaffected by the discount.

Test your understanding 7

Melvin Co has a turnover of $900,000 (90% of which is on credit) and

receivable days are currently 42 despite the company only offering 30-days’
credit. Melvin Co finances its receivables using its overdraft, which has an
annual interest cost of 8% and has a contribution margin of 30%.

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Melvin Co is considering the introduction of an early settlement discount at the
same time as extending their standard credit terms to 50 days. The company
would offer customers a 1% discount for payment within 14 days. It is
anticipated that 40% of customers will take the discount, while those that do
not take the discount will keep to the new standard credit terms. As a result of
the extended credit terms, credit sales are expected to rise by 10%. Due to
the extra administration involved it is thought that administration costs will rise
by $10,000 per year.

Required
Evaluate whether or not Melvin Co should offer the discount.

Factoring
Some companies use either factoring or invoice discounting to improve
liquidity or to reduce administration costs. Insurance, particularly of overseas
debts, can also help reduce the risk of bad debts.

A factor is defined as 'a doer or transactor of business for another', but a

factoring organisation specialises in trade debts, and manages the debts
owed to a client (a business customer) on the client's behalf.

Factoring is the outsourcing of the credit control department to a third party.

Aspects of factoring
The main aspects of factoring include the following.
1. Administration of the client's invoicing, sales accounting and debt
collection service
2. Credit protection for the client's debts, whereby the factor takes over the
risk of loss from bad debts and so 'insures' the client against such losses.
This is known as a non-recourse service. However, if a non-recourse
service is provided, the factor, not the firm, will decide what action to take
against non-payers.
3. Making payments to the client in advance of collecting the debts. This is
sometimes referred to as 'factor finance' because the factor is providing
cash to the client against outstanding debts.)

Benefits of factoring
The benefits of factoring for a business customer include the following.

a) The business receives early payment for most of its receivables in the form
of finance from the factor. It can use this money to pay its suppliers.

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management b)
O
ptimum inventory levels can be maintained, because the business will
have enough cash to pay for the inventories it needs.
c) Growth can be financed through sales rather than by injecting fresh
external capital.
d) The business gets finance linked to its volume of sales. In contrast,
overdraft limits tend to be determined by historical statements of financial
position.
e) The managers of the business do not have to spend their time on the
problems of slow-paying accounts receivable. Factoring organisations are
also likely to employ staff who are experienced and skilled at collecting
payments from customers and chasing overdue payments.
f) The business does not incur the costs of running its own sales ledger
department, and can use the expertise of debtor management that the
factor has.

Criticisms of factoring include:

a) The factor’s charges may be high

b) Once a company has started to use a factor it is hard to rebuild its own
sales ledger function
c) The factor will collect receivables in a vigorous manner and this may
damage the company’s relationship with its clients
d) The use of a factor may indicate that the company has cash flow
problems (this last criticism is less relevant in the modern business
environment where outsourcing of support functions has become very
common)

Types of factoring

Non-recourse:
If the factor protects the company against all bad debts then this is known as
a non-recourse factoring agreement. Obviously the factor will charge a higher
fee to cover the risk it is bearing

With recourse:
If a factoring agreement is with recourse, the factor provides no protection
against bad debts.

Credit protection is provided only when the service is non-recourse and this is
obviously more costly.

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Test your understanding 8

Velmin Co has a turnover of $700,000. Receivable days are currently 48

despite the company only offering 30-days’ credit and bad debts are currently
3% of turnover. Velmin Co finances its receivables using its overdraft, which
has an annual interest cost of 8%.

Velmin is considering the use of a factor.

The factor would charge 4% of turnover for a non-recourse agreement and
would expect to reduce receivable days to 34 and bad debts to 2%. The factor
would lend Velmin 75% of the outstanding receivables and would charge
Velmin 1% above their current overdraft interest cost. It is anticipated that
using the factor would reduce administration costs by $6,000 per annum

Required
Evaluate whether or not Velmin Co should use the factor.

Test your understanding 9

A company makes annual credit sales of $1,500,000. Credit terms are 30
days, but its debt administration has been poor and the average collection
period has been 45 days with 0.5% of sales resulting in bad debts, which are
written off.
A factor would take on the task of debt administration and credit checking, at
an annual fee of 2.5% of credit sales. The company would save $30,000 a
year in administration costs. The payment period would be 30 days.

The factor would also provide an advance of 80% of invoiced debts at an

interest rate of 14% (3% over the current base rate). The company can obtain
an overdraft facility to finance its accounts receivable at a rate of 2.5% over
base rate.

Should the factor's services be accepted? Assume constant monthly revenue.

