304 FIN: AFM

Unit 4.4: Receivables

Management

Dr. Bhagyashree S Kunte

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 Unit 4.4: Receivables Management
Working Capital Management: Determination of level of current
assets, Working capital financing by banks;
Cash and liquidity Management- aspects of cash management,
motives for holding cash and marketable securities, Cash
Management Models,
Strategies for managing surplus funds;
Credit Management: Objectives of trade credit, credit policies.
Control and collection of accounts receivables.
Role of factoring in receivables management (No problems on
estimation of working capital). (9+2)

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 Unit 4.4: Receivables Management
Credit Management: Objectives of trade credit, credit policies.
Control and collection of accounts receivables.

Receivables Management
Receivables mean the book debts or debtors and these arise, if the
goods are sold on credit.
Debtors form about 30% of current assets in India. Debt involves
an element of risk and bad debts also.
Hence, it calls for careful analysis and proper management.
The goal of Receivables Management is to maximize the value of
the firm by achieving a trade off between risk and profitability.

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 Unit 4.4: Receivables Management
Receivables Management
The objectives of Receivables Management are as follows:
(a) To obtain optimum (non-maximum) value of sales;
(b) To control the cost of receivables, cost of collection,
administrative expenses, bad debts and opportunity cost of
funds blocked in the receivables.
(c) To maintain the debtors at minimum according to the credit
policy offered to customers.
(d) To offer cash discounts suitably depending on the cost of
receivables, bank rate of interest and opportunity cost of funds
blocked in the receivables.

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 Unit 4.4: Receivables Management
Costs of Maintaining Receivables
Capital costs: Maintenance of accounts receivable results in
blocking of the firm’s financial resources in them. This is
because there is a time lag between the sale of goods to
customers an the payments by them. The firm has, therefore, to
arrange for additional funds to meet its own obligations, such
as payment to employees, suppliers of raw materials, etc.
Administrative costs: The firm has to incur additional
administrative costs for maintaining accounts receivable in the
form of salaries to the staff kept for maintaining accounting
records relating to customers, cost of conducting investigation
regarding potential credit customers to determine their credit
worthiness etc

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 Unit 4.4: Receivables Management
Costs of Maintaining Receivables
Collection costs: The firm has to incur costs for collecting the
payments from its credit customers. Sometimes, additional
steps may have to be taken to recover money from defaulting
customers.
Defaulting costs: Sometimes after making all serious efforts to
collect money from defaulting customers, the firm may not be
able to recover the over dues because of the inability of the
customers. Such debts are treated as bad debts and have to be
written off since they cannot be realised.

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 Unit 4.4: Receivables Management
Factors Affecting the size of receivables
The size of accounts receivable is determined by a number of
factors. Some of the important factors are as follows:
Level of sales: This is the most important factor in determining
the size of accounts receivable.
Generally in the same industry, a firm having a large volume of
sales will be having a larger level of receivables as compared to a
firm with a small volume of sales.
Credit policies: A firm’s credit policy, determines the amount of
risk the firm is willing to undertake in its sales activities.
If a firm has a lenient or a relatively liberal credit policy, it will
experience a higher level of receivables as compared to a firm
with a more rigid or stringent credit policy.
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 Unit 4.4: Receivables Management
Factors Affecting the size of receivables
Terms of trade: The size of the receivables is also affected by
terms of trade (or credit terms) offered by the firm. The two
important components of the credit terms are (i) Credit period
and (ii) Cash discount.

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 Unit 4.4: Receivables Management
Determinants of Credit Policy
1. Level of credit sales required to optimize the profit.
2. Credit period: i.e. duration of credit, 15/30/45 days
3. Cash discount, discount period and seasonal offers.
4. Credit standard of a customer : 5 C’s of credit :
i) Character of the customer i.e. willingness to pay.
ii) Capacity: ability to pay. iii) Capital: financial resources
of a customer. iv) Conditions: Prevailing economic and
market conditions. v) Collateral security.
5. Profits. 6. Market and economic conditions.
7. Collection policy. 8. Paying habits of customers.
9. Billing efficiency 10. Grant of credit: size and age of receivable
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 Unit 4.4: Receivables Management
Optimum Size of Receivables
The optimum investment in receivables will be at a level where
there is a trade-off between costs and profitability.
When the firm resorts to a liberal credit policy, the profitability of
the firm increases on account of higher sales.
However, such a policy results in increased investment in
receivables, increased chances of bad debts and more collection
costs.
The total investment in receivables increases and, thus, the
problem of liquidity is created.
On the other hand, a stringent credit policy reduces the
profitability but increases the liquidity of the firm.

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 Unit 4.4: Receivables Management
Optimum Credit Policy

Profitability

Liquidity

A firm should establish receivables policies after carefully

considering both benefits and costs of different policies. These
policies relate to:
(i) Credit Standards, (ii) Credit Terms, and (iii) Collection
Procedures.

