18673969 Accounts Receivable

8/8/2019 18673969 Accounts Receivable

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ACCOUNTS RECEIVABLE

Trade credits creates accounts receivable or trade debtors that the firm is expected to

collect in future.

The customers from whom receivable or book debts have to be collected in the future arecalled trade debtors or debtors


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CHARACTERISTICS OF CREDIT

SALES

It involves an element of risk that should

be carefully analyzed.

It is based on economic value.

It implies futurity.


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CREDIT POLICY A Firms investment in accounts receivabledepends on:

a. The volume of credit sales

b. The collection period

Firms average investment =Daily credit sales X Average collection

periodCredit policy is evaluated in terms of return andcosts of additional sales.


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CREDIT POLICY

Credit policy refers to1. Credit standards :

Criteria to decide the types of customersto whom goods could be sold on credit.

Slow paying customers will increaseinvestment in receivable and is exposed tohigh default risk


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CREDIT POLICY2. Credit terms :The duration of credit and terms of payment bycustomers. Extended time period for making paymentswill increase investment in receivables.

3. Collection efforts:Determine the actual collection period. The lower thecollection period, the lower the investment in accounts

receivables and vice versa.


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G OALS OF CREDIT POLICY

A firm following a lenient credit policy willgrant credit in liberal terms and standardsand grant credit to longer period and alsoto customers whose creditworthiness isnot fully known.A firm following a stringent credit policy

sells on credit on a highly selective basisonly to customers with provencreditworthiness.


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CREDIT POLICY AS MARKETIN G

TOOLF irms use credit policy as a marketing tool during expansionsales.

In a declining market, it is used to maintain market share. Ithelps to retain old customers and to create new customers.

In a growing market, it is used to increase firms market share.

Under a highly competitive situation or recessionary economicconditions, firm loosen its credit policy to maintain sales or tominimize erosion of sales.


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NECESSITY OF G RANTIN G

CERDITCompanies in India grant credit for

1. Competition: Higher the degree of competition, the more the credit grant2. Bargaining power: Higher bargaining power

leads to less credit or no credit3. Buyers status and requirement: Large

buyers demand easy credit terms.


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NECESSITY OF G RANTIN G

CERDIT4. Dealer relationship

5. Marketing tool

6. Industry practice & past practice

7. Transit delays: Forced reason for grantingcredit.


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TYPES OF COST INVOLVED1. Production and selling cost:If sales expand with in the existing production capacitythere will be increase only in variable production andselling cost.If capacity is added, then the incremental production andselling costs will include both variable and fixed costs.

Incremental contribution of the change in credit policy is

the difference between incremental sales revenue andthe incremental production and selling costs.


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TYPES OF COST INVOLVED

2. Administration costs:when the firm loosens its credit policy, two typesof administration costs are involved.

1. Credit investigation cost

2. Collection costs

3. Bad debt losses.


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CHAN G E IN CREDIT POLICY

The evaluation of change in credit policyinvolves analysis of

Opportunity cost of lost contribution

Administration costs and bad-debt losses.

Credit policy will be determined by the trade-off between opportunity cost and creditadministration and bad debts looses.


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OPTIMUM CREDIT POLICY

Optimum credit policy is one whichmaximizes the firms value.

Value of firm is maximized when theincremental or marginal rate of return of aninvestment is equal to the incremental or marginal cost of funds used to finance theinvestment


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M ARGINAL COST- BENE F IT

ANALYSISTo achieve the goal of maximization of firms value, the evaluation of investment in accounts receivable should involve

1. Estimation of incremental operating profit (change in contribution additional costs)

2. Estimation of incremental investment in accounts receivable

( Investment in accounts receivable = credit sales per day X Averagecollection period)

3. Estimation of the incremental rate of return of investment(Operating profit after tax / Investment in accounts receivable)4. Comparison of the incremental rate of return with the required rate of return.


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CREDIT POLICY VARIABLES1. CREDIT STANDARDS

The two aspects of quality of customers are

Time taken by customers to repay credit obligation.