Test your understanding 10

H Finance Co is prepared to advance 80% of D Co's sales invoicing, provided

its specialist collection services are used by D Co. H Finance Co would
charge an additional 0.5% of D Co's revenue for this service. D Co would
avoid administration costs it currently incurs amounting to $80,000 per
annum.
The history of D Co's accounts receivable ledgers may be summarised as
follows:

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20X8 20X9 20Y0

Revenue ($'000) 78,147 81,941 98,714

% Accounts receivable at year end 17 20 22
% Accounts receivable of
90+ days (of revenue) 1.5 2 2.5
Bad debts ($'000) 340 497 615

D Co estimates that the aggressive collection procedures adopted by the

finance company are likely to result in lost revenue of some 10% of otherwise
expected levels.

Currently, each $1 of revenue generates 18 cents additional profit before

taxation. D Co turns its capital over, on average, three times each year. On
receipt by H Finance Co of amounts due from D Co's customers, a further
15% of the amounts are to be remitted to D Co. The cheapest alternative form
of finance would cost 20% per annum.
Required

a. Calculate whether the factoring of D Co's accounts receivable ledger

would be worthwhile.
b. Explain how the factoring of sales invoicing may assist a firm's financial
performance.

Test your understanding 11

WQZ Co is considering making the following changes in the area of working

capital management:

WQZ Co could introduce an early settlement discount of 1% for customers

who pay within 30 days and at the same time, through improved operational
procedures, maintain a maximum average payment period of 60 days for
credit customers who do not take the discount. It is expected that 25% of
credit customers will take the discount if it were offered.

It is expected that administration and operating cost savings of $753,000 per

year will be made after improving operational procedures and introducing the
early settlement discount.

Credit sales of WQZ Co are currently $87.6 million per year and trade
receivables are currently $18 million. Credit sales are not expected to change
as a result of the changes in receivables management. The company has a
cost o

f short-term finance of 5.5% per year.

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a) Calculate and comment on whether the proposed changes in
receivables management will be acceptable. Assuming that only 25%
of customers take the early settlement discount, what is the maximum
early settlement discount that could be offered?
b) Discuss the factors that should be considered in formulating working
capital policy on the management of trade receivables.

Test your understanding 12

KXP Co is an e-business, which trades solely over the Internet. In the last
year the company had sales of $15 million. All sales were on 30 days' credit to
commercial customers.

Extracts from the company's most recent statement of financial position

relating to working capital are as follows:

$'000

Trade receivables 2,466

Trade payables 2,220
Overdraft 3,000
In order to encourage customers to pay on time, KXP Co proposes
introducing an early settlement discount of 1% for payment within 30 days,
while increasing its normal credit period to 45 days. It is expected that, on
average, 50% of customers will take the discount and pay within 30 days,
30% of customers will pay after 45 days, and 20% of customers will not
change their current paying behaviour.

KXP Co currently orders 15,000 units per month of Product Z, demand for
which is constant. There is only one supplier of Product Z and the cost of
Product Z purchases over the last year was $540,000. The supplier has
offered a 2% discount for orders of Product Z of 30,000 units or more. Each
order costs KXP Co $150 to place and the holding cost is 24 cents per unit
per year. KXP Co has an overdraft facility charging interest of 6% per year.

Required

a) Calculate the net benefit or cost of the proposed changes in trade

receivables policy and comment on your findings.
b) Calculate whether the bulk purchase discount offered by the supplier is
financially acceptable and comment on the assumptions made by your
calculation.
c) Discuss the factors to be considered in formulating a trade receivables

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management policy.

MANAGEMENT OF FOREIGN ACCOUNTS RECEIVABLE

Foreign accounts receivable present some additional challenges to a

business that are not present with domestic-based customers.
It is harder for a business to pursue any overdue amounts from a business in
another country with a different legal system.

One option for a business is to simply trust the foreign customer to pay within
the stated credit period without demanding additional security, a method
known as ‘open account’. This option means the business faces a level of
non-payment risk that some businesses may find unacceptable.

Several measures available to exporters to help overcome risks of non-

payment.

REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE

A company can reduce its investment in foreign accounts receivable by asking
for full or part payment in advance of supplying goods. However consumers
may resist this, particularly if competitors do not ask for payment up front.

