Unit - - III

Management of Receivables ( 7 Hrs)

Syllabus
Receivables: Nature & cost of maintaining
receivables, objectives of receivables management,
factors affecting size of receivables, policies for
managing accounts receivables, determination of
potential credit policy including credit analysis, credit
standards, credit period, credit terms,
Collection Policies; Credit Management in India.
Notes
Meaning of Receivables
“Receivables are sales made on credit basis”

According to Hampton - “Receivables are asset accounts representing

amount owned to the firm as a result of the sale of goods or services
in the ordinary course of business”.

Thus, receivables are an asset and represent claims of the firms against
its customers.

As a part of the operating cycle , Time lag between sales and

receivables creates need for working capital.

Nature of Receivables
 Risk involvement- It involves Risk.
 Based on credit sales & collection period.
 Based on present economic value.
 It implies Futurity - The buyer makes the cash payment for goods or
services received by him in future period.
 Ranging between stringent & linent policy
 Stringent-Selective basis credit sale
  Linent – Very liberal credit sale

Factors Affecting the Size of Receivables

 Size of credit sales
The volume of credit sale is the first factor that influences receivables.
Firm adhering to cash sales would have low receivables as compared to
firms allowing sales on credit. Higher the credit allowed more will be the
receivables and vice a versa
 Credit Policies
Firm with conservative credit policies will have low receivables as
compared with firms following liberal credit policies. Prompt collections
even with liberal credit policies will help in keeping receivables under
control. Outstanding for long period may result in bad debts.

 Terms of trade
The period for which the credit is allowed will decide the extent of
receivables. Longer the period of credit more would be the receivables.
Again, cash purchases followed up with credit sale is the main reason
for increasing receivables.

Eg: Firm’s credit sales- Rs. 50,000 per day. Credit period for payment
of dues – 40 days.

Average investment in accounts receivable= 50,000 X 40 = 20 lakhs.

 Expansion plans
Firm that want to expand into new markets attract customers by
providing incentives in terms of credit. Once the firm gets the permanent
customers it may start reducing the period for which credit was allowed.

 Credit collection efforts

A firm should always have strong and well equipped credit collection
machinery. Delayed collection will increase receivables and will pose
serious financial troubles for the company.
Meaning of Receivables Management
Receivable management is the process of making decisions relating to
investment in trade debtors.

Certain investment in receivables is necessary to increase the sales and

the profits of the firm and to meet the competition effectively.

However, investment in this asset involves cost consideration also.

Receivable management may be defined as - collection of steps and

procedure required to properly weigh the costs and benefits attached
with the credit policies.

It consists of matching the cost of increasing sales (particularly credit sales

) with the benefits arising out of increased sales with the objective of
maximising the return on investment of the firm.

BENEFITS OF RECEIVABLES MANAGEMENT

 Growth in sales.
 Increase in Profits.
 Capability to Face competition.
 Helps to increase customer satisfaction.
 Takes control of sales processes.

Cost of Maintaining Receivables

Carrying Costs/Capital Cost

Cost incurred for arranging additional funds to support credit.

Administrative Costs

A firm is also required to incur various costs in order to maintain the record
and collection from customers which includes salaries of the staff, Use of
office space, processing equipments , Accounting, recording and
processing costs of debtors balances.
Cost of collection - Cost of collecting cheques, Cost of ph calls, reminders
and follow up.

Deliquency Costs

These are the costs which are to be incurred additionally by a firm in order
to recover the amount due from defaulting customers. The costs of such
extra steps e.g. Reminders, legal charges etc... are known as deliquency
costs.

Defaulting Costs

Sometimes, the firm may not collect the overdue from the customers since
they are unable to pay. These debts are treated as bad debts and are to be
written off accordingly since the amounts will not be realised in future.

Objectives of receivable Management

1. To 4maximize the return on investment in receivables.

2. To maximise the sales to the extent the risk involved remains within
the acceptable limit.

3. Maintaining up-to-date record.

4. Accurate billing.

5. To establish the credit policies.

6. To control cost of credit and keep it to the min.

7. To maximize value of firm

8. To cope up with competition

Factors Affecting Size of Receivables

 The effect of credit on volume of sales.

 Credit terms
 Cash discount
 Policies and practices of firm for selecting credit customers.
 Paying practices and habbits of customers.
 The firm’s policy and oractices of collection.
 The degree of oprating efficiency in billing, recordkeeping and other
functions.
 Other costs such as interest, collection costs and bad debts.

