Accounts Receivable

Management
 Nature of Credit Policy
A firm’s investment in accounts receivable
depends on
a) Volume of credit sales
b) The collection period

Credit policy is used to refer to the combination of

three decision variables
1. Credit standards
2. Credit terms
3. Collection Effort
 Goal of credit policy
…is to maximise the value of the firm. To achieve
this goal, the evaluation of investment in AR’s
should involve the following:
1. Estimation of incremental operating profit
2. Estimation of incremental investments in AR
3. Estimation of the incremental rate of return of
investment
4. Comparison of the incremental rate of return
with the required rate of return
 Marketing tool
Firms use credit policy as a marketing tool
for
• expanding sales.
• Company position
• Buyers status & requirement
• Dealer relationship
• Industrial practice etc.
Change in firms credit policy involves analysis of:
• Opportunity cost of last contribution
• Credit administration costs and bad debt losses

The firm’s credit policy will be determined by the

trade off between opportunity cost & credit
administration costs & bad debt losses
 Profitability

Liquidity

TIGHT ---------------Credit Policy-----------Loose

Credit Policy Variables
1. Credit standards are the criteria which a firm
follows in selecting customers for the purpose
of credit extension
2. Credit Analysis
a. Time taken by customers to repay credit obligation
b. The default rate

• The Average collection period determines the

speed of payment by customers
 Numerical Credit scoring
1. Ad Hoc approach: One can develop one’s own
ad hoc approach of numerical credit scoring.
The attributes identified by the firm may be
assigned weights depending upon their
importance. Eg. Income, Employment,
Residence, Age etc.
2. Simple Discriminant Analysis: Eg. Empirical
study may show that the ratio of EBDIT to
sales is a significant factor in discriminating
good customers from bad customers
 Multiple Discriminant Analysis
• It combines many factors according to the
importance(weights) to be given to each
factor & determine a composite score to
differentiate between good & bad
customers
 Altman’s Bankruptcy Model
• He focused on the financial attributes in the US
to use multiple Discriminant Analysis to predict
bankruptcy

Z= 0.012(NWC/TA) + 0.014(RE/TA) +
0.033(EBIT/S) + 0.006(MV/D) + 0.01(S/TA)
Where D is book value of debt, MV is mkt value of
equity, TA is total assets. Altman established a
cut off Z score of 2.675. Firms having Z value >
2.675 are financially strong
Example: You are extending credit to firms X & Y
which have the following financial ratios. What
are their Z scores if you use Altman’s model?

Firm NWC/ RE/T EBIT/ MV/D S/TA

TA A S
X 20% 10% 7.5% 360% 2.8

Y 16% 12% 6.5% 210% 2.5

Z score for X = 0.012(20) + 0.014(10) +
0.033(7.5) + 0.006(360) + 0.010(2.8) =
2.8135

Z score for Y = 0.012(16) + 0.014(12) +

0.033(6.5) + 0.006(210) + 0.010(2.5) =
1.895

Firm X may be extended credit.

Example: A company currently has annual sales of
Rs. 5 lacs & an average collection period of 30
days. It is considering a more liberal credit
policy. If the credit period is extended, the
company expects sales & bad debt losses to
increase in the following manner:

Credit + in credit + in Bad debt %

Policy period sales(Rs.) (Total Sales)
A 10 days 25000 1.2
B 15 days 35000 1.5
C 30 days 40000 1.8
D 42 days 50000 2.2
Credit period days 30 40 45 60 72

B. Annual Sales 5lac 5.25la 5.35 5.4 lac 5.5 lac

c lac
C. Level of recievables 41667 58333 66875 90000 110000
(at sale value) AB/360
D. Incremental investment in 16667 25208 48333 68333
recievables (C-41667)
E. Required incremental profit @ 3333 5042 9667 13667
20% (0.2D)
F. Incremental contribution on 10000 14000 16000 20000
additional sales @40%
G. Bad debt losses Bx(% bad 5000 6300 8025 9720 12100
debt)
H. Incremental bad debt 1300 3025 4720 7100
losses(G-5000)
I. Incremental expected 8700 10975 11280 12900
profit(F_H)
J. Net gain I-E 5367 5933 1613 (767)

K. Expected return, I/D 52.2% 43.5% 23.3% 18.9%