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Tata McGraw-Hill Publishing Company Limited, Financial Management 15-1

Receivables Management


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RECEIVABLES MANAGEMENT

Objectives

Credit Policies

Credit Terms

Collection Policies

Solved Problem

Mini Case


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The term receivables is defined as debtowed to the firm by customers

arising from sale of goods or services in the ordinary course of

business. When a firm makes an ordinary sale of goods or servicesand does not receive payment, the firm grants trade credit and creates

accounts receivable which could be collected in the future. Receivables

management is also called t rade credit m anagement. Thus, accounts

receivable represent an extension of credit to customers, allowingthem a reasonable period of time in which to pay for the goods

received.

Objectives


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Costs

Administration Cost Collection cost is the administrative cost incurred

in collecting receivables.

Capital Cost Capital cost is the cost on the use of additional capital to

support credit sales which alternatively could have been employedelsewhere.

Delinquency Cost Delinquency cost is cost arising out of failure of

customers to pay on due date.

Default Cost Default costs are the over dues that cannot be recovered.

Benefits Apart from the costs, another factor that has a bearing on

accounts receivable management is the benefitemanating from credit

sales. The benefi ts arethe inc reased sales and antic ipated pro f i ts

because of a moreliberal policy.


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Credit Policies

The credit policy of a firm provides the framework to determine

1) whether or not to extend credit to a customer and

2) how much credit to extend.

The credit policy decision of a firm has two broad dimensions:

1) Credit standards and

2) Credit analysis. A firm has to establish and use standards in

making credit decisions, develop appropriate sources of

credit information and methods of credit analysis. We

illustrate below how these two aspects are relevant to the

accounts receivable management of a firm.


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Credit Standards

The term credit standards represents the basic criteria for the

extension of credit to customers. The trade-off with reference to

credit standards covers

1) the collection cost,

2) the average collection period/cost of investment in accounts

receivable,

3) level of bad debt losses, and

4) level of sales. These factors should be considered whiledeciding whether to relax credit standards or not

Collection Costs

The implications of relaxed credit standards are

1) more credit,2) a large credit department to service accounts receivable and

related matters,

3) increase in collection costs. The effect of tightening of credit

standards will be exactly the opposite.


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Bad Debt Expenses

Another factor which is expected to be affected by changes in the

credit standards is bad debt (default) expenses. They can beexpected to increase with relaxation in credit standards and

decrease if credit standards become more restrictive.

Sales Volume

Changing credit standards can also be expected to change thevolume of sales. As standards are relaxed, sales are expected to

increase; conversely, a tightening is expected to cause a decline in

sales.The basic changes and effects on profits arising from a relaxation of

credit standards are summarised in Exhibit 1. If the credit standards

are tightened, the opposite effects, as shown in the brackets, would

follow.


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EXHIBIT 1 Effect of Relaxation of Standards

Item Direction of

Change (Increase = I

Decrease = D)

Effect on

Profits (Positive +

Negative )

1.2.

3.

Sales VolumeAverage Collection Period

Bad Debt

I(D)I(D)

I(D)

+()(+)

(+)

The effect of alternative credit standards is illustrated in Example 1.

Example 1A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales

(all credit) were 30,000 units. The variable cost per unit is Rs .6 and the average

cost per unit, given a sales volume of 30,000 units, is Rs 8. The total fixed cost is

Rs 60,000. The average collection period may be assumed to be 30 days.

The firm is contemplating a relaxation of credit standards that is expected to result

in a 15 per cent increase in units sales; the average collection period wouldincrease to 45 days with no change in bad debt expenses. It is also expected that

increased sales will result in additional net working capital to the extent of Rs

10,000. The increase in collection expenses may be assumed to be negligible. The

required return on investment is 15 per cent.

Should the firm relax the credit standard?


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Solution

The decision to put the proposed relaxation in the credit standards

into effect should be based on a comparison of (i) additional profits on

sales and (ii) cost of the incremental investments in receivables. If the

former exceeds the latter, the proposal should be implemented,

otherwise not.

Profit on Incremental Sales

This can be computed in two ways:

(i) long approach, and(ii) short-cut-method.


