Accounts Receivable Accounts Receivable ManagementManagement

A / RA / RA / RA / R

JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS OF ICMAP, ICAP, MA-

ECONOMICS, B.COM.ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE FINANCIAL ACCOUNTING OF ICMAP STAGE

1,3,4 ICAP MODULE B, B.COM, BBA, MBA & 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.PIPFA.

COST ACCOUNTING OF ICMAP STAGE 2,3 COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT:CONTACT: 0322-33857520322-3385752 0312-23028700312-2302870 R-1173,ALNOOR SOCIETY, BLOCK R-1173,ALNOOR SOCIETY, BLOCK

19,F.B.AREA, KARACHI, PAKISTAN.19,F.B.AREA, KARACHI, PAKISTAN.

JOIN KHALID AZIZJOIN KHALID AZIZ

CRASH CLASSES FOR CRASH CLASSES FOR COMPLETION OF COMPLETION OF IMPORTANT TOPICSIMPORTANT TOPICS

ICMAP STAGE 1 & 2ICMAP STAGE 1 & 2FINANCIAL AND COST FINANCIAL AND COST

ACCOUNTINGACCOUNTING JOIN NOWJOIN NOW

The Cash Flow TimelineThe Cash Flow Timeline

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received AccountsAccounts Collection Collection < Inventory > < < Inventory > < ReceivableReceivable > < Float > > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed

Learning ObjectivesLearning Objectives

Define credit policy and indicate its components.Define credit policy and indicate its components. Describe the typical credit-granting sequence.Describe the typical credit-granting sequence. Apply net present value analysis to credit Apply net present value analysis to credit

extension decisions.extension decisions. Define credit scoring and explain limitations.Define credit scoring and explain limitations. List the elements in a credit rating report.List the elements in a credit rating report. Describe how receivables management can Describe how receivables management can

benefit from EDI.benefit from EDI.

Trade Credit and Trade Credit and Shareholder ValueShareholder Value

Trade credit arises when goods sold under delayed Trade credit arises when goods sold under delayed payment termspayment terms

Traced to Romans due to obstacles faced in Traced to Romans due to obstacles faced in transferring money through various trading areastransferring money through various trading areas

Credit terms are taken for granted todayCredit terms are taken for granted today Value can be added by managing three areas:Value can be added by managing three areas:

– aggregate investment in receivablesaggregate investment in receivables– credit termscredit terms– credit standardscredit standards

Over-investing in receivables can be costlyOver-investing in receivables can be costly ...but, if credit terms are not competitive, then lost ...but, if credit terms are not competitive, then lost

sales can be costlysales can be costly

ConclusionConclusion

Minimize bad debts and outstanding Minimize bad debts and outstanding receivablesreceivables

Maintain financial flexibilityMaintain financial flexibility Optimize mix of company assetsOptimize mix of company assets Convert receivables to cash in a Convert receivables to cash in a

timely mannertimely manner Analyze customer riskAnalyze customer risk Respond to customer needsRespond to customer needs

A/R Management and A/R Management and Shareholder ValueShareholder Value

Marketing StrategyMarketing Strategy

Market Share Obj.Market Share Obj.

Aggregate Inv. in A/RAggregate Inv. in A/R Credit TermsCredit Terms Credit StandardsCredit Standards

Total Dollar InvestmentTotal Dollar Investment Length of Time to PayLength of Time to Pay Acceptance of Marg Cust.Acceptance of Marg Cust.

Max Shareholder ValueMax Shareholder Value

Trade vs. Bank CreditTrade vs. Bank Credit

Length of termsLength of terms SecuritySecurity Amounts involvedAmounts involved Resource transferred (goods vs. Resource transferred (goods vs.

money)money) Extent of analysisExtent of analysis

Why Extend Credit?Why Extend Credit?

Financial MotiveFinancial Motive Operating MotiveOperating Motive Contracting MotiveContracting Motive Pricing MotivePricing Motive All reasons are related to market All reasons are related to market

imperfectionsimperfections

Financial MotiveFinancial Motive

Potential of getting a higher pricePotential of getting a higher price Sellers raise capital at lower rates than customers Sellers raise capital at lower rates than customers

and have cost advantages vis-a-vis banks due to:and have cost advantages vis-a-vis banks due to:– similarity of customerssimilarity of customers– the information gathered in the selling processthe information gathered in the selling process– lower probability of default (the goods lower probability of default (the goods

purchased are an essential element of the purchased are an essential element of the buyer’s business)buyer’s business)

– seller can more easily resell product if payment seller can more easily resell product if payment is not made.is not made.

Operating MotiveOperating Motive

Respond to variable and uncertain Respond to variable and uncertain demanddemand

Change credit terms rather than:Change credit terms rather than:– install extra capacity,install extra capacity,– building or depleting inventories, building or depleting inventories, – or forcing customers to wait.or forcing customers to wait.

