Advanced Financial Management – 20MBAFM306 2021

UNIT: 05
Receivable / Credit Management
Receivable: The term receivable is defined as “debt owed to the firm by customers
arising from sale of goods/services in the ordinary course of business”. When the firm
sells its products or services on credit, and it does not receive cash for it immediately, but
would be collected in near future. Till collection they form as current assets.
Objectives of Receivable Operation
Receivables arise out of credit extended to customers. Therefore, the objectives of
receivables management are as follows
1. Accounts receivables arise due to credit sales. Credit sales helps the firm to increase its
total sales because, the firm can sell the goods to parties who are not able to make payment
immediately.
2. Credit sales increase the profit of the firm. The profit of the firm is increased due to the
credit sales because,
 The margin of profit can be increased due to credit sales because customers accept the
goods even at a little higher price if the goods are supplied on credit terms.
 Credit sales becomes necessary to face competition from other firms in the industry,
when other firms are selling the goods on credit, to cope up with the competition a firm
has to resort credit sales.
Cost of maintaining Accounts Receivables
1. Cost of financing: maintaining accounts receivables results in locking-up of the funds of
a firm. The amount or cost of funds locked-up in receivables is called cost of financing.
2. Administrative cost: maintaining receivables involves keeping up of records of the
credit sales made to customers and payments received from them. The cost involves in this
job is called administrative cost.
3. Collection cost: there are certain expenses to be incurred for collecting the amount from
the debtors. Ex: cost of sending reminders, legal charges, and salaries to collecting staff.
4. Defaulting cost: when a firm has receivables, a part of them may become irrecoverable
or bad. The bad debts arising from the receivables are called defaulting cost.

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Receivable Management emphasizes the following

1. Terms of payment
2. Credit policy variables
3. Credit evaluation
4. Credit granting decision
5. Control of accounts receivables
1. TERMS / MODES OF PAYMENT: the various terms used in the receivable management
include:
a. Cash Terms or cash mode: cash in advance or cash on delivery. Whenever a firm sells
goods or services on cash terms, the value of goods or services will be received either cash
in advance (before the goods are shifted) or on delivery.
b. Open Account: it is created when the goods are sold on credit; credit facility may include
discount on period. Open account means, after the sale and purchase agreement between
seller and buyers, the seller first shifts goods with invoice (bill), which consists of the credit
terms, credit period allowed, cash discount for early payment, and the period of cash
discount offer, quantity of goods with their total value and so on. The invoice generally
acknowledged by the buyer.
 Cash discount is a type of discount for prompt payment before the credit period. Is the
discount allowed to buyer for the early payment? For example a seller has given 2/15,
net 45. It means that discount of 2 percent is allowed; if the payment is made on or
before 15 days, otherwise full payment is due by 45th day.
 Credit period means the length of time extended by the supplier of raw materials, goods
or services. Credit period is the period allowed by seller to customer to pay economic
value of goods.
c. Bill of exchange: A bill of exchange represents an unconditional order issued by the
seller asking the buyer to pay the amount mentioned on it on demand at a certain future
date. This type of demand is made only when the seller does not have strong evidence of
the buyer’s obligation. In other words, if the seller wants a clear commitment from the
buyer, before he/she delivers the goods/seller can arrange a commercial draft. When the
buyer accepts a bill than it becomes a trade acceptance, which may hold till the maturity or
get it discounted.