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Long Approach

According to this approach, the costs and profits on both the present and the

proposed sales level are calculated and the difference in profit at the two levels will

be the incremental profit. This is shown in Table 1.

TABLE 1 Long Method to Calculate Marginal Profits

(A) Proposed Plan:

1.Sales revenue (34,500 units Rs 10) Rs 3,45,000

2.Less: Costs:

(a)Variable (34,500 Rs 6) Rs 2,07,000

(b)Fixed 60,000 2,67,000

3.Profits from sales (I) 78,000

(B) Current Plan:

1.Sales revenue (30,000 units Rs 10) 3,00,000

2.Less: Costs:(a)Variable (30,000 Rs 6) 1,80,000

(b)Fixed 60,000 2,40,000

3.Profits from sales (II) 60,000

(C) Marginal profits with new plan (III): 18,000


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Short-Cut Method

The profits on sales will increase by an amount equal to the product

of the additional units sold and additional profit per unit. Since the

30,000 units representing the current level of sales absorb all thefixed costs, any additional units sold will cost only the variable cost

per unit. The marginal profit per unit will be equal to the difference

between the sales price per unit (Rs 10) and the variable cost per

unit (Rs 6). The marginal profit/contribution margin per unit would,

therefore, be Rs 4. The total additional (marginal) profits fromincremental sales will be Rs 18,000 (Rs 4,500 Rs 4).

Cost of Marginal/Incremental

Investment in Receivables The second variable relevant to the

decision to relax credit standards is the cost of marginal investmentin accounts receivable. This cost can be computed by finding the

difference between the cost of carrying receivables before and after

the proposed relaxation in credit standards. It can be calculated as

follows:


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(i)Turnover of accounts receivable:

Proposed Plan = (Number of days in the year / Average collection period)

= (360 / 45) = 8

Present Plan = (360 / 30) = 12(ii) Total cost of sales:

Present plan = Number of units cost per unit = 30,000 Rs 8 = Rs 2,40,000

Proposed plan = (30,000 Rs 8) + (4,500 Rs 6) = Rs 2,67,000

(iii) Average investment in accounts receivable:

Present plan = Rs 2,40,000/12 = Rs 20,000

Proposed plan = Rs 2,67,000/8 = Rs 33,375

(iv) The cost of marginal investments in accounts receivable: This is the difference

between the average investments in accounts receivable under (i) the proposed

plan and (ii) under the present plan. It is calculated as follows:

Average investments with proposed plan Rs 33,375

Less average investment with present plan 20,000

Marginal investments 13,375


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Marginal investments represent the amount of additional funds required to

finance incremental accounts receivable if the proposal to relax the credit

standards is implemented. The additional cost of Rs 13,375 is the cost of

marginal investment in accounts receivable.

Given 15 per cent as required return on the investments, the cost = [(Rs

13,375 x 15) / 100] = Rs 2,006.25

This is an opportunity cost in that the firm would earn this amount from

alternative uses if the funds are not tied up in additional accountsreceivable.

(v) Cost of working capital: Rs 10,000 0.15 = Rs 1,500.

In the above illustration, since the additional profits on increased sales as a

result of relaxed credit standards (Rs 18,000) is considerably more than the

cost of incremental investments in accounts receivable (Rs 2,006.25) and

working capital (Rs 1,500), the firm should relax its credit standards. Such

an action would lead to an overall increase in the profits of the firm by Rs

14,493.75 (Rs 18,000 Rs 2,006.25 Rs 1,500).


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Credit Analysis

The second aspect of credit policies of a firm is credit analysis and

investigation. Two basic steps are involved in the credit investigation process:

(a) obtaining credit information, and

(b) analysis of credit information.Obtaining Credit Information

The first step in credit analysis is obtaining credit information on which to base

the evaluation of a customer. The sources of information, broadly speaking, are

(1)internal, and

(2)external.

Internal

Usually, firms require their customers to fill various forms and documents

giving details about financial operations. They are also required to furnish

trade references with whom the firms can have contacts to judge the suitability

of the customer for credit. This type of information is obtained from internal

sources of credit information.

Another internal source of credit information is derived from the records of the

firms contemplating an extension of credit. It is likely that a particular

customer/applicant may have enjoyed credit facility in the past.