Policies for Managing Account receivables

A firm need to continuously monitor and control its receivables to ensure

success of the collection efforts.

Two traditional methods of eval the mgmnt of receivables are :

(a) Average collection period

(b) Aging schedule

(c) collection schedule matrix

Average collection period (ACP)

It measures the duration from the time sale is made to the time cash is
collected from the customers.

ACP= Debtors x 360

Credit Sales
The ACP so calculated is compared with the firm’s stated credit period to
judge the collection efficiency.

An extended collection period delays cash inflows, impairs firm’s liquidity

position and incr the chances of bad debts.

The average collection period measures the quality of receivables since it

indicates the speed of their collectability.
Limitations

It provides an average picture of the collection experience, however for

control purposes, one need specific info about the age of outstanding
receivables.

It is susceptible to sales variations and the period over which sales and
receivables are aggregated. Thus, it does not provide meaningful info
about the quality of outstanding receivables.

Aging schedule

It removes one of the limitations of ACP.

It breaks down the receivables according to the length of time for which it is
outstanding(age). Thus, it is a statement that shows age wise grouping of
debtors.

The purpose of classifying receivables by age group is to have closer

control over the quality of individual accounts.

It is helpful for identifying slow paying debtors, with which firm may have to
encounter stringent collection policy.

It is a quick and effective method for comparing the liquirdity of the

receivables with the liquidity of receivables in the past.

It also helps to predict collection pattern of receivables in the future.

Limitations

Fail to relate the outstanding receivables of a period with the credit sales of
the same period.

Collection Experience Matrix

The maor limitations of traditional methods are removed by relating the

receivables to the sales of same period.
The sales over a period of time are shown horizontally and the associated
receivables vertically in a tabular form, a matrix is constructed.

It shows the percentage of receivables collected during the month of sales

and subsequent months.

It helps in studying the efficiency of collections whether they are improving

or deteriorating
Determination of Potential credit Policy
Credit Policy

Credit policy refers to the application of those factors which influence the
amount of trade credit, i.e. Investment in receivables.

It is used to refer to three decision variables

(a) Credit Stds and Analysis – are criteria to decide the type of
customers to whom goods could be sold on credit. If a firm has more slow
paying customers, its investment in acct receivable will increase. The firm
will also b exposed to higher risk of default.

(b) Credit terms- specify duration and terms of payment by customers.

Investment in accts receivable will be high if customers are allowed
extended time period for making payments.

(c) Collection efforts determine the actual collection period. The lower
the collection period, the lower the investment in accts receivables and vice
versa.

TYPES:-

(a) Liberal or lenient credit policy.

Wherein credit sales are made liberally to those customers whose credit –
worthiness is either doubtful or even is not known at all.

(b) Stringent or tight credit policy.

Wherein credit sales are made only to those customers whose credit-
worthiness has been tested and is proved good.

Optimum credit Policy

As the firm moves from tight to loose credit policy, the opportunity cost
declines(The firm recaptures lost sales and thus,lost contribution) but the
admin cost & bad debt losses increases( more accts to be handeled which
incl bad debt accts which ultimately fail to pay)
The optimum credit policy is determined by the trade – off between the
opportunity cost and credit administration costs & bad debt losses.

It occurs where the total of opportunity cost of lost contributions and credit
administration cost & bad debt losses is minimum.

Factors to be considered while deciding the credit Policy

 Collection Costs
 Investment in receivables or average collection period
 Bad debts expenses
 Sales Volume
 The effects of relaxed or tightened credit policy.

Credit Standards

The credit standards are the criteria that a firm follow in selecting
customers for the purpose of credit extension.

The firm may have tight credit stds and may extend credit to only few
reliable and fin strong customers.

Such stds will result in less bad debt losses and admin cost but may not be
able to expand sales.

The profit sacrificed on lost sales may be more than the costs saved by the
firm
Alternatively, the company may follow a very liberal credit standard . the
firm will have larger sales but will have to carry larger receivables. The bad
debt losses and cost of admininstering credit will also incr.

The choice of optimum credit stds involve a trade off between incremental
returns and incremental costs

Credit Analysis & Decision ( Investigating the customer)

The credit std influence the quality of firm’s customers . There are two
aspects of quality.

(a) The time taken by customers to repay credit.

(b) The default rate.