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 Unit 4.4: Receivables Management
1 Credit Standards
The term credit standards represent the basic criteria for
extension of credit to customers.
The levels of sales and receivables are likely to be high if the
credit standards are relatively loose, as compared to a situation
when they are relatively tight.
The firm’s credit standards are generally determined by the five
“C’s”. Character, Capacity, Capital, Collateral and Conditions.
Character denotes the integrity of the customer, i.e. his
willingness to pay for the goods purchased.
Capacity denotes his ability to manage the business. Capital
denotes his financial soundness.

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 Unit 4.4: Receivables Management
1 Credit Standards
Collateral refers to the assets which the customer can offer by
way of security.
Conditions refer to the impact of general economic trends on the
firm or to special developments in certain areas of economy that
may affect the customer’s ability to meet his obligations.
Information about the five C’s can be collected both from internal
as well as external sources. Internal sources include the firm’s
previous experience with the customer supplemented by its own
well developed information system. External resources include
customer’s references, trade associations and credit rating
organizations.

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 Unit 4.4: Receivables Management
2. Credit terms
It refers to the terms under which a firm sells goods on credit to
its customers.
The two components of the credit terms are (a) Credit Period and
(b) Cash Discount.
a) Credit period: Length of Credit period means the period
allowed to the customers for making the payment.
The length of credit period and quantum of discount allowed
determine the magnitude of investment in receivables.
A firm may allow liberal credit terms to increase the volume of
sales. The lengthening of this period will mean blocking of more
money in receivables. There may be an increase in debt
collection costs and bad debts losses too.
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 Unit 4.4: Receivables Management
2. Credit terms
b) Cash discount: cash discount is allowed to expedite the
collection of receivables. The funds tied up in receivables are
released. The concern will be able to use the additional funds
received from expedited collection due to cash discount.
The discount allowed involves cost. The finance manager should
compare the earnings resulting from released funds and the cist
of the discount.
The discount should be allowed only if its cost is less than the
earnings from additional funds. If the funds cannot be profitably
employed then discount should not be allowed.

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 Unit 4.4: Receivables Management
3. Collection procedures
stringent collection procedure is expensive for the firm because
of high out-of-pocket costs and loss of goodwill of the firm
among its customers.
However, it minimizes the loss on account of bad debts as well as
increases savings in terms of lower capital costs on account of
reduction in the size of receivables.
A balance has therefore to be stuck between the costs and
benefits of different collection procedures or policies.

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 Unit 4.4: Receivables Management
Qu. 1) Gemini Products Ltd. is considering the revision of its
credit policy with a view to increasing its sales and profits.
Currently all its sales are on credit and the customers are given
one month’s time to settle the dues. It has a contribution of 40%
on sales and it can raise additional funds at a cost of 20% per
annum. The marketing director of the company has given the
following options with draft estimates for consideration.

Particulars (₹ Lakhs) Current Option Option Option

position I II III
200 210 220 250
Sales
1 1½ 2 3
Credit period (months)
2 2½ 3 5
Bad debts (% of sales)
1.20 1.30 1.50 3.00
Cost of credit administration
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 Unit 4.4: Receivables Management
Qu. 1) Advise the company to take the right decision. (Workings
should form part of the answer).
Solution: Evaluation of the different options in credit policy of
Gemini Products Ltd.

Credit period Current Option I Option II Option III

(Months) (1.0) (1.5) (2.0) (3.0)
Sales 200 210 220 250
Less: Variable cost (60%) 120 126 132 150
Contribution (40%) (A) 80 84 88 100
Investment in debtors
[Sales x credit period / 12 16.67 26.25 36.67 62.50
months]

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 Unit 4.4: Receivables Management
Solution 1: Evaluation of the different options in credit policy of
Gemini Products Ltd.

Credit period Current Option I Option II Option III

(Months) (1.0) (1.5) (2.0) (3.0)
Cost of funds invested in 3.33 5.25 7.33 12.5
debtors balances @ 20%
Bad debts (% of sales) 2% 2.5% 3% 5%
Bad debts 4 5.25 6.6 12.5
Cost of Credit Admin. 1.2 1.3 1.5 3.0
Total Cost (B) 8.53 11.80 15.43 28
Net Contribution (A-B) 71.47 72.20 72.57 72

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 Unit 4.4: Receivables Management
Qu. 2) Surya Industries Ltd. is marketing all its products through a
network of dealers. All sales are on credit and the dealers are given one
month time to settle bills. The company is thinking of changing the
credit period with a view to increase its overall profits. The marketing
department has prepared the following estimates for different periods of
credit:
Particulars (₹ Lakhs) Current Plan I Plan II Plan III
Credit period One 1&1/2 Two Three
(months)
Sales 120 130 150 180
TheFixed Cost has a P/V ratio 30
company of 40%, it30
requires a35 40 at 20%.
pre-tax ROI
Evaluate the above
Bad Debts (% of proposals
Sales) 0.5 and recommend
0.8 the best
1.0 credit2.0
period for
the company.