FORFAITING
One method of doing this is forfaiting. Forfaiting involves the purchase of
foreign accounts receivable from the seller by a forfaiter. The forfaiter takes on
all of the credit risk from the transaction (without recourse) and therefore the
forfaiter purchases the receivables from the seller at a discount. The
purchased receivables become a form of debt instrument (such as bills of
exchange) which can be sold on the money market.
The non-recourse side of the transaction makes this an attractive
arrangement for businesses, but as a result the cost of forfaiting is relatively
high.
Forfaiting is usually available for large receivable amounts (over $250,000)
and also is only for major convertible currencies. It is usually only available for
medium-term or longer transactions.

LETTER OF CREDIT
This is a further way of reducing the investment in foreign accounts receivable
and can give a business a risk-free method of securing payment for goods or
services.

Letters of credit take up a significant amount of time and therefore are slow to
arrange and must be in place before the sale occurs. The use of letters of
credit may be considered necessary if there is a high level of non-payment
risk.

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Customers with a poor or no credit history may not be able to obtain a letter of
credit from their own bank.

Letters of credit are costly to customers and also restrict their flexibility: if they
are short of cash when the payment to the bank is due, the commitment under
the letter of credit means that the payment must be made.

COUNTERTRADING
In a countertrade arrangement, goods or services are exchanged for other
goods or services instead of for cash.

The benefits of countertrading include the fact that it facilitates conservation of

foreign currency and can help a business enter foreign markets that it may not
otherwise be able to.

The main disadvantage of countertrading is that the value of the goods or

services received in exchange may be uncertain, especially if the goods being
exchanged experience price volatility.

Other disadvantages of countertrade include complex negotiations and

logistical issues, particularly if a countertrade deal involves more than two
parties.

EXPORT CREDIT INSURANCE

Export credit insurance protects a business against the risk of non-payment
by a foreign customer. Exporters can protect their foreign accounts receivable
against a number of risks, which could result in non-payment.

Export credit insurance usually insures the seller against commercial risks,
such as insolvency of the purchaser or slow payment, and also insures
against certain political risks, for example war, riots, and revolution which
could result in non-payment.

It can also protect against currency inconvertibility and changes in import or

export regulations.

Export credit insurance therefore helps reduce the risk of non-payment, but
its’ disadvantages include the relatively high cost of premiums and the fact
that the insurance does not typically cover 100% of the value of the foreign
sales.

EXPORT FACTORING
An export factor provides the same functions in relation to foreign accounts
receivable as a factor covering domestic accounts receivable and therefore
can help with the cash flow of a business. However, export factoring can be

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more costly than export credit insurance and it may not be available for all
countries, particularly developing countries.

Test your understanding 13

The finance director of Widnor Co has been looking to improve the company’s
working capital management. Widnor Co has revenue from credit sales of
$26,750,000 per year and although its terms of trade require all credit
customers to settle outstanding invoices within 40 days, on average
customers have been taking longer. Approximately 1% of credit sales turn into
bad debts which are not recovered.

Trade receivables currently stand at $4,458,000 and Widnor Co has a cost of

short-term finance of 5% per year.

The finance director is considering a proposal from a factoring company,

Nokfe Co, which was invited to tender to manage the sales ledger of Widnor
Co on a with-recourse basis. Nokfe Co believes that it can use its expertise to
reduce average trade receivables days to 35 days, while cutting bad debts by
70% and reducing administration costs by $50,000 per year. A condition of
the factoring agreement is that the company would also advance Widnor Co
80% of the value of invoices raised at an interest rate of 7% per year. Nokfe
Co would charge an annual fee of 0.75% of credit sales.

Assume that there are 360 days in each year.

Required

a) Advise whether the factor’s offer is financially acceptable to Widnor Co.

b) Briefly discuss how the creditworthiness of potential customers can be
assessed.
c) Discuss how risks arising from granting credit to foreign customers can
be managed and reduced.

Test your understanding 14

XYZ Co has annual credit sales of $20 million and accounts receivable of $4
million. Working capital is financed by an overdraft at 12% interest per year.
Assume 365 days in a year.

What is the annual financial effect if management reduces the collection

period to 60 days by offering an early settlement discount of 1% that all
customers adopt?

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Test your understanding 15

Which of the following services may be provided by a debt factor?

 Bad debt insurance

 Advancement of credit
 Receivables ledger management
 Management of debt collection processes

Test your understanding 16

Which of the following is LEAST likely to be used in the management of

foreign accounts receivable?

 Letters of credit
 Bills of exchange
 Invoice discounting
 Commercial paper

Test your understanding 17

L Co is considering whether to factor its sales invoices. A factor has offered L
Co a non-recourse package at a cost of 1.5% of sales and an admin fee of
$6,000 per annum. Bad debts are currently 2% of sales per annum and sales
are $1.5m per annum.

What is the cost of the package of L Co?

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