“Credit analysis is the evaluation of the borrowing capacity of the applicant

and the promptness and repaying ability of a customer according to the
terms of contract.

Two basic steps are involved in the credit investigation process

(a) Obtaining credit information
(b) Analysis of credit information

Obtaining credit information

Internal Sources

 Filling up of various forms

 Trade references
 Internal records

External Sources

 Financial Statements/published info

 Bank references
 Trade references
 Credit Bureau reports
 Credit scoring
ANALYSIS OF CREDIT INFORMATION

Quantitative
i.e. ratio analysis of liquidity, profitability, debts capacity, Trend analysis of
over a period of time to reveal the financial strength.

Qualitative
i.e. references from other suppliers, bank references and special bureau
reports.

It must be clear that the main purpose of credit analysis is to assess the
credit worthiness of the customers.

The 5 C’s- Customer evaluation.

Character:- It is to be judged whether the customer is honest and is

prompt in paying the dues that he had undertaken to pay.

Capacity:- The ability of the customer to pay back the purchase price.

Capital:- Financial position of the customer.

Collateral:- Express the additional ability of the customer.

Condition:- Economic conditions & competitive factors that may affect the
customer’s ability to pay.

CREDIT TERMS

The terms under which goods are sold on credit are referred as credit
terms.

Thus, credit terms specify the repayment terms of receivables.

Components of Credit Terms

Credit Period- The length of time for which credit is extended to customer.
Generally stated in terms of net date.
A firm’s credit period is governed by industry norms but the firm can
lengthen credit pd depending upon its objective to expand sales . however,
the net incr in opr profit results only when the cost of extended credit pd is
less than the incr opr profit.

The firm may tighten the credit pd if customers are defaulting frequently
and the bad debt losses are increasing.

Cash Discount

Cash Discount Period

These components are usually written in abbreviations such as 2/10 net 30.
It means 2% discount if the payment is made in 10 days otherwise payment
to be made within 30 days.

Credit Discount

The credit discount is reduction in payment offered to induce the credit

buyer to pay within a specified time pd which will be less than the normal
credit pd.

Usually expressed as percentage of sales. It indicates the rate of discount

and the pd for which it is avlb.

Credit terms may be expressed as 2/10 net 30. This means 2% discount
will be granted if customer pays within 10 days , else he must make the
payment within 30 days.

It is used as a tool to incr sales and accelerate payments from customers.

Cost involved is the discount taken by the customer.

Cost of discount

= Sales x Percentage of customers taking discount x %Discount

Collection Policies

They refer to the procedures followed to collect accounts receivables after

the expiry of the credit period.

Components of Collection Policies

Degree of collection efforts

Degree of efforts to collect the over dues.

Tight - The collection policy would be tight if very vigorous procedure are
followed. A tight collection policy has both types of implications - benefits
as well as cost.

The management has to consider the trade- off between them.

The bad debt expenses would decline and average collection period will be
reduced. Therefore the profit of the firm will increase.

There may be decline in sales volume because some consumer may not
like the pressure and switch to another one.

Lenient - A lenient collection effort also affect the cost benefits trade off.
The effect of lenient policy will be just the opposite of the tight policy.

Types of collection period

This relates to the steps that should be taken to collect over dues from the
customers.

The collection policy should have clear cut guide-lines about the sequences
of collection efforts.

After the collection period is over and payment remain due, the firm should
take measures to collect them.

Type of collection efforts - Letters, Telephone Calls, Personal Visits, Help

of collection agencies and Legal action
 A case to illustrate this credit std approach.

Example: ADE LIMITED is engaged in manufacturing water.

Each water pack is priced at N100. The sales of the company during
the last accounting year were 80,000 units. The variable cost per unit
is N60, the fixed costs of the company are N16. The company is
contemplating to relax its credit standards and as a result, the
company is expecting 10 percent increase in sales. But at the same
time by relaxing the credit standards the average collection period of
the company is likely to increase from 30 days to 45 days. The bad
debt losses are expected to be 2% of increased sales. The collection
expenses are likely to go up by N50,000. The company also pay
commission of 10% on the sales and this cost is not included in the
variable cost. If the after-tax required rate of return on investment of
the company is 15 percent and the tax rate is 50% should the
company relax its credit standards?