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The advantages of bills of exchange are (i) It represents negotiable instrument. (ii) It serves
as a written evidence of a definite obligation. (iii) It helps in reducing cost of finance to
some extent, since it can be discounted.
d. Letter of Credit: Letter of credit (L/C) is a formal document issued by a bank on behalf
of customer, stating the conditions under which the bank will honor the commitments of its
customer (buyer). Payment through the letter of credit arises whenever trade takes place
at international level, but now a day it has been used in domestic trade also. In other words,
whenever trade takes place in the absence of face-to-face unknown people, issue of letter of
credit (L/C) arises.
Functions of the letter of credit are, (i) It eliminates risk, since letter of credit issued by
good standing bank. (ii) It reduces uncertainty, as the seller knows the conditions that
should be fulfilled to receive payments. (iii) It provides safety to the buyer, who wants to
ensure that payment is made only in conformity with the conditions of the letter of credit.
e. Consignment: In consignment, business consigner (seller) sends goods to consignee
(agent of the seller). In this case goods are just shipped but not sold to the consignee. Since
the consigner retains the title of the goods till they are sold by the consignee to a third
party. In this consignment only sales proceeds are remitted to the consignor by the
consignee.
2. Credit Policy Variables
The major credit policy tools are:
1. Credit standards
2. Credit period
3. Collection efforts
4. Cash discount
1. Credit standards: What standard should be applied in accepting or rejecting the
customer?
Following are the options for extension of credit to customer. It can be:-
a. Option 1: Tight or restrictive policy
b. Option 2 : Liberal or non-restrictive policy
Option 1 (strict): firm may decide not to extend credit to any customer, however strong the
customer’s credit rating may be.

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Or
Option 2 (liberal): firm may decide to grant credit to all customers, irrespective of their
credit rating.
Between these 2 extremes points, there are several possibilities.
Often, liberal credit standard push the sales by attracting more customers.
This policy, however may lead to higher chances of bad debt loss.
 More investment is needed on receivables & also leads to higher collection charges.
 Strict, credit standards have opposite effect,
 It tends to reduce sales
 Reduces bad debts
 Less investment on debtors
 Lower collection cost.

Credit standard model shows how liberal credit policy effects on residual income/profit
 When we sell more, sales volume increases
 Variable cost also increases
 There is increase in contribution
 Increase in sales leads to increase in bad-debts
 Total investment on receivables also increases
 Increase in investment, leads to increase in interest charges.(amount invested
from Short Term Loan)
 Cost of capital assumed to be constant
 Even then the company can make profit.
2. Credit period: It refers to length of time customers are allowed to pay their purchases. It
generally varies from 15 to 60 days. When firm does not extend any credit – then the credit
period will be zero. If a firm allows 30 days credit – its credit term is ‘net 30’.

Lengthening of credit period pushes-up sales not only to the existing customers but also
attracts new customers. This leads to more investment in debtors. As a result of higher
investment in debtors, it also leads to increase in bad-debts losses. Shortening of credit
period, tends to lower sales. Leads to less investment on debtors. Reduces bad-debt losses

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3. Collection Policy / efforts: Is required for timely collection of receivables from the
customers, when they become due.
 Collection policy consists of
 Monitoring the state of receivables
 Sending letters to customers, when due date is approaching
 Electronic & telephonic advice to customers around the date
 Threat of legal actions to overdue customers
 Legal actions against overdue customers

Strict collection policy: decreases sales, shortens average collection period, reduces bad-
debts percentage & increases collection charges.
Liberal collection policy: push-up sales, lengthens the average collection period,
increases bad-debts percentage & decreases collection expenses.
4. Cash Discount: Firm generally offers cash discounts to induce customers to make
prompt payments. The percentage allowed & the period during which it is available is
reflected in the credit terms.
For ex: 2/10, net 30. Means that a discount of 2% is allowed if the payment is made by the
10th day, otherwise full payment should be made by the 30th day.
Liberalizing the cash discount policy:
Means higher percentage of discount is allowed or the discount period is lengthened. Such
an action – increases the sales [as discount is regarded as price reduction]. Reduction in
ACP [as customers pay promptly.Increases the profit].
3. Credit Evaluation of Customers
a. Credit information
i. financial statements
ii. bank references
iii. trade references
b. Credit investigation and analysis
i. analysis of credit file
ii. financial analysis
iii. analysis of business and management

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ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur:
Type I error: A good customer is misclassified as a poor credit risk
Type II error: A bad customer is misclassified as a good credit risk