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External

In India, the external sources of credit information are not as developed as in the

industrially advanced countries of the world. Depending upon the availability, the

following external sources may be employed to collect information.

Financial StatementsOne external source of credit information is the published financial statements, that

is, the balance sheet and the profit and loss account.

Bank References

Another useful source of credit information is the bank of the firm which is

contemplating the extension of credit. The mod us operandihere is that the firmsbanker collects the necessary information from the applicantsbanks. Alternatively,

the applicant may be required to ask his banker to provide the necessary

information either directly to the firm or to its bank.

Trade References

These refer to the collection of information from firms with whom the applicant hasdealings and who on the basis of their experience would vouch for the applicant.

Credit Bureau Reports

Finally, specialist credi t bureau reports from organisations specialising in

supplying credit information can also be utilised.


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Analysis of Credit Information

Once the credit information has been collected from different sources, it should be

analysed to determine the credit worthiness of the applicant. The analysis should

cover two aspects:

(1) Quantitative

The assessment of the quantitative aspects is based on the factual information

available from the financial statements, the past records of the firm, and so on. The

first step involved in this type of assessment is to prepare an Aging Schedule of the

accounts payable of the applicant as well as calculate the average age of the

accounts payable. Another step in analysing the credit information is through a

ratio analysis of the liquidity, profitability and debt capacity of the applicant. These

ratios should be compared with the industry average.

(2) Qualitative

The quantitative assessment should be supplemented by a qualitative/subjective

interpretation of the applicantscreditworthiness. The subjective judgement would

cover aspects relating to the quality of management. Here, the references fromother suppliers, bank references and specialist bureau reports would form the basis

for the conclusions to be drawn. In the ultimate analysis, therefore, the decision

whether to extend credit to the applicant and what amount to extend will depend

upon the subjective interpretation of his credit standing.


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Credit Terms

The second decision area in accounts receivable

management is the credit terms. After the credit standards

have been established and the creditworthiness of the

customers has been assessed, the management of a firm

must determine the terms and conditions on which trade

credit will be made available. The stipulations under which

goods are sold on credit are referred to as credit terms.

These relate to the repayment of the amount under the

credit sale. Thus, credit terms specify the repayment terms

of receivables.


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Credit period, in terms of the duration of time for which trade credit is

extendedduring this period the overdue amount must be paid by thecustomer;

Cash discount, if any, which the customer can take advantage of, that is, the

overdue amount will be reduced by this amount; and

Cash discount period, which refers to the duration during which the discount

can be availed of. These terms are usually written in abbreviations, forinstance, 2/10 net 30. The three numerals are explained below:

2 signifies the rate of cash discount (2 per cent), which will be available to

the customers if they pay the overdue within the stipulated time;

10 represents the time duration (10 days) within which a customer must pay

to be entitled to the discount;

30 means the maximum period for which credit is available and the amount

must be paid in any case before the expiry of 30 days.


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Cash Discount

The cash discount has implications for the sales volume, average collection

period/average investment in receivables, bad debt expenses and profit perunit. The implications of increasing or initiating cash discount are as follows:

The sales volume will increase. The grant of discount implies reduced

prices. If the demand for the products is elastic, reduction in prices will

result in higher sales volume.

Since the customers, to take advantage of the discount, would like to pay

within the discount period, the average collection period would be reduced.

The reduction in the collection period would lead to a reduction in the

investment in receivables as also the cost. The decrease in the average

collection period would also cause a fall in bad debt expenses. As a result,

profits would increase.

The discount would have a negative effect on the profits. This is because

the decrease in prices would affect the profit margin per unit of sale.


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The effects of increase in the cash discount are summarised in Table 2. The

effect of decrease in cash discount will be exactly opposite.

TABLE 2 Effects of Increase in Cash Discounts

Item Direction of Change

(I = Increase D =

Decrease)

Effect on Profits

(Positive+ or Negative)

Sales Volume I +

Average Collection Period D +

Bad Debt Expenses D +

Profit Per Unit D


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Thus, if cash discount is allowed, the average investments in receivables will

decline by Rs 8,875 (i.e. Rs 20,000 Rs 11,125). Given a 15 per cent rate of

return, the firm could earn Rs 1,331.25 on Rs 8,875. Thus, the saving resulting

from a drop in the average collection period is Rs 1,331.25.

