Chapter 5 Accounts Receivable Management

A / /R A R

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The Cash Flow Timeline

Order Order Placed Placed

Order Order Received Received

Payment Sent Cash Payment Sent Cash Received Received Accounts Collection Accounts Collection < Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float > Time ==> Time ==>

Sale Sale

Accounts Accounts < Payable > < Payable > Invoice Received Invoice Received

Disbursement Disbursement < Float > < Float >

Payment Sent © 2005 by Thomson Learning, Inc. Cash Disbursed Payment Sent Cash Disbursed Copyright

Learning Objectives
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Define credit policy and indicate its components. Describe the typical credit-granting sequence. Apply net present value analysis to credit extension decisions. Define credit scoring and explain limitations. List the elements in a credit rating report. Describe how receivables management can benefit from EDI.

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Trade Credit and Shareholder Value
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Trade credit arises when goods sold under delayed payment terms Traced to Romans due to obstacles faced in transferring money through various trading areas Credit terms are taken for granted today Value can be added by managing three areas:
– – – aggregate investment in receivables credit terms credit standards

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Over-investing in receivables can be costly ...but, if credit terms are not competitive, then lost sales can be costly
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Conclusion
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Minimize bad debts and outstanding receivables Maintain financial flexibility Optimize mix of company assets Convert receivables to cash in a timely manner Analyze customer risk Respond to customer needs

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A/R Management and Shareholder Value
Marketing Strategy

Market Share Obj.

Aggregate Inv. in A/R

Credit Terms

Credit Standards

Total Dollar Investment

Length of Time to Pay

Acceptance of Marg Cust.

Max Shareholder Value
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Trade vs. Bank Credit
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Length of terms Security Amounts involved Resource transferred (goods vs. money) Extent of analysis

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Why Extend Credit?
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Financial Motive Operating Motive Contracting Motive Pricing Motive All reasons are related to market imperfections

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Financial Motive
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Potential of getting a higher price Sellers raise capital at lower rates than customers and have cost advantages vis-a-vis banks due to:
– similarity of customers – the information gathered in the selling process – lower probability of default (the goods purchased are an essential element of the buyer’s business) – seller can more easily resell product if payment is not made.

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Operating Motive
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Respond to variable and uncertain demand Change credit terms rather than:
– install extra capacity, – building or depleting inventories, – or forcing customers to wait.

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Contracting Cost Motive
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Buyer gets to inspect goods prior to payment Seller has less theft with separation of collection and product delivery

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Pricing Motive
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Change price by changing credit terms

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Trends Affecting Trade Credit
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Zero net working capital objective Improved internal and external credit-related information Electronic commerce

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The Credit Decision Process
Marketing contact Credit investigation Customer contact for information Finalize written documents, e.g.. security agreements Establish customer credit file Financial analysis
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Time Time

Basic Credit Granting Model

S - EXP(S) NPV = ----------------- - VCR(S) 1 + iCP Where: NPV = net present value of the credit sale VCR = variable cost ratio S = dollar amount of credit sale EXP = credit administration and collection expense ratio i = daily interest rate CP = collection period for sale
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Managing the Credit Policy
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Should we extend credit? Credit policy components Credit-granting decision

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Should We Extend Credit?
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Follow industry practice Extent and form of credit offer
– in-house credit card – sell receivables to a factor – captive finance company?

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Components of Credit Policy
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Development of credit standards
– profile of minimally acceptable credit worthy customer

Credit terms
– credit period – cash discount

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Credit limit
– maximum dollar level of credit balances

Collection procedures
– how long to wait past due date to initiate collection efforts – methods of contact – whether and at what point to refer account to collection agency
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Credit-Granting Decision
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Development of credit standards Gathering necessary information Credit analysis: applying credit standards Risk analysis

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Grant-Granting Sequence
Order and credit request received New/increased credit limit Yes Size of proposed credit limit Large Indepth Indepth credit invest. credit invest. Medium Moderate credit invest. No Yes Material change in customer status No Redo credit investigation

Check new A/R Check new A/R total vs credit lmt total vs credit lmt Record disposition Extend Credit No Yes Set up,post A/R, ship
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Small Minimal credit invest.

Credit Standards
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Based on five C's of Credit
– – – – – Character Capital Capacity Collateral Conditions

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Determine risk classification system Link customer evaluations to credit standards

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Gathering Information
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credit reporting agencies, e.g.. Dun & Bradstreet credit interchange bureaus, NACM bank letters references from other suppliers financial statements field data gathered by sales reps

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Credit Analysis: Applying the Standards
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Nonfinancial
– concerned with willingness to pay, character

Financial
– ability to pay, financial ratios etc.. (other C’s of credit)

Credit scoring models
– Example: Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)

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Emergence of Expert Systems
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Example of decision rule: “If gross income is equal to or grater than $20,000 and the applicant has not been delinquent and gross income per household member is equal to or greater than $12,000 and debt/equity ratio is equal to or greater than 30% but less than 50% and personal property is equal to or greater than $50,000, then grant credit.”

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Factors Affecting Credit Terms
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Competition Operating cycle Type of good (raw materials vs finished goods, perishables, etc.) Seasonality of demand Consumer acceptance Cost and pricing Customer type Product profit margin
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Cash Discounts
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The lower the VC, the higher the feasible discount Based on company’s cost of funds Consider timing effect when changing discounts Should be based on product’s price elasticity Higher the bad debt experience, higher the optimal discount

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Practice of Taking Cash Discounts
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51% of firms always took cash discount 40% sometimes 9% take discount and pay late Study found that 4 or 5 companies would be more profitable if cash discount was eliminated

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A/R Management in Practice
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Discounts appear to be changed to match competitors, not inflation or interest rates The higher a firm’s contribution margin, the more likely the firm should be to offer discounts. A price cut is thought to have more impact than instituting a cash discount The more receivables a firm has, does not necessarily relate to use of penalty fees The greater amount of receivables does not relate to a more active credit evaluation.
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Receivables, Collections, and EDI
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If credit approval is delayed...
– buyers using EDI purchase orders and JIT manufacturing can encounter serious problems. – sellers can now ship within hours of receiving orders...thus seller must be able to handle electronically transmitted orders.

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Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that remittance data can be automatically read by seller’s A/R system Trend is for use of data transmission to automate the cash application process

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Summary
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Investment in A/R represents a significant investment. Key aspects outlined
– – – – – credit policy credit standards credit granting sequence credit limits credit terms

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Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations. Proper use of NPV techniques can ensure that credit decisions enhance shareholder value.

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