Receivables Management

Accounts Receivable
• Although some sales are made for cash, today most sales are on credit.

• Thus, in the typical situation, goods are shipped, inventories are reduced, and an account
receivable is created.

• Eventually, the customer pays, the firm receives cash, and its receivables decline.

• The firm’s credit policy is the primary determinant of accounts receivable, and it is under
the administrative control of the CFO.

• Moreover, credit policy is a key determinant of sales, so sales and marketing executives
are concerned with this policy.
CREDIT POLICY
• Credit policy consists of these four variables:

• Credit period is the length of time buyers are given to pay for their purchases. For
example, the credit period might be 30 days.

• Customers prefer longer credit periods, so lengthening the period will stimulate sales.
However, a longer credit period lengthens the cash conversion cycle; hence, it ties up
more capital in receivables, which is costly.

• Also, the longer a receivable is outstanding, the higher the probability that the customer
will default and that the account will end up as a bad debt.
Discounts
• Discounts are price reductions given for early payment. The discount specifies what the
percentage reduction is and how rapidly payment must be made to be eligible for the
discount. For example, a 2% discount is often given if the customer pays within 10 days.

• Offering discounts has two benefits. First, the discount amounts to a price reduction,
which stimulates sales. Second, discounts encourage customers to pay earlier than they
otherwise would, which shortens the cash conversion cycle. However, discounts also
mean lower prices—and lower revenues unless the quantity sold increases by enough to
offset the price reduction. The benefits and costs of discounts must be balanced when
credit policy is being established.
Credit standards
• Credit standards refer to the required financial strength of acceptable credit customers. With regard
to credit standards, factors considered for business customers include ratios such as the customer’s
debt and interest coverage ratios, the customer’s credit history (whether the customer has paid on
time in the past or tended to be delinquent), and the like.

• For individual customers, their credit score as developed by credit rating agencies is the key item. In
both cases, the key question is this: Is the customer likely to be willing and able to make the
required payment on schedule?

• Note that when standards are set too low, bad debt losses will be too high; on the other hand, when
standards are set too high, the firm loses sales and thus profits. So a balance must be struck between
the costs and benefits of tighter credit standards.
Collection policy
• Collection policy refers to the procedures used to collect past due accounts, including the
toughness or laxity used in the process. At one extreme, the firm might write a series of
polite letters after a fairly long delay; at the other extreme, delinquent accounts may be
turned over to a collection agency relatively quickly.

• Companies should be somewhat firm, but excessive pressure can lead customers whose
business is profitable to take their business elsewhere. Again, a balance must be struck
between the costs and benefits of different collection policies.
Credit Terms
• Firms generally publish their credit terms, defined as a statement of their credit period and
discount policy.

• Thus, Allied Food might have stated credit terms of 2/10, net 30, which means that it
allows a 2% discount if payment is received within 10 days of the purchase; if the
discount is not taken then, the full amount is due in 30 days.
What is the primary concern associated with lengthening the credit period in receivable
management?
a. Increased customer satisfaction
b. Tying up more capital in receivables
c. Stimulating sales
d. Shortening the cash conversion cycle
What is the purpose of offering discounts in a credit policy?
a. Increasing product prices
b. Encouraging late payments
c. Stimulating sales and shortening the cash conversion cycle
d. Discouraging early payments
In a credit policy, what does a 2% discount within 10 days mean?
a. 2% discount for payments made within 10 days
b. 10% discount for payments made within 2 days
c. 2% discount for payments made within 20 days
d. 10% discount for payments made within 2 weeks
What financial ratios are considered in setting credit standards for business customers?
a. Age of customers
b. Debt and interest coverage ratios
c. Customer preferences
d. Quantity of past purchases
What is the risk associated with setting credit standards too low in a credit policy?
a. Increased bad debt losses
b. Decreased sales and profits
c. Delays in payment
d. Lower customer satisfaction
What is the key consideration in assessing individual customers for credit standards?
a. Debt and interest coverage ratios
b. Customer preferences
c. Credit history and credit score
d. Quantity of past purchases
What is the main purpose of a collection policy in receivable management?
a. Increasing sales
b. Encouraging early payments
c. Minimizing bad debt losses
d. Discouraging customer inquiries
What could be a consequence of turning delinquent accounts over to a collection agency too quickly? a.
Improved customer relationships
b. Increased sales
c. Profitable customers taking their business elsewhere
d. Higher credit ratings
What is the potential drawback of offering longer credit periods in a credit policy?
a. Decreased sales
b. Lower customer satisfaction
c. Increased cash conversion cycle
d. Higher discount expenses
1.Answer: b. Tying up more capital in receivables
2.Answer: c. Stimulating sales and shortening the cash conversion cycle
3.Answer: a. 2% discount for payments made within 10 days
4.Answer: b. Debt and interest coverage ratios
5.Answer: a. Increased bad debt losses
6.Answer: c. Credit history and credit score
7.Answer: c. Minimizing bad debt losses
8.Answer: c. Profitable customers taking their business elsewhere
9.Answer: c. Increased cash conversion cycle
 • Credit policy is important for three main
reasons:

• (1) It has a major effect on sales.

• (2) It influences the amount of funds tied up in

Why Credit policy receivables.

is important? • (3) It affects bad debt losses.

ABC Corporation has the following financial information:

Inventory conversion period: 50 days

Average collection period: 35 days

Payables deferral period: 28 days

a. Calculate the length of ABC Corporation's cash conversion cycle.

b. If ABC's annual sales amount to $3,500,000, and all sales are on credit,
determine the investment in accounts receivable.
c. Calculate the inventory turnover ratio for ABC Corporation. Assume
that the cost of goods sold is 60% of sales.
Trade Credit
• Trade Credit Debt arising from credit sales and recorded as an account receivable by the
seller and as an account payable by the buyer

• Trade credit may be free, or it may be costly. If the seller does not offer discounts, the
credit is free in the sense that there is no cost for using it. However, if discounts are
available, a complication arises.
Example
• To illustrate, suppose PCC Inc. buys 20 microchips each day, with a list price of $100 per
chip on terms of 2/10, net 30. Under those terms, the “true” price of the chips is
0.98($100) = $98 because the chips can be purchased for only $98 by paying within 10
days. Thus, the $100 list price has two components:
Nominal cost of trade credit is the stated percentage discount, while effective cost considers
compounding and the actual time taken to settle, providing a more accurate representation of the true
cost.
Greenway Supplies offers credit terms of 2/15, net 45. Total sales for the
year are $2,500,000. Approximately 25% of the customers take advantage
of the 2% discount and pay on the 15th day, while the remaining 75% pay,
on average, 60 days after their purchases.

a. Calculate the days sales outstanding (DSO) for Greenway Supplies.

b. Determine the average amount of receivables for Greenway Supplies.

c. Find the percentage cost of trade credit to customers who take the
discount.

d. Calculate the percentage cost of trade credit to customers who do not take
the discount and pay in 60 days.

e. Explore the potential impact on Greenway's accounts receivable if it

tightens its collection policy, resulting in all non-discount customers paying
on the 45th day.
Harbor Electronics has annual sales of $8 million, and all sales are made
on credit terms requiring payment within 45 days. The current days sales
outstanding (DSO) is calculated at 40 days, and accounts receivable
amount to $1.2 million.

a. Determine Harbor Electronics' current Days Sales Outstanding (DSO).

b. Calculate the Days Sales Outstanding if all customers paid on time

(within 45 days).

c. Estimate the amount of capital that could be released if Harbor

Electronics implemented measures leading to on-time payments by all
customers.