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 Unit 4.4: Receivables Management
Solution 2: Evaluation of the different options in credit policy of
Gemini Products Ltd.
Credit period Current Option I Option II Option III
(Months) (1.0) (1.5) (2.0) (3.0)
Sales 120 130 150 180
Less: Variable cost (60%) 72 78 90 108
Contribution (40%) (A) 48 52 60 72
Fixed Cost (B) 30 30 35 40
Profit (C) 18 22 25 32
Cost of sales (VC+FC+ 102 108 125 148
Investment in debtors
[cost of sales x credit 8.5 13.5 20.83 37
period / 12 months]
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 Unit 4.4: Receivables Management
Solution 2: Evaluation of the different options in credit policy of
Gemini Products Ltd.

Credit period Current Option I Option II Option III

(Months) (1.0) (1.5) (2.0) (3.0)
Cost of funds invested in 1.7 2.7 4.17 7.4
debtors balances @ 20% (a)
Bad debts (% of sales) 0.5% 0.8% 1% 2%
Credit Sales 120 130 150 180
Bad debts (b) 0.60 1.04 1.50 3.60
Total Cost (D) =(a+b) 2.3 3.74 5.67 11.00
Net Profit (A-B) 15.7 18.26 19.33 21
Net Profit is higher in case of 3 months credit policy.
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 Unit 4.4: Receivables Management
Qu. 3) A firm is considering pushing up its sales by extending
credit facilities to the following categories of customers:
Customers with a 10% risk of non-payment, and
Customers with a 30% risk of non-payment.
The incremental sales expected in case of category (a) are `
40,000 while in case of category (b) they are ₹ 50,000.
The cost of production and selling costs are 60% of sales while
the collection costs amount to 5% of sales in case of category (a)
and 10% of sales in case of category (b).
You are required to advise the firm about extending credit
facilities to each of the above categories of customers.

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 Unit 4.4: Receivables Management
Solution 3: Evaluation of the different options in credit policy of
Gemini Products Ltd.
Category a) 10% risk of non-payment
`
Particulars

Incremental sales 40,000

Less: Bad debts @ 10% 4,000
Sales realized 36,000
Less: Cost of production and selling cost 24,000
(40,000 x 60%)
Less: Collection cost (40,000 x 5%) 2,000 26,000
Incremental profit 10,000
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 Unit 4.4: Receivables Management
Solution 3: Evaluation of the different options in credit policy of
Gemini Products Ltd.
Category b) 30% risk of non-payment
`
Particulars

Incremental sales 50,000

Less: Bad debts @ 30% 15,000
Sales realized 35,000
Less: Cost of production and selling cost 30,000
(50,000 x 60%)
Comment: Advise to extend credit facility to category (a)
Less: Collection cost (50,000 x 10%) 5,000 35,000
customers alone.
Incremental profit Nil
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 Unit 4.4: Receivables Management
Factoring may be defined as the relationship between the seller
of goods and a financial firm, called the factor, whereby the latter
purchases the receivables of the former and also administer the
receivable of the former. Factoring involves sale of receivable of
a firm to another firm under an already existing agreement
between the firm and the factor.
Graphical representation of factoring
Sale of Goods (1)

Selling Factor Customer, or

Firm Receivable

Invoice Copy (2) Payment on Due Date (4)

Advance Payment (3)

Final Payment, if any (5)

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 Unit 4.4: Receivables Management
Modus Operandi
A factor provides finance to his client up to a certain percentage
of the unpaid invoices which represent the sale of goods or
services to approved customers. The modus operandi of the
factoring scheme is as follows.
There should be a factoring arrangement (invoice purchasing
arrangement) between the client (which sells goods and services
to trade customers on credit) and the factor, which is the
financing organization.
Whenever the client sells goods to trade customers on credit, he
prepares invoices in the usual way.

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 Unit 4.4: Receivables Management
Modus Operandi
(a) There should be a factoring arrangement (invoice purchasing
arrangement) between the client (which sells goods and services
to trade customers on credit) and the factor, which is the
financing organization.
(b) Whenever the client sells goods to trade customers on credit,
he prepares invoices in the usual way.
(c) The goods are sent to the buyers without raising a bill of
exchange but accompanied by an invoice.
(d) The debt due by the purchaser to the client is assigned to the
factor by advising the trade customers, to pay the amount due to
the client, to the factor.

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 Unit 4.4: Receivables Management
Modus Operandi
(e) The client hands over the invoices to the factor under cover of
a schedule of offer along with the copies of invoices and
receipted delivery challans or copies of R/R or L/R.
(f) The factor makes an immediate payment up to 80% of the
assigned invoices and the balance 20% will be paid on realization
of the debt.

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Unit 4.4: Receivables Management

End of Unit 4.4: Receivables Management

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