CHAPTER 4

ACCOUNT RECEIVABLE
MANAGEMENT

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 INTRODUCTION
All firm by their nature Some of these sales
are involved in selling will be for cash, a large
either goods or The efficient
portion will involve management of AR
services credit. would be collect
from debtor quickly
as possible without
losing their sales
Thus, the important of from high-pressure
Whenever a sale is how a firm manages its of collection
made on credit, it AR depends on the techniques.
increase the firm’s AR degree to which the
firm sells on credit.
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ACCOUNT RECEIVABLE
MANAGEMENT

Moreover, because the

AR typically comprise
cash flow from a sale
more than 25% of a
cannot be invested until
firm’s assets
the account is collected,
management of ¼ of
profitability & liquidity
the firm’s assets.
of the firm.

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FACTORS DETERMINING THE SIZE OF INVESTMENT IN AR

% of credit
sales to
1 total sales
nature of
the Example :
business
tends to Large grocery store tends to sell
determine exclusive on a cash basis, where as
the blend manufacturing firm makes their sales
between primarily with credit
credit sales
& cash sales
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FACTORS DETERMINING THE SIZE OF INVESTMENT IN AR

2 Level
of sales

Normally if
more sales,
the greater the
AR would be
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FACTORS DETERMINING THE SIZE OF INVESTMENT IN AR

Term of sale
Credit and • Identified the possible discount
3 collection for early payment, the discount
policies period, and the total credit period

Quality of customer
• Involves determining the
type of customer who
qualifies for trade credit

Collection efforts
• Focuses on the control &
elimination of past-due
receivable by using ratio
analysis

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THE PROCESS OF CREDIT SELECTION

Involves the application of

technique for determining the
customers that should receive The decline in customers quality
Several costs are associated with
credit, by first evaluating their will result in an increase in the
extending credit to less
creditworthiness and then costs of investigation, collection
creditworthiness customers.
comparing it with the minimum and default
requirements for extending
credit.

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TECHNIQUE OF CREDIT SELECTION
ɕ Customers who purchase in large monetary amounts may be
selected based on the following criteria :

 Character reliability in payments

 Capital the customer’s debt to equity ratio
 Capacity the CF available for repayment
 Collateral the assets available for securing the debt
 Conditions prevailing economic & industry conditions

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 Credit scoring

Customers who purchase in high volume but small monetary

amounts. It is involves the use of statistically derived weights
representing key financial & credit characteristics that will
measure a customer overall credit strength. The decision to
accept or reject a particular applicant will be dependent on
the score.

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CREDIT TERM
Usually stated as a/b net c
meaning that the customer can
The terms of sale identify the
Term of sale that are laid out by a deduct “a” % (the discount ) if the
possible discount of early
firm, for credit to be extended to discount is paid within “b” days
payment, the discount period and
customers (the discount period); if not, the
the total credit period.
account must be paid within “c”
days (the total credit period)

For example :Terms 3/10 net 45

indicates that a 3% discount is
Failure to take up this discount is
obtained if the account is paid
a cost to the customer
within 10 days; if not it must be
paid within 45days

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• Represented by the formula :

ANNUALIZED OPPURTINITY
COST FOREGOING THE = [ a / ( 1 – a ) ] x [ 360 / ( c – b ) ]
DISCOUNT

• Typically, in the industries, the discount ranges from 0.5% to 10% the discount period is about 10 days and
the total credit period is from 30 to 90 days.
• For example : 3 / 10 net 30
= 0.03 x 360
1 – 0.03 30 - 10
= 0.03 x 360
0.97 20

= 0.0309 x 18
= 0.0562 @ 55.62%

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CASH DISCOUNT
A cash discount acts as an incentive for the customer to pay earlier rather than
later.

The discount decrease the firm’s investment in AR although it also decrease

profit.

A cash discount also helps in reduction of bad debts and may increase sale
volume.

Firms offering a cash discount should perform a cost benefit analysis to

determine whether extending a cash discount is profitable.

