Chapter Four

Receivable Management
3.1 Nature of Account Receivable
When a firm allows customers to pay for goods and services at a later date, it creates accounts
receivable. By allowing customers to pay some time after they receive the goods or services, you are
granting credit, which we refer to as trade credit. Trade credit, also referred to as merchandise credit
or dealer credit, is an informal credit arrangement.
Unlike other forms of credit, trade credit is not usually evidenced by notes, but rather is generated
spontaneously: Trade credit is granted when a customer buys goods or services.
Reasons for Extending Credit
Firms extend credit to customers to help stimulate sales. Suppose you offer a product for sale at $20,
demanding cash at the time of the sale. And suppose your competitor offers the same product for sale,
but allows customers 30 days to pay. Who’s going to sell the product? If the product and its price are
the same, your competitor, of course. So the benefit from extending credit is the profit from the
increased sales.
When a firm extends credit to its customers, it does so to encourage sales of its goods and services.
The most direct benefit is the profit on the increased sales. If the firm has a variable cost margin (that
is, variable cost/sales) of 80%, then increasing sales by $100,000 increases the firm’s profit before
taxes by $20,000. Another way of stating this is that the contribution margin (funds available to cover
fixed costs) is 20%: For every $1 of sales, 20 cents is available after variable costs. The benefit from
extending credit is:
Benefit from extending credit = Contribution margin * Change in sales
For example, if a firm liberalizes its credit to customers, it results in an increase sale by $5 million and
if its contribution margin is 25%, the benefit from liberalizing credit will be 25% of $5 million, or
$1.25 million.
Costs of Credit: Giving credit has a cost.
 The value of the interest charged on an overdraft to fund the period of credit
 The carrying cost of tying-up funds in accounts receivable instead of investing them
elsewhere. The firm granting the credit is forgoing the use of the funds for a period—so there
is an opportunity cost associated with giving credit, which is, the interest lost on the cash not
received and deposited in the bank.
 The cost of administering and collecting the accounts.
 The risk of bad debts. There is a chance that the customer may not pay what is due when it is
due.

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  Cost of discount - when a customer pays cash within a specified discount period he can get a
discount from the invoice price. But the customer that pays after this discount period pays the
full invoice price.
Cost of discount = Discount percentage * Credit sales using discount
For example, if a discount is 5% and there are $20 million credit sales using the discount, the cost of
the discount is 5% of $20 million, or $1 million.
The goal of receivables management is to maximize the value of the firm by achieving a trade-off
between cost of credit and profitability.
3.2 Setting and Implementing the Credit Policy
Designing credit policy is the first step in receivables management.
A firm’s credit policies specify the terms of extending credit, deciding who gets credit and procedures
for collecting delinquent accounts. In deciding what its credit and collection policies will be, a firm
considers the trade-off between the costs of accounts receivable ( the opportunity cost of investing in
receivables, the cost of administering the receivables, and the cost of delinquent accounts) and the
benefits of accounts receivable( the expected increase in profits and the return received from its trade
credit).
3.3 Components of Credit Policy
Credit policy consists of four variables:
1. Credit terms consist of the maximum amount of credit, the length of period allowed for payment
(that is, the net period), and the discount rate and discount period, if any.
 Credit period - is the length of time buyers are given to pay for their purchases. For example, the
credit period might be 30 days. Customers prefer longer credit periods, so lengthening the period
will stimulate sales. However, a longer credit period lengthens the cash conversion cycle; hence,
it ties up more capital in receivables, which is costly. Also, the longer a receivable is outstanding,
the higher the probability that the customer will default and that the account will end up as a bad
debt.
 Discounts – are price reductions given for early payment. The purpose of discounts is to attract
customers, thereby increasing sales, and to encourage the early payment of accounts, thereby
reducing the amount tied up in accounts receivable. Offering discounts has two benefits:
i. The discount amounts to a price reduction, which stimulates sales.
ii. Discounts encourage customers to pay earlier than they otherwise would, which shortens
the cash conversion cycle.