The average collection period (ACP) determines thespeed of payment by customers.The default rate: It can be measured in terms of bad-debt losses ratio.The customers are categorized as good, bad andmarginal accounts.


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DEFAULT RISKTo estimate the probability of default thefollowing three Cs are considered.

1. Character: It refers to the customers willingness to pay. Themanager should judge whether the customers will make honestefforts to honour their credit obligations.2. Capacity: It refers to the customers ability to pay. It is judgedby assessing the customers capital and assets offered as security.This is done by analysis of ratios and trends in firms cash andworking capital.3. Condition: It refers to the prevailing economic and other

conditions that affect the customers ability to pay.


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CREDIT ANALYSIS A firm can do credit analysis using1. Numerical credit scoring models: It includesa. Adhoc approach: The attributes identified by the firm

may be assigned weights depending on their importance and combined to create an overall score or index.

b. Simple discriminant analysis: A firm use moreobjective methods of differentiating between good andbad customers.(Eg:- ratio of EBDIT to sales)

c. Multiple discriminant analysis: It combines manyfactors according to the importance (weight) given toeach factor and determine a score to differentiatecustomers as good and bad


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CREDIT SCORIN G MODELS

Credit scoring models such as MDA arebased on objective factors and help a firmto quickly distinguish between good andbad customers.These models can mislead since they arebased on past data.


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CREDIT G RANTIN G DECISIONCredit granting decision

G rant Credit

Paymentreceived

PaymentNot received

BenefitPV of Future

Net CashFlow

CostPV of Lost

Investment

Net Payoff PV of

Benefit-cost

No Credit

No Pay-off


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CREDIT TERMSThe stipulations under which the firm sells on credit tocustomers are called credit terms.

These include1. Credit period: The length of time for

which credit is extended to customers iscalled the credit period.

2. Cash discount: It is a reduction in paymentoffered to customers to include them to repay credit

obligations within a specified period of time, whichwill be less than the normal credit period. It isexpressed as a percentage of sales. It is a cost tothe firm for faster recovery of cash.


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COLLECTION POLICYCollection policy is needed to acceleratecollections from slow payers and reduce baddebt losses.

1. It should ensure prompt and regular collection.2. It should lay down clear cut collection

procedures.3. The responsibility for collection and follow up

should be explicitly fixed.( Accounts or sales)4. The firm should decide on cash discounts to

be allowed for prompt payment5. It should be flexible


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CREDIT EVALUATION

For effective management of credit, clear cutguidelines and procedures for granting credit toindividual customers and collecting individual

accounts should be laid down.

The credit evaluation procedure includes:1. Credit information

2. Credit investigation3. Credit limits4. Collection procedures


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CREDIT INFORMATIONTo ensure full and prompt collection of receivables,credit should be allowed only to customers who have theability to pay in time. For this the firm should have creditinformation of customers.

Collecting credit information involves cost. The costshould be less than the potential profitability.

Depending on cost and time, the following sources canbe employed to collect credit information


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SOURCES OF CREDITINFORMATION

1. Financial statement: One of the easiest ways toobtain information on the financial condition of thecustomer is to scrutinise his financial statements.(Balance sheet & P&L a/c)

2. Bank references: Bank where the customer maintains his account is another source of collectingcredit information3. Trade references: Contacting the persons or firmswith whom the customer has current dealings is anuseful source to obtain credit information at no cost.4. Other sources: Credit rating organisations such asCRISIL, CARE etc


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CREDIT INVESTIN G ATION AND ANALYSIS

The factors that affect the nature and extent of credit investigation of an individual customer are:

1. Type of customer, whether new or existing2. The customers business line, background and

the related trade risks.3. The nature of the product- perishable or

seasonal4. Size of the customers order and expected

further volumes of business with him5. Companys credit policies and practices.