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CREDIT STANDARDS AND POLICY

The RELAXATION
standards by increasing
If credit standards were
AR will lead to a higher
TIGHTENED , it will lead
Credit standard for sales volume which in
to lower sales volume &
customer selection may turn increase
lower profitability.
change from time to time profitability. However, it
However, the chances of
will also increase debt
bad debts are also lower
collection efforts &
chances of bad debts

RS/JPG/PSA/2016 13
 EXAMPLE FOR CALCULATION :

Nilam Corporation is considering a change in credit policy from the current terms of 1/10 net 40 to 2/10 net 60
as an effort to increase sales. Given the following information, should the firm adopt the new policy?

Current policy (1/10 net 60)

Sales (credit) RM100,000,000
50% of customers enjoyed the discount
35% of customers paid on day 40
15% of customer paid on day 50
Bad debt RM3,000,000
Inventory level RM50,000,000

New policy (2/10 net 60)

Expected sales (credit) RM130,000,000
65% of customer will enjoy the discount
25% of customers paid on day 60
10% of customers paid on day 70
Bad debt RM5,200,000
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Inventory level RM55,000,000
Assume: variable cost is 75% and yield before tax is 14%. Do you advise the firm to change its
current credit policy?

Solution :

Step 1 = Estimate the change in profit

∆Y = ( ↑ S x CM ) – ( ∆ BD ) where :
∆Y = change in profit
↑ S = increased sales @ new sales – original sales
CM = contribution margin @ 1 – variable cost
∆BD = change in bad debt @ new bad debt level – original bad debt level

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 Step 2 : Estimate the cost of additional investment in accounts receivable and inventory

Cost of additional investment in accounts receivable and inventory

= (Additional accounts receivable + additional inventory) x (pre-tax required rate of return)

Additional accounts receivable =

New Sales Level (New Average collection period) - Original sales level (Original average collection period )

360 360

Additional inventory = new inventory level – original inventory level

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New average collection period = 0.65(10 days) + 0.25 (60 days) + 0.10 (70 days)
= 6.5 + 15 + 7
= 28.5 days
Original average collection period = 0.50 (10 days) + 0.35 (40 days) + 0.15 (50 days)
= 5 + 14 + 7.5
= 26.5 days
Additional account receivable =
New Sales Level
360 ( New Average Collection Period )
Original Sales Level
360 ( Original Average Collection Period)

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 = 130,000,000 100,000,000
360 28.5 360 26.5
= 10,291,666.67 – 7,361,111.11
= 2,930,555.56

Additional inventory = new inventory level – original inventory level

= 55,000,000 – 50,000,000
= 5,000,000

Additional account receivable and inventory = 2,930,555,56 + 5,000,000

= RM7,930,555.56
Cost of additional investment in accounts receivable and inventory
= (Additional accounts receivable + additional inventory) x (pre-tax required rate of return)
= RM7,930,555.56 x 14%
= RM1,110,277.78

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Step 3 = Estimated the change in the cost of the cash discount (if a change in the cash discount is
enacted)

∆ cost of cash discount =

New New % % Customer Original Original % % Customer
Level Cash Taking - Level Cash Taking
Of Sales Discount Discount of Sales Discount Disount

∆ Cost of cash discount = [ (130,000,000)(0.02)(0.65) ] – [ (100,000,000)(0.01)(0.50) ]

= 1,690,000 – 500,000
= RM1,190,000

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 Step 4 : Compare the incremental revenues with the incremental cost

∆ net change in pre-tax profits = Step 1 – (Step 2 + Step 3)

∆ net change in pre-tax profits = 5,300,000 – (1,110,277.78 + 1,190,000)

= RM2,999,722.22

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 Step 4 : Compare the incremental revenues with the incremental cost

∆ net change in pre-tax profits = Step 1 – (Step 2 + Step 3)

∆ net change in pre-tax profits = 5,300,000 – (1,110,277.78 + 1,190,000)

= RM2,999,722.22

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