Copyright 2005 by Thomson Learning, Inc. Chapter 5 Accounts Receivable Management A / R.

Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.

Chapter 5Chapter 5Accounts Receivable ManagementAccounts Receivable Management

A / RA / RA / RA / R


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 extension Apply net present value analysis to credit extension

decisions.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 benefit Describe how receivables management can benefit

from EDI.from EDI.


Trade Credit and Shareholder ValueTrade Credit and Shareholder 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 transferring Traced to Romans due to obstacles faced in transferring money through various trading areasmoney 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 sales ...but, if credit terms are not competitive, then lost sales

can be costlycan be costly


ConclusionConclusion

Minimize bad debts and outstanding receivablesMinimize bad debts and outstanding receivables Maintain financial flexibilityMaintain financial flexibility Optimize mix of company assetsOptimize mix of company assets Convert receivables to cash in a timely mannerConvert receivables to cash in a timely manner Analyze customer riskAnalyze customer risk Respond to customer needsRespond to customer needs


A/R Management and Shareholder A/R Management and Shareholder ValueValue

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. money)Resource transferred (goods vs. 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 imperfectionsAll reasons are related to market imperfections


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 purchased are an lower probability of default (the goods purchased are an essential element of the buyer’s business)essential element of the buyer’s business)

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


Operating MotiveOperating Motive

Respond to variable and uncertain demandRespond to variable and uncertain demand 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.


Contracting Cost MotiveContracting Cost Motive

Buyer gets to inspect goods prior to paymentBuyer gets to inspect goods prior to payment Seller has less theft with separation of collection Seller has less theft with separation of collection

and product deliveryand product delivery


Pricing MotivePricing Motive

Change price by changing credit termsChange price by changing credit terms


Trends Affecting Trade CreditTrends Affecting Trade Credit

Zero net working capital objectiveZero net working capital objective Improved internal and external credit-related Improved internal and external credit-related

informationinformation 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 agencywhether and at what point to refer account to collection agency


Credit-Granting DecisionCredit-Granting Decision

Development of credit standardsDevelopment of credit standards Gathering necessary informationGathering necessary information Credit analysis: applying credit standardsCredit analysis: applying credit standards 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 standardsLink customer evaluations to credit standards


Gathering InformationGathering Information

credit reporting agencies, e.g.. Dun & Bradstreetcredit reporting agencies, e.g.. Dun & Bradstreet 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 the Credit Analysis: Applying the StandardsStandards

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

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

Credit scoring modelsCredit scoring models– Example:Example:

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


Emergence of Expert SystemsEmergence of Expert Systems

Example of decision rule:Example of decision rule:

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


Factors Affecting Credit TermsFactors Affecting Credit Terms

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

perishables, etc.)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 feasible discountThe lower the VC, the higher the feasible discount Based on company’s cost of fundsBased on company’s cost of funds Consider timing effect when changing discountsConsider timing effect when changing discounts Should be based on product’s price elasticityShould be based on product’s price elasticity Higher the bad debt experience, higher the optimal Higher the bad debt experience, higher the optimal

discountdiscount


Practice of Taking Cash DiscountsPractice of Taking Cash Discounts

51% of firms always took cash discount51% of firms always took cash discount 40% sometimes40% sometimes 9% take discount and pay late9% take discount and pay late Study found that 4 or 5 companies would be more Study found that 4 or 5 companies would be more

profitable if cash discount was eliminatedprofitable if cash discount 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, and EDIReceivables, Collections, and EDI

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

encounter serious problems.encounter serious problems.

– sellers can now ship within hours of receiving orders...thus sellers can now ship within hours of receiving orders...thus seller must be able to handle electronically transmitted orders.seller must be able to handle electronically transmitted orders.

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

Trend is for use of data transmission to automate Trend is for use of data transmission to automate the cash application processthe cash 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.

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Copyright 2005 by Thomson Learning, Inc. Chapter 5 Accounts Receivable Management A / R.

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