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However, discounts mean lower prices and lower revenues unless the quantity sold increases by
enough to offset the price reduction. The benefits and costs of discounts must be balanced when credit
policy is being established.
2. Credit Eligibility/ Evaluation of Creditworthiness
Having intended the credit period and discount rate, the after that logical step is to describe the
customers, who are eligible for the credit conditions. Creditworthiness refers to the required financial
strength of acceptable credit customers. So, the decision whether a customer is eligible for credit
conditions usually involves a detailed analysis of some of the attributes of the customer. Credit analysts
normally cluster the attributes or factors in order to assess the credit worthiness of customers in five
dimensions namely: Capital, Character, Collateral, Capability and Circumstances. These five
dimensions are also popularly described Five Cs of credit analysis.
a) Capital
The term capital here refers to financial position of the applicant firm. It needs an analysis of financial
strength and weakness of the firm in relation to other firms in the industry to assess the credit
worthiness of the firm. Financial fact is normally derived from the financial statements of the firm and
analyzed by ratio analysis. The liquidity ratios like current ratio, debt service coverage ratio, etc. are
often used to get a preliminary thought on the financial strength of the firm. Further analysis contains
trend analysis and comparison with the other industry norm or other firms in the industry.
b) Character
A prospective customer may have high liquidity but delay payment to their suppliers. The character
therefore relates to willingness to pay the debts. Some relevant questions/facts useful to assess the
applicant‘s character are:
 What is the applicant‘s history of payments to the deal?
 Has the firm defaulted to other deal suppliers?
 Does the applicant‘s management create a good-faith attempt to honour debts as they become
due?
c) Collateral
If a debt is supported through collateral, then the debt enjoys lower risk because in the event of default,
the debt holder can liquidate the collateral to recover the dues. Therefore, the analysts should look into
both the availability of collateral for the debt and the amount of collateral the firm has given to others.
The credit worthiness improves if the customer is willing to offer collateral assets
d) Capability/capacity

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 The capability has two dimensions - management‘s capability to run the business and applicant firm‘s
plant capability. The future of the firm depends on the management‘s skill to meet the challenges.
Likewise, the facility should exist to use the opportunity.
e) Circumstances/conditions
These are the economic circumstances in the applicant‘s industry and in the economy in common.
Scope for failure and default is high when the industry and economy are in contraction stage. Credit
policy is required to be customized when the circumstances are not favourable.
The fact composed under five Cs can be analyzed in common to decide whether the customer is eligible
for credit or not.
3. Credit Limit
If a customer falls within the desired limit of credit worthiness, the after that issue is fixing the credit
amount. This is some item same to banks fixing overdraft limit for the explanation holders. If a
customer is new, normally the credit limit is fixed at the lowest stage initially and expanded in excess
of the period based on the performance of the customer in meeting the liability. Credit limit may
undergo a transform depending on the changes in the credit worthiness of the customer and changes
in the performance of customer‘s industry.
4. Collection policy:
Collection policies specify the procedures for collecting delinquent accounts. Collection could start
with polite reminders, continuing in progressively severe steps, and ending by placing the account in
the hands of a collection agency, a firm that specializes in collecting accounts. The following sequence
is typical:
i. Mailing a duplicate reminders
When an account is a few days overdue, a letter is sent reminding the customer of the amount due and
the credit terms. A second or third letter may be required, followed by a final demand stating clearly
the action that will be taken. The aim is to goad/push customers into action, perhaps by threatening not
to sell any more goods on credit until the debt is cleared.
ii. Chasing payment by telephone
If a customer fails to respond to these reminders, then expensive processes are initiated. The telephone
is of greater nuisance/pain value than a letter, and the greater immediacy can encourage a response. It
can however be time-consuming, in particular because of problems in getting through to the right
person.
iii. Making a personal approach- A personal visit through the credit manager or representative to sort
out the issue would be useful.
iv. Notifying debt collection section- This means not giving further credit to the customer until he has

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 paid the due amounts.
v. Instituting legal action to recover the debt
If the credit manager realizes that the customer is wilfully defaulting or is in deep trouble and hence
unlikely to pay the dues, a formal legal activity is initiated either to recover the dues or file a liquidation
petition before the court to recover the dues.
3.3 Monitoring Accounts Receivable
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 Days Sales Outstanding,
as well as reports on the level of bad debts.
 The ageing schedule highlights the debtors according to the age or length of time of the
outstanding debtors.
 Days Sales Outstanding/ average collection period- Measures the average number of days an
accounts receivable remain outstanding. It represent the length time the firm must wait after
making a sale to receive cash.
 The fewer the days it takes the firm to collect on its receivables, the more efficient the firm
365days
Days Sales Outstanding =
Accounts Re ceivabletu rnover
 After your customer payment habits compared to your payment terms then you may need to step
up your collection practices or tighten your credit policies.
Receivable turnover
How many times, on average, does a company turn its receivables in to cash during an
accounting period.
Receivable turnover = Net credit sales
Average gross A/R
This measures how quickly account receivable is collected.
WHERE,
Average gross A/R = Beg. Grosss A/R + End. Grosss A/R
2
3.4 Optimum credit policy
Credit policy refers to those decision variables that influence the amount of trade credit (the investment
in trade credit). A company’s credit policy could be liberal or restrictive credit policy.
When a firm resorts to a liberal credit policy increases the profitability of the firm on account of
higher sales. However, such a policy results in
 increased investment in accounts receivables,
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  increases chance of uncollectible debts and more collection charges.
 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 below.
Costs & Benefits Optimum
Profitability

Liquidity

0 Rigid Credit Policy Liberal

3.5 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 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
overdue 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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