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CREDIT INVESTIN G ATION AND ANALYSIS

Steps involved in credit analysis are1. Analysis of the credit file: A credit file updated

regularly is maintained for each customer, which givesinformation on his trade experiences, performance

report based on financial statements, credit amountetc.2. Analysis of financial ratios: The evaluation of the

customers financial conditions should be done verycarefully. Ratios should be calculated to determine thecustomers liquidity position, ability to repay debts etc.,

3. Analysis of business and its management: The firmshould also consider the quality of management andthe nature of the customers business. For this amanagement audit.


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CREDIT LIMIT

A credit limit is a maximum amount of creditwhich the firm will extend at a point of time.It indicates the extent of risk taken by the firm bysupplying goods on credit to a customer.The decision on the magnitude of credit, the timelimit etc depends on the amount of sales,industry norms and customers financialstrength.


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CREDIT EFFORTS

The firm should follow a well defined creditpolicy and procedure to collect dues fromcustomers.


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MONITORIN G RECEIVABLE

For the success of collection efforts, thefirm needs to monitor and control itsreceivables.

The methods used for evaluation are

1. Average collection period2. Aging schedule3. Collection Experience Matrix


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Average Collection periodTo judge the collection efficiency, the average collection period(ACP) is compared with the firms stated credit period.

ACP = Debtor X360Credit sales

It measures the quality of receivablesLimitations:

1. It provides an average picture of collection experience and isbased on aggregate data.

2. It is susceptible to sales variations and the period over which salesand receivables have been aggregated.

Thus ACP cannot provide a very meaningful information about thequality of outstanding receivable


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AG ING SCHEDULE

It breaks down receivables according tothe length of time for which they havebeen outstanding.

It overcomes one of the limitations of aging schedule


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COLLECTION EXPERIENCEMATRIX

Using disaggregated data for analysingcollection experience, the problem of relatingoutstanding receivables of a period with thecredit sales of the same period is eliminated.

The receivables is related to sales of the sameperiod.

Sales over a period of time are shownhorizontally and associated receivablesvertically, and a matrix is constructed


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Sales and Receivables from July to December

(Rs. In lakhs)M onth July Aug. Sept. Oct. Nov. Dec.

Sales 400 410 370 220 205 350Receivable

July 330Aug 242 320Sept 80 245 320Oct. 0 76 210 162

Nov. 0 0 72 120 160Dec. 0 0 0 40 130 285


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Sales and Receivables from July to December

(Rs. In lakhs)M onth July Aug. Sept. Oct. Nov. Dec.

Sales 400 410 370 220 205 350Receivable

July 82.5Aug 60.5 78.0Sept 20.0 59.8 86.5Oct. 0 18.5 56.8 73.6

Nov. 0 0 19.5 54.5 78.0Dec. 0 0 0 18.2 63.0 81.4


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FACTORIN G

Factoring is a popular mechanism of managing,financing and collecting receivables.It is assigning the credit management and

collection, to specialist organisations.It is an unique financial innovationIt is a method of converting non-productiveinactive asset, receivables into productive asset,

cash by selling receivables to a company thatspecialises in their collection and administration.It is a means of short-term financing


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FACTORIN G

It is a business involving a continuing legalrelationship between a financial institution(the factor) a business concern (the client)selling goods or providing services to tradecustomers whereby the factor purchasesthe clients accounts receivable and in

relation thereto, controls the credit,extended to customers and administersthe sales ledger.


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FACTORIN G SERVICES

The factor provides the following services.

1. Sales ledger administration and creditmanagement2. Credit collection and protection against

default and bad-debt losses3. Financial accommodation against theassigned book debts (receivables).


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CREDIT ADMINISTRATION A factor

1. Helps and advises the firm from the stage of decidingcredit extension to customers to the final stage of bookdebt collection

2. Maintains an account for all customers of all itemsowing to the firm

3. Provides information about market trends, competitionand customers.

4. Makes a systematic analysis of the informationregarding credit for its proper monitoring andmanagement.

5. Prepares reports regarding credit and collection


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CREDIT COLLECTION ANDPROCTECTION

The factor undertakes all collectionactivity.