Unit N

Additional sales generated 8000 x 100 800,000 Variable cost

8000 x 60 480,000 Gross margin 320,000

Other costs:

Bad debt expenses 800,000 x 0.2 16,000 Commission 800,000 x 1

80,000 Collection expenses 50,000 146,000 Profit 174,000 After –
tax profit50% 87,000

The effect of increase in sales on investment in accounts

receivable will be calculated as follows:

Average Collection Accounts receivable= -----------------------

Period x sales per day

Accounts receivable before change in credit standards:

30 x (8,000,000/360) = N666,667

Accounts receivable after change in credit standards:

45 x (88,000,000/360) = N1,100,000

Additional investment in accounts receivable as a result of

change in result standard is N433,333 required return on
additional investment:

4,333,333 x 1.5 N65,000.

The above analysis shows that the profitability on additional

sales as a result of change in credit far exceeds the required
return on account receivable investment, thus, the change is
profitable for ADE LIMITED

Credit Management in India

During recent years, a no. of tool , techniques and measures have
been invented to increase the effectiveness in management of
receivable accts.

1. Re-engineering Receivable processes – cost reduction and

performance improvements have been achieved by re-engineering
the accts receivable processes. The following aspects are modified to
improve the mgmt of accts receivables

(a) Centralization – Centralisation of high nature transactions of

accts receivable is one practice for better efficiency as it focuses on
specialized groups for speedy recovery.

(b) Alternative Payment Strategies - alt payment strategies in

addition to traditional practices results into efficiencies in mgmt of
acct receivables. Payment of accts outstanding is likely to be quicker
when a no. of alt methods of payments are avlb to the customer
besides acting as a marketing tool to attract and retain customers.
Some of the alt methods are :-
 (i) Direct debit – Authorization for the transfer of funds
from customer’s bank acct.

(ii) Integrated Voice response(IVR) – This sys uses human

operation and computer sys to allow customer’s to make
payment over phone,generally by credit card.

(iii) Collection by third party – The payment can be

collected by an auth ext firm.

(iv) Lock box sys – An outsourced partner ( a local bank)

collects and processes the cheques.

(b) Customer Orientation - When indl customer or gp of customers

have strategic imp for the firm, a case study appch is followed to which may
lead to fmn of a strategy for prompt settlement of debt.

2. Risk evaluation – It is an effective method to introduce cont. to

either contain the risk or eliminate them completely. This also paves way
foe effectiveness and efficiency in the mgmt of acct receivables.

3. Use of Latest Technology – The major innovations avlb are the

integration of sys used in the mgmt of accts receivables, the automation
and use of e-commerce.

(a) e-commerce – It involves the use of computer and

telecommunication sys such as Electronic data interchange(EDI),
Electronic Mail, Electronic fund tfr (EFT) and electronic catalogue sys to
enable the buyers and sellers to transact business by exchange of info
between computer application sys.

(b) Automated Accts Receivable Management Sys - Manual sys of

recording and managing receivables which were cumbersome
and costly have been replaced by automated receivable mgmt
sys to automatically update all the record affected by a
transaction and to store info of unltd no. of customers and
transactions to achieve efficient processing of customers
payments and adjustments.
4. Receivable Collection Practices – The major receivable collection
processes and practices adopted are :-

 Issue of Invoice
 Open Acct or Open-end credit
 Credit terms or time limits.
 Use of payment incentives and penalty.
 Periodic statements
 Record keeping and continuous audit.
 Business Process Outsourcing – a strategic business tool whereby
an outside agency takes the responsibility for managing a business
process.

5. Use of fin tools/Techniques

The fintools and techniques used are:-

(a) credit Analysis – Ascertain the credit rating of prospective

Customer

(b) Credit Rating – Rate the various customers who are

seeking credit facility to ascertain how much credit can be
extended and for how long.

(c) Credit Worthiness – Once ascertained from the fin

position, reputation and prev record of meeting
commitments, credit limit is sanctioned.
i help in
0
of the =f

1. IMPORTANCE OF RECEIVABLES MANAGEMENT  Credit policy

helps to meet the competition.  Credit sales help to attract not only
existing customers but also the new customers but also the new
customers.  It helps to minimize bad debts.  Liberalised credit
policy helps to increase the growth of sales.  Helps to increase the
operating profits because of more credit sales.  It ensures higher
investment in trade debtors, which will produce larger sales.  It gives
guidance to the management for effective financial planning and
control.  It helps to make effective coordination between finance,
production, sales, profit and cost.