UNIT VI

Receivables Management
 Outcome

• Analyze the concept of receivables management by

employing various credit policies.
News Analysis Dec 8,2021
 Meaning of Trade Credit
Trade credit happens when a firm sells its products or services on credit
and does not receive cash immediately. It is an essential marketing tool,
acting as a bridge for the movement of goods through the production
and distribution stages to customers.

A firm grants trade credit to protect its sales from the competitors and
to attract the potential customers to buy its products at favorable
terms. Trade credit creates accounts receivable or trade debtors.
 Nature of Credit Policy
A firm’s investment in accounts receivable depends on:
•Volume of credit sales
The volume of credit sales is a function of the firm’s total sales and the
percentage of credit sales to total sales. Total sales depend on market
size, firm’s market share, product quality, intensity of competition,
economic conditions etc. The financial manager hardly has any control
over these variables.
•Collection period
 Credit Policy
Financial manager can affect the volume of credit sales and collection
period through the changes in credit policy. The term credit policy is
used to refer to the combination of three decision variables:
•Credit standards are the criteria to decide the types of customers to
whom goods could be sold on credit.
•Credit terms specify duration of credit and terms of payment by
customers.
•Collection efforts determine the actual collection period. The lower
the collection period, the lower will be the investment in accounts
receivable and vice versa.
 MCQ
A change in credit policy has caused an increase in sales, an
increase in discounts taken, a reduction in the investment in
accounts receivable, and a reduction in the number of
doubtful accounts. Based upon this information, we know
that
A.Net profit has increased.
B.The average collection period has decreased.
C.Gross profit has declined.
D.The size of the discount offered has decreased.
 Answer
B. The average collection period has decreased.
 Goals of Credit Policy

1. Marketing tool (expanding sales)

2. Maximisation of sales Vs. incremental profit

• production and selling costs

• administration costs

• bad-debt losses
 Optimum Credit Policy
Optimum credit policy is one which maximizes the firm’s value. The
value of the firm is maximized when the incremental or marginal rate
of return of an investment is equal to the incremental or marginal cost
of funds used to finance the investment. To achieve this goal, the
evaluation of investment in accounts receivable should involve the
following four steps:
•Estimation of incremental operating profit
•Estimation of incremental investment in accounts receivable
•Estimation of the incremental rate of return of investment
•Comparison of the incremental rate of return with the required rate of
return
 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

There are the two aspects of the quality of customers:

I.Time taken by the customers to repay credit obligations

II.Default risk
 Contd…..
To estimate the probability of default the financial manger should
consider three C’s:

1)Character (willingness to pay)

2)Capacity (ability to pay)

3)Conditions (prevailing economic and other conditions)

 MCQ
A change in credit policy has caused an increase in sales, an increase in
discounts taken, a decrease in the amount of bad debts, and a
decrease in the investment in accounts receivable. Based upon this
information, the company is

A.Average collection period has decreased.

B.Percentage discount offered has decreased.

C.Accounts receivable turnover has decreased.

D.Working capital has increased.

 Answer
A. Average collection period has decreased.
Credit-Granting Decision
CREDIT GRANTING
DECISION

NO CREDIT GRANT CREDIT

PAYMENT PAYMENT
RECEIVED NOT RECEIVED

BENEFIT COST
PV OF FUTURE PV OF LOST
NET CASH INVESTMENT
FLOWS
NO PAYOFF

NET PAYOFF
PV OF
(BENEFIT - COST)

Credit-granting Decision
 Credit Evaluation of Customers
Credit information
• financial statements
• bank references
• trade references
Credit investigation and analysis
• analysis of credit file
• financial analysis
• analysis of business and management
Credit limit
Collection efforts
 MCQ

A decrease in the firm's receivable turnover ratio

means that __________.
A.it is collecting credit sales more quickly than before

B.it is collecting credit sales more slowly than before

C.sales have gone down

D.inventories have gone up

 Answer
B. it is collecting credit sales more slowly than before