Provides full or partial protection againstbed-debts.

Develops appropriate strategy to guardagainst possible defaults


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FINANCIAL ASSISTANCE

The factor provides financial assistance tothe client by extending advance cashagainst book debts.

The advance amount will be equal toamount of factored receivables minus

1. factoring commission2. interest on advance3. reserve for bad debts losses.


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Types of factoring

Factoring facilities can be divided into

1. Full service non-recourse(Old linefactoring)2. Full service recourse

3. Bulk/agency factoring4. Non-notification factoring


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FULL SERVICE NON-RECOURSE

In this method,The book debts are purchased by the factor,assuming 100% credit risk

Advances upto 80-90% of book debts to clientimmediatelyThe customer pays directly to the factor This is best suited where

1. Amount involved per customer is substantial2. There are large number of customers of whom

the client cannot have personal knowledge3. The client prefers to obtain 100% cover


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FULL SERVICE RECOURSEIn this method1. The client is not protected against eh risk of bad debts.2. It is often used as a short term financing rather than

pure credit management and protection service.3. Less risky from factors point of view and less

expensive for the firm.4. This method is preferred when the customers are

largely spread with low amount involved or if the firm is

selling to high risk customers.


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BULK/AG ENCY FACTORIN G

It is basically used as a method of financing book debts.

The client continues to administer creditand operate sales ledger.It is used when there is a good system of credit administration but the client needfinances.


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NON-NOTIFICATION FACTORIN G

Customers are not informed about thefactoring agreement.

The factor keeps the accounts ledger inthe name of a sales company to which theclient sells his book debts.


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COST AND BENEFIT OFFACTORIN G

Costs involved are1. The factoring commission or service fee2. The interest on advance granted by the factor to the

firm.

Benefits are:1. It provides specialised service in credit management

and helps the firms management to concentrate onmanufacturing and marketing

2. Helps the firm to save cost of credit administration dueto the scale of economics and specialisation.


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A company is currently selling 1,00,000units of its product at Rs.50 each unit. Atthe current level of production, the cost per unit is Rs. 45, variable cost per unit beingRs. 40. The company is current extending

one months credit to its customers. It isthinking of extending credit period to twomonths in the expectation that sales willincrease by 25%. If the required rate of return(Before tax) on the fims investmentis 30%, is the new credit policy desirable?


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Incremental sales unit = 25000Contribution per unit = Rs. 50-40 = Rs.10Incremental contribution= Rs.2,50,000

New level of receivables= 125000 X 50 X 60360

= Rs. 1041667

Old level of receivables = 100000 X 50 X 30360

= Rs. 416667

Incremental investment in receivables = Rs.1041667-416667

= Rs. 625000


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Incremental rate of return = 250000625500= 0.40 or 40%

Since incremental rate of return is more thanrequired rate of return, new credit policy can beaccepted.Net gain = Incremental profit

Incremental cost= 250000 0.30 X 625000

= 250000 - 187500= Rs. 62500


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Assumptions:1.Credit period is increased to all2.All sales are credit sales.3.Fixed cost does not change with increase

in level4.Investment in receivables is represented

by sales value

If investment in receivable is representedat cost, then


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variable cost per unit = Rs. 40F ixed cost per unit (100000 units) = Rs. 5

Total fixed cost = Rs. 500000Old sales at cost = 100000 X 40 + 500000

= Rs. 4500000Old level of receivables = Rs. 4500000 X 30

360=Rs. 375000

New sales at cost = 125000 X 40 + 500000= Rs. 5500000

New level of receivables = Rs. 5500000 X 60360= Rs. 916667


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Incremental level of receivables at cost= 916667 375000= Rs. 541667

Incremental cost = Rs. 541667 X 0.30= Rs. 162500

Net gain = Rs. 250000 162500= Rs. 87500

Date post:	10-Apr-2018
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18673969 Accounts Receivable

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