JOIN KHALID AZIZJOIN KHALID AZIZ

CRASH CLASSES FOR CRASH CLASSES FOR COMPLETION OF COMPLETION OF IMPORTANT TOPICSIMPORTANT TOPICS

ICMAP STAGE 1 & 2ICMAP STAGE 1 & 2FINANCIAL AND COST FINANCIAL AND COST

ACCOUNTINGACCOUNTING JOIN NOWJOIN NOW

Contracting Cost MotiveContracting Cost Motive

Buyer gets to inspect goods prior to Buyer gets to inspect goods prior to paymentpayment

Seller has less theft with separation Seller has less theft with separation of collection and product deliveryof collection and product delivery

Pricing MotivePricing Motive

Change price by changing credit Change price by changing credit termsterms

Trends Affecting Trade Trends Affecting Trade CreditCredit

Zero net working capital objectiveZero net working capital objective Improved internal and external Improved internal and external

credit-related informationcredit-related information Electronic commerceElectronic commerce

The Credit Decision ProcessThe Credit Decision Process

Marketing contactMarketing contact

Credit investigationCredit investigation

Customer contact for informationCustomer contact for information

Finalize written documents, e.g.. security agreementsFinalize written documents, e.g.. security agreements

Establish customer credit fileEstablish customer credit file

Financial analysis Financial analysis

Tim

eTim

e

Basic Credit Granting ModelBasic Credit Granting Model

S - EXP(S)S - EXP(S)NPV = ----------------- - VCR(S)NPV = ----------------- - VCR(S) 1 + iCP1 + iCP

Where:Where:

NPV = net present value of the credit saleNPV = net present value of the credit saleVCR = variable cost ratioVCR = variable cost ratioS = dollar amount of credit saleS = dollar amount of credit saleEXP = credit administration and collection expense ratioEXP = credit administration and collection expense ratioi = daily interest ratei = daily interest rateCP = collection period for saleCP = collection period for sale

Managing the Credit PolicyManaging the Credit Policy

Should we extend credit?Should we extend credit? Credit policy componentsCredit policy components Credit-granting decisionCredit-granting decision

Should We Extend Credit?Should We Extend Credit?

Follow industry practiceFollow industry practice Extent and form of credit offerExtent and form of credit offer

– in-house credit cardin-house credit card– sell receivables to a factorsell receivables to a factor– captive finance company?captive finance company?

Components of Credit PolicyComponents of Credit Policy Development of credit standardsDevelopment of credit standards

– profile of minimally acceptable credit worthy customerprofile of minimally acceptable credit worthy customer Credit termsCredit terms

– credit periodcredit period– cash discountcash discount

Credit limitCredit limit– maximum dollar level of credit balancesmaximum dollar level of credit balances

Collection proceduresCollection procedures– how long to wait past due date to initiate collection effortshow long to wait past due date to initiate collection efforts– methods of contactmethods of contact– whether and at what point to refer account to collection whether and at what point to refer account to collection

agencyagency

Credit-Granting DecisionCredit-Granting Decision

Development of credit standardsDevelopment of credit standards Gathering necessary informationGathering necessary information Credit analysis: applying credit Credit analysis: applying credit

standardsstandards Risk analysisRisk analysis

Grant-Granting SequenceGrant-Granting Sequence

NoNo

Order and creditOrder and creditrequest receivedrequest received

New/increasedNew/increasedcredit limitcredit limit

MaterialMaterialchange in change in customer statuscustomer status

Redo creditRedo creditinvestigationinvestigation

Size of proposedSize of proposedcredit limitcredit limit

MediumMedium SmallSmallLargeLarge

IndepthIndepthcredit invest.credit invest.

IndepthIndepthcredit invest.credit invest.

ModerateModeratecredit invest.credit invest.

MinimalMinimalcredit invest.credit invest.

Check new A/RCheck new A/Rtotal vs credit lmttotal vs credit lmt

Check new A/RCheck new A/Rtotal vs credit lmttotal vs credit lmt

NoNo YesYes

YesYes

Extend CreditExtend CreditNoNo

YesYes

RecordRecorddispositiondisposition

Set up,postSet up,postA/R, shipA/R, ship

Credit StandardsCredit Standards

Based on five C's of CreditBased on five C's of Credit– CharacterCharacter– CapitalCapital– CapacityCapacity– CollateralCollateral– ConditionsConditions

Determine risk classification systemDetermine risk classification system Link customer evaluations to credit Link customer evaluations to credit

standardsstandards

Gathering InformationGathering Information

credit reporting agencies, e.g.. Dun & credit reporting agencies, e.g.. Dun & BradstreetBradstreet

credit interchange bureaus, NACMcredit interchange bureaus, NACM bank lettersbank letters references from other suppliersreferences from other suppliers financial statementsfinancial statements field data gathered by sales repsfield data gathered by sales reps