Credit analysis
It refers to the analyzing of the quality of the customer on individual basis. The credit
manager will analyze 3c’s i.e., character, capacity and condition of the person to whom the
credit is to be given. The credit analysis depends upon the experience of the financial or
credit manager to judge the extent and genuineness of the customer. This mainly involves
the analysis of the following relating to a customer:
 Collection period
 Default rate

Five Cs of Credit
 Character : The willingness of the customer to honor his obligations
 Capacity : The operating cash flows of the customer
 Capital : The financial reserves of the customer
 Collateral : The security offered by the customer
 Conditions : The general economic conditions that affect the customer

Techniques of credit analysis

 Numerical Credit Scoring
 Discriminate analysis

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NUMERICAL CREDIT SCORING

It tries to overcome the drawbacks of the traditional analysis which is more of subjective
and is difficult to draw the judgment based on the risk analysis. According to this
technique; credit worthiness or project rating index is calculated using following steps.
1) Identify the relevant factors useful for credit evaluation.
2) Assign weights to each factor, based on the relative importance of each factor.
3) Rate the customer based on various listed factors, using an appropriate rating scale.
4) Multiply the factor rating with the factor weight to get the factor score for each factor.
5) Add all the factor scores to determine the overall ‘project-rating index’.
6) Accept the customer if the rating index is more than desired value or Reject the
customer if the rating index is less than the desired value

DISCRIMINANT ANALYSIS
The credit rating under numerical analysis is somewhat based on ad-hoc and characterized
by subjectivity, the discriminate analysis overcome this drawback with a Z score. It
considers the financial ratio of its customers as the basic determination of credit
worthiness. The ratio includes current ratio and ROE.
Two variables differentiate good customer from the bad customer with a straight line.
+ signifies the good customers who are above the straight line. o signifies the bad
customers who are placed below the straight line.

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4. Credit Granting Decision

5. Control of Receivables
• Receivables turnover – provides relationship between credit sales and debt of a firm.
• Average collection period – is a time taken by firm in collecting receivables cash from
the customer.
• Day’s sales outstanding – The ratio of receivables outstanding at the time to sales per
day.

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Ageing Schedule:
The ageing schedule of debtors is prepared based on the collection pattern. The total
debtors’ balances are classified according to their age i.e. the outstanding period for which
the amount is uncollected. The ageing schedule provides useful information for assessing
the company’s liquidity position, efficiency of credit control department, efficiency in
collection of receivables, comparison with previous ageing schedules etc. The age analysis
of debtors may be used to help and decide what action to take about older debts.
For better control on collection of receivables, ageing schedule is prepared and analyzed
for identifying the overdue amounts.

The age-wise distribution of accounts receivables at a given time is depicted in the ageing
schedule. For example, the ageing schedule at the end of various quarters may be as
follows:
Outstanding accounts receivable

A comparison of ageing schedules at periodic intervals helps to identify change in the

payment Behavior of customers.

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The ageing schedule can be compared with the credit period extended by the company.
When the percentage of receivables belonging to higher age groups is above a stipulated
norm, action has to be initiated before they turn into bad debts. If the company’s credit
terms are say ‘net sixty days,’ then control needs to be exercised in the form of follow up
measures in respect of the bottom 20 percent accounts.
The average collection period and the ageing schedule have traditionally been popular
measures for monitoring receivables. However, they suffer from a limitation. They are
influenced by the sales pattern as well as the decreasing, average collection period and the
ageing schedule will differ from what they would be if sales are constant. This holds even
when the payment behaviour of customers remains unchanged. The reason is simple: a
greater portion of sales is billed currently. Similarly, decreasing sales lead to the same
results. The reason here is that a smaller portion of sales is billed currently. It can be well
explained with an example.
Collection Matrix
Collection matrix is a method of showing percentage of receivables collected during the
month of sales and subsequent months. It helps in studying the efficiency of collections
whether they are improving or deteriorating.

