MANAGEMENT OF ACCOUNTS RECEIVABLE Chapter 14

MANAGEMENT OF ACCOUNTS RECEIVABLE

Chapter 14

There are two ways to approach the management of accounts receivable:– 1) See how the “Parameters“ interface

with the “Variables”, and– 2) The development of a “Credit Granting

Decision Rule”.

First, we will examine the relationships between the Parameters and the Variables.

ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE


The PARAMETERS are:

Cash Discount - A discount from the face amount of invoice for paying before end of discount period

Cash Discount Period - Period in which you can take the Cash Discount, e.g. … 10 days

Credit Period - e.g. … 30 days; customer is expected to pay before this date.

Collection Effort - The effort that goes into collecting the account.


The VARIABLES are:

Sales Net Income Rate of Return on Sales and ROA Volume of Accounts Receivable NOCF Bad Debt Expense

A/R … Cash Discount

Effective Annual Interest Rates in Typical 10 day Effective Annual Interest Rates in Typical 10 day Discount Period and 30 day Credit Period:Discount Period and 30 day Credit Period:

0.5% Discount0.5% Discount == 9%9% 1.0% Discount1.0% Discount == 18%18% 2.0% Discount2.0% Discount == 36%36% 3.0% Discount3.0% Discount == 54%54%


What determines the elasticity (of demand) with regard to Sales?

It appears that it’s the relative importance of the order to the customer. – If the order is relatively unimportant, then inelastic– If the order is important, then elastic - every “price change”

will be important.


Elasticity of Cash Discount relative to Sales:Elasticity of Cash Discount relative to Sales:

Cash Discount

3%2 1 1/2

Sales Elastic; Inelastic.


Now the elasticity of the Cash Discount with regard to Net Income:

If inelastic, and you lowered the Cash Discount, then

Net Income - $’s

Cash Discount

321


And the And the Cash DiscountCash Discount relative to relative to Rate of Rate of Return on Sales Return on Sales if if inelasticinelastic relative to Sales relative to Sales

Rate of Return on Sales

Cash Discount

321

1 2 3 4 5 6


But, while the Rate of Return on Sales may go up, what might happen to ROA? It may actually go down!– If A/R’s account for a large proportion of Total Assets

and A/R’s go up because customers have less incentive to pay early. Thus:

ROA

Cash Discount

321


And what might happen to NOCF with this decrease in Cash Discount if we assume inelasticity?

NOCF will be larger, but it may go down first when the A/R’s increase.

Cash discount

Time

3%21

NOCFIN$’S

NOCF


If you reduce the Cash Discount this will have a tendency to increase Bad Debt Expense.

The Cash Discount is, in effect, an “early warning system” because if a customer suddenly stops taking a cash discount when it was taking it, this may signal that customer is having liquidity problems.

A/R … Cash Discount Period

With respect to the Cash Discount Period, there is little that can be done to shorten it

Problem … “Confusion” as to when & how much discount can be taken

Solution … Instead of using printed forms, have your invoices printed by a computer– You can specify that a Cash Discount of so much can

be taken if the check is post marked by a specified date.

A/R … Cash Discount Period

What do you do if a customer takes a Cash Discount and pays LATER than the end of the Cash Discount Period?

This is what might be called “Economic Bullyism” and it is to be abhorred! If you are really small relative to the customer, you may try charging an interest rate on the period over the “late date.” But if you are rather big, your customer - who may also be rather big - may refuse to pay any interest and continue to

pay slowly.

A/R … Credit PeriodA/R … Credit Period

And now for the Credit Period. This is the “bluntest instrument” in the A/R management “Tool Bag”.

What would happen if a firm increased its credit period from 30 to 60 days? For many items, there will be noticeable elasticity, especially from customers in the retail and mercantile field - until the competition responds!


Credit Period versus Sales

Sales

Credit Period

60

30

0

Often, there will be elasticity of demandwith respect to the credit period.