Credit Analysis: Applying Credit Analysis: Applying the Standardsthe Standards

NonfinancialNonfinancial– concerned with concerned with willingnesswillingness to pay, character to pay, character

FinancialFinancial– abilityability to pay, financial ratios etc.. (other C’s to pay, financial ratios etc.. (other C’s

of credit)of credit) Credit scoring modelsCredit scoring models

– Example:Example:

Y = .000025(INCOME) + 0.50(PAYHIST) + Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)0.25(EMPLOYMT)

Emergence of Expert Emergence of Expert SystemsSystems

Example of decision rule:Example of decision rule:

“If gross income is equal to or grater than “If gross income is equal to or grater than $20,000 and the applicant has not been $20,000 and the applicant has not been delinquent and gross income per delinquent and gross income per household member is equal to or greater household member is equal to or greater than $12,000 and debt/equity ratio is than $12,000 and debt/equity ratio is equal to or greater than 30% but less than equal to or greater than 30% but less than 50% and personal property is equal to or 50% and personal property is equal to or greater than $50,000, then grant credit.”greater than $50,000, then grant credit.”

Factors Affecting Credit Factors Affecting Credit TermsTerms

CompetitionCompetition Operating cycleOperating cycle Type of good (raw materials vs finished Type of good (raw materials vs finished

goods, perishables, etc.)goods, perishables, etc.) Seasonality of demandSeasonality of demand Consumer acceptanceConsumer acceptance Cost and pricingCost and pricing Customer typeCustomer type Product profit marginProduct profit margin

Cash DiscountsCash Discounts

The lower the VC, the higher the The lower the VC, the higher the feasible discountfeasible discount

Based on company’s cost of fundsBased on company’s cost of funds Consider timing effect when changing Consider timing effect when changing

discountsdiscounts Should be based on product’s price Should be based on product’s price

elasticityelasticity Higher the bad debt experience, higher Higher the bad debt experience, higher

the optimal discountthe optimal discount

Practice of Taking Cash Practice of Taking Cash DiscountsDiscounts

51% of firms always took cash 51% of firms always took cash discountdiscount

40% sometimes40% sometimes 9% take discount and pay late9% take discount and pay late Study found that 4 or 5 companies Study found that 4 or 5 companies

would be more profitable if cash would be more profitable if cash discount was eliminateddiscount was eliminated

A/R Management in PracticeA/R Management in Practice

Discounts appear to be changed to match Discounts appear to be changed to match competitors, not inflation or interest ratescompetitors, not inflation or interest rates

The higher a firm’s contribution margin, the more The higher a firm’s contribution margin, the more likely the firm should be to offer discounts.likely the firm should be to offer discounts.

A price cut is thought to have more impact than A price cut is thought to have more impact than instituting a cash discountinstituting a cash discount

The more receivables a firm has, does not The more receivables a firm has, does not necessarily relate to use of penalty feesnecessarily relate to use of penalty fees

The greater amount of receivables does not relate The greater amount of receivables does not relate to a more active credit evaluation.to a more active credit evaluation.

Receivables, Collections, Receivables, Collections, and EDIand EDI

If credit approval is delayed...If credit approval is delayed...– buyers using EDI purchase orders and JIT buyers using EDI purchase orders and JIT

manufacturing can encounter serious problems.manufacturing can encounter serious problems.– sellers can now ship within hours of receiving sellers can now ship within hours of receiving

orders...thus seller must be able to handle orders...thus seller must be able to handle electronically transmitted orders.electronically transmitted orders.

Seller may also issues electronic invoices and be paid Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that electronically using an EDI-capable bank so that remittance data can be automatically read by seller’s remittance data can be automatically read by seller’s A/R systemA/R system

Trend is for use of data transmission to automate the Trend is for use of data transmission to automate the cash application processcash application process

SummarySummary Investment in A/R represents a significant investment.Investment in A/R represents a significant investment. Key aspects outlinedKey aspects outlined

– credit policycredit policy– credit standardscredit standards– credit granting sequencecredit granting sequence– credit limitscredit limits– credit termscredit terms

Management of A/R is influenced by what competitors Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations.are doing not by shareholder wealth considerations.

Proper use of NPV techniques can ensure that credit Proper use of NPV techniques can ensure that credit decisions enhance shareholder value.decisions enhance shareholder value.

JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS OF ICMAP, ICAP, MA-

ECONOMICS, B.COM.ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE FINANCIAL ACCOUNTING OF ICMAP STAGE

1,3,4 ICAP MODULE B, B.COM, BBA, MBA & 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.PIPFA.

COST ACCOUNTING OF ICMAP STAGE 2,3 COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT:CONTACT: 0322-33857520322-3385752 0312-23028700312-2302870 R-1173,ALNOOR SOCIETY, BLOCK R-1173,ALNOOR SOCIETY, BLOCK

19,F.B.AREA, KARACHI, PAKISTAN.19,F.B.AREA, KARACHI, PAKISTAN.