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Factoring
Factor: A financial institution which render services relating to the management and
financing of debtors. Factor selects accounts receivables of their client. Factor takes
responsibility of collecting accounts receivables selected by it
What is factoring? What functions does it perform?
Factoring involves an outright sale of receivables of an organization to a financial
institution or private agency, called factor. A factor specializes in management of trade
credit. Factors collect receivables and also advance cash against receivables to solve the
client firms’ liquidity problem. For providing their services, they charge interest on
advance and commission for other services.
The factor performs the following functions:
1. Factors provide financial assistance by extending advance cash against book debts.
2. Sales ledger administration and credit management services to his clients, by
maintaining the ledger of customers of clients, taking all follow-up actions, etc.
3. Protection against default in payment by debtors, by initializing legal actions at an early
time.
4. Credit collection
5. He guards the interest of his client, by developing better strategy against possible
defaults by customers of his client; etc.

Costs of Receivables Management

The following are the main costs associate with accounts receivable management:
• Capital cost
• Collection cost
• Bad debt cost
Capital cost/opportunity cost:
Providing goods or services on credit involves block of firm’s funds. In other words the
increased level of accounts receivables is an investment in current assets (as
debtors/receivables). These blocked funds in receivables need to be financed, by
shareholders funds or from short-term borrowings. They involve some cost. If receivables

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are financed by shareholders funds there involves opportunity cost to shareholders. If they
are financed by borrowed funds, it involves payments of interest, which is also a cost.
Collection cost:
Collection costs are those costs that are incurred in collecting the debts from the customers
to whom the credit sales have been granted. The collection costs may include, staff salaries,
records, stationery, postage that are related to maintenance credit department, and
expenses involved in collecting information about prospective customers, from specialized
agencies, for evaluation of prospective customer before going to grant credit.
Bad debt cost:
Sometimes customer may not pay their dues because of the inability to pay. Such costs are
referred as bad debts, and they have to be written off, because they cannot be collected.
These costs can be reduced to some extent if the firm properly evaluates customer before
granting credit, but complete avoidance is not possible.
Factors Influencing Receivables Investments
The level of investment in receivables is affected by the following factors:
– Volume of credit sales
– Credit policy of firm
– Seasonality of business
– Trade terms
– Collection policy
– Bill discounting
Volume of credit sales:
– Size of credit sale is the prime factor that affects the level of investment in receivables.
– Investment in receivable increase when the firm sells major portion of goods on credit
basis and vice versa. In other words increase in credit sales increase the level of receivables
and vice versa.

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Credit policy of firm

– There are two types of credit policies such as lenient and stringent credit policy.
– A firm that is following lenient credit policy tends to sell on credit to customers very
liberally, which will increase the size of receivables, on the other hand, a firm that following
stringent credit policy will have low size of receivables, because, the firm is very selective
in providing of stringent credit.
– A firm providing stringent credit may be able to collect debts promptly this will keep the
level of receivables under control.
Seasonality of business
– A firm doing seasonal business has to provide credit sales in un-season.
– When the firm provides credit automatically the level of investment in receivables will
increase with the comparison of the level of receivables in the season; because in season
firm will sell goods on cash basis only.
– For example refrigerators, air cooling products will be sold on credit in the winter season
and on cash in summer season.
Trade terms
– It is the most important factor (variable) in determining the level of investment in
receivables.
– The important credit terms are credit period and cash discount.
– If credit period is more when compared to other companies / industry, then the
investment in receivables will be more.
– Cash discount reduces the investment in receivables because it encourages early
payments.
Collection policy
– Collection policy is needed because all customer do not pay the firm’s bills in time.
– A firm’s liberal collection policy will not be able to reduce investment in receivables, but
in future sales may be increased.
– On the other hand a firm that follows stringent collection policy will definitely reduce
receivables, but it may reduce future sales.
– Therefore the collection policy should aim at accelerating collections from slow payers
and reducing bad debt base.

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Bill discounting and Endorsement

– Bills discounting and endorsing to the third party to him/her the firm has to pay will
reduce the size of investment in receivables.
– If the bills are dishonored on the due date, again the investment in receivable will
increase because, discounted bills or endorsed bills have to be paid by the firm.

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