Credit periodCredit period versus versus Net IncomeNet Income

Net Income

Credit Period

60

30

0

But this rise in Net Income may be misleading;what's going to happen to the Volume of A/R?


Credit Period versus Volume of Receivables

Volume Of Receivables

Credit Period

60

30

0

DemandEffect

Note that the Volume of Receivables will go up because Credit Period is increased, plus a “Demand Effect” increase - other customers will buy.


Credit Period versus Rate of Return on Sales & Rate of Return on Assets

Rate of Returnon Sales

CreditPeriod

60

30

0

ROA


Credit period versus NOCF

CreditPeriod

30

60

NOCF

NOCFIN $’S

Time

0 $’s

A/R … Collection EffortA/R … Collection Effort

Collection Effort - How hard do you try to collect Receivables? Also, what sort of screening do you do on customers? For example, re: Sales

CollectionEffort

SalesWith better screening, more sales may result at first; but pushing Collection Effort will result in declining sales.

ACCOUNTS RECEIVABLE

Bad Debt Expense - If you were the Collection Manager and during your tenure Bad Debt Expense went up, would you think that you did a good job?

Maybe “Yes” if your Net Income went up! The object is to OPTIMIZE Bad Debt Expense, not minimize it!

ACCOUNTS RECEIVABLE - Credit Granting Decision Rule

How do you decide whether or not to grant credit to a customer?

Grant Credit if: Expected Gain > Expected Loss– i.e. where … P x G > (1-P) x C

P = Probability of Collection G = Gross Profit C = Cost of Goods Sold


An example of the decision rule:An example of the decision rule:

Where P = .9, G = $300, and C = $700, Where P = .9, G = $300, and C = $700, then then

.9 ( 300 ) > (1- .9) ( 700 ).9 ( 300 ) > (1- .9) ( 700 )

$270 > $70$270 > $70

Grant Credit!Grant Credit!


Slow pay decreases Margin & increases Cost - we can add this to the decision rule as follows:

P [ G - ( i(t) S) ] >(1- P )[ C + (i(t) S) ] Or

.9 [ 300 - (36( 1/6 yr.) 1,000)] > .1 [ 700 + (.36(1/6yr) 1,000)] $216 > $76 Still Grant Credit!

Slow Pay Factor is “i(t)S” … where:

i = Interest (36%)t = Time payment is delayed (2 months)S = Sales amount of order


As you can see, the probability of collection, As you can see, the probability of collection, PP, is , is quite important in this model. Now it can be shown quite important in this model. Now it can be shown that :that :

P = C/S or (S - G)/SP = C/S or (S - G)/S

and if you include the Slow Pay Factor, it becomes:and if you include the Slow Pay Factor, it becomes:

P = [ C + ( i(t) S)] / SP = [ C + ( i(t) S)] / S

oror

P = [ S - (G - (i(t) S)) ] / SP = [ S - (G - (i(t) S)) ] / S

Where P is the probability of collection that makes the left side of the equation equal right side.


It follows from the preceding equation that the decision rule for granting credit boils down simply to:

Grant Credit if P > P

If you have a very big Gross Profit, you should be quite liberal when granting credit (because your P will be quite small)

If you have a thin Gross Profit, you must be quite careful in granting credit.


Caveats:

P is “ at the margin”, meaning that it applies for just one more sale.

The customer’s probability of collection is not fixed in granite; it will be changing over time. So you must keep checking the probability over time.

You can kill a customer with too much credit.

One big sale “gone bad” can “ruin your whole day”!!!

A Last Thought …A Last Thought …

It isn’t about managing your own It isn’t about managing your own company …company …

– Often you have to manage your Often you have to manage your customers as well …customers as well …

– And your suppliers!And your suppliers!

MANAGEMENT OF ACCOUNTS RECEIVABLE

END

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MANAGEMENT OF ACCOUNTS RECEIVABLE Chapter 14

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