(iii) The total benefits associated with the cash discount

Profit on additional sale Rs 18,000.00

Saving in cost 1,331.25

Total 19,331.25

(iv) Cash discount:The cost involved in the cash discount on credit sales, that

is, 2 per cent of credit sales = 0.02 Rs 2,07,000 (i.e. 0.60 Rs 3,45,000) = Rs

4,140

Thus, against a cost of Rs 4,140, the benefit from initiating cash discount is Rs

19,331.25; that is, there is a net gain of Rs 15,191.25 (Rs 19,331.25 Rs 4,140).The firm should, therefore, implement the proposal to allow 2 per cent cash

discount for payment within 10 days of the credit purchase by the customers.

A similar type of analysis can be made to illustrate the effect of either reduction

or elimination of cash discount.


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Credit Period

The second component of credit terms is the credit period. The expected effect

of an increase in the credit period is summarised in Table 3.

TABLE 3 Effect of Increase in Credit Period


(I = Increase D =

Decrease)

Effect on Profits

(Positive or Negative)

Sales Volume I +

Average Collection Period I

Bad Debt Expenses I

A reduction in the credit period is likely to have an opposite effect. The credit

period decision is illustrated in Example 3.


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Example 3

Suppose, a firm is contemplating an increase in the credit period from 30 to 60

days. The average collection period which is at present 45 days is expected to

increase to 75 days. It is also likely that the bad debt expenses will increase

from the current level of 1 per cent to 3 per cent of sales. Total credit sales areexpected to increase from the level of 30,000 units to 34,500 units. The present

average cost per unit is Rs 8, the variable cost and sales per unit is Rs 6 and

Rs 10 per unit respectively. Assume the firm expects a rate of return of 15 per

cent.

Should the firm extend the credit period?Solution

(i) Profit on additional sales: = (Rs 4 4,500) = Rs 18,000

(ii) Cost of additional investments in receivables: = Average investments with

the proposed credit period less average investments in receivables with the

present credit period:

000,30Rs45360

30,0008RsplanesentPr

625,55Rs75360

500,46Rs000,308Rs

sreceivableofTurnover

salesofCostplanProposed


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TABLE 4 Effect of Relaxation of Credit Period to Two Months

Particulars Amount

Incremental sales revenue (4,500 Rs 10)

Less: incremental variable costs (4,500 Rs 6)

Incremental contributionLess: incremental cost of additional investment in debtors

Less: increase in bad debts

Incremental profit

Rs 45,000

27,000

18,0003,843.75

7,350.00

6,806.25

The effect of a decrease in the credit period can be similarly analysed.

(iii) Additional bad debt expenses: This is the difference between the bad debt

expenses with the proposed and present credit periods.

Bad debt with proposed credit period = 0.03 Rs 3,45,000 = Rs 10,350

Bad debt with present credit period = 0.01 Rs 3,00,000 = Rs 3,000

Additional bad debt expense = (Rs 10,350 - Rs 3,000) = Rs 7,350Thus, the incremental cost associated with the extension of the credit period is

Rs 11,193.75 (Rs 3,843.75 + Rs 7,350). As against this, the benefits are Rs

18,000. There is, therefore, a net gain of Rs 6,806.25, that is,

(Rs 18,000 Rs 11,193.75). The firm would be well-advised to extend the credit

period from 30 to 60 days.


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Collection Policies

The third area involved in the accounts receivable management is

collection policies. They refer to the procedures followed to

collect accounts receivable when, after the expiry of the credit

period, they become due. These policies cover two aspects:

1) degree of effort to collect the overdues, and

2) type of collection efforts.

Degree of Collection Effort

To illustrate the effect of the collection effort, the credit policies of a firm

may be categorised into (i) strict/light, and (ii) lenient. The collectionpolicy would be tight if very rigorous procedures are followed. A tight

collection policy has implications which involve benefits as well costs.

The management has to consider a trade-off between them. Likewise, a

lenient collection effort also affects the cost-benefit trade-off. The effect

of tightening the collection is discussed below.


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In the first place, the bad debt expenses (default cost) would decline. Moreover,

the average collection period will be reduced. As a result of these two effects,

the firm will benefit and its profits will increase. But, there would be a negative

effects also. A very rigorous collection strategy would involve increasedcollection costs. Yet another negative effect may be in the form of a decline in

the volume of sales. This may be because some customers may not like the

pressure and intense efforts initiated by the firm, and may switch to other firms.

These effects are tabulated in Table 5.

TABLE 5 Basic Trade-off from Tight Collection Effort


(I = Increase D = Decrease)

Effect on Profits

[Positive (+) or Negative ()

Bad Debt Expenses D +

Average Collection

Period

D +

Sales Volume D

Collection Expenditure I

The effect of the lenient policy will be just the opposite. We illustrate the basic trade-

off in Example 4.


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Type of Collection Efforts

The second aspect of collection policies relates to the steps thatshould be taken to collect overdues from the customers. A well-

established collection policy should have clear-cut guidelines as to

the sequence of collection efforts. After the credit period is over and

payment remains due, the firm should initiate measures to collect

them. The effort should in the beginning be polite, but, with thepassage of time, it should gradually become strict. The steps usually

taken are1) letters, including reminders, to expedite payment;

2) telephone calls for personal contact;

3) personal visits;4) help of collection agencies; and finally,

5) legal action.


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SOLVED PROBLEM


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A company is currently engaged in the business of manufacturing computer

component. The computer component is currently sold for Rs 1,000 and its

variable cost is Rs 800. For the year ended 31-12-2007 the company sold on an

average 500 components per month.Presently the company grants one month credit to its customers. The company

is thinking of extending the credit to two months on account of which the

following is expected

Increase in sales 25 per cent

Increase in stock Rs 2,00,000

Increase in creditors Rs 1,00,000

You are required to advise the company on whether or not to extend the credit

terms if:

(a) All customers avail the credit period of two months and (b) the new creditpolicy is given to only new customers. Assume that the entire increase in sales

is attributable to the new customers. The company expects a minimum return

of 40 per cent on investment.


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Solution

Incremental analysis whether to extend credit period of two months to all

customers or the new customers only

Particulars All customers New customers

only

Incremental sales:

Sales at proposed 2 months credit period

(500 units 12 months Rs 1,000 per unit)

1.25

Less sales at existing 1 month credit period

(500 units 12 months Rs 1,000 per unit)

Increase in sales

Less increased variable costs (@80% of sales)

Incremental contribution

Less cost of additional working capital required

(see working note 1)

Incremental profit

Rs 75,00,000

60,00,000

15,00,000

12,00,000

3,00,000

2,80,000

20,000

Rs 75,00,000

60,00,000

15,00,000

12,00,000

3,00,000

1,20,000

1,80,000

Recommendation The company is advised to extend the credit terms only for new

customers as it yields higher incremental profit.


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Working Note 1

(i) Existing investment in debtors at variable cost with credit period of 1 month

(Rs 60,00,000 0.8)/Debtors turnover ratio 12 = Rs 4,00,000

(ii) (a) Investment in debtors with incremental sales due to 2 months credit

period. When all customers are extended 2 months credit period:

(Rs 75,00,000 0.8)/Debtors turnover ratio 6 = Rs 10,00,000).

b. When credit period is extended to new customers only: (Rs 15,00,000

0.8)/Debtors turnover ratio 6 = Rs 2,00,000.

(iii) Additional investment in working capital required and its cost:

Particulars All customers New customers

only

Incremental investment in debtors Rs 6,00,000* 2,00,000

Increase in stock 2,00,000 2,00,000

Less increase in creditors (1,00,000) (1,00,000)Increase in working capital 7,00,000 3,00,000

Cost of additional working capital @ 40% 2,80,000 1,20,000

(*Rs 10,00,000 Rs 4,00,000)


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MINI CASE


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Option 1:Increase the credit period to 60 days. In that case, the sales

are likely to increase by 20 per cent. But bad debts would go up to 2 per

cent and an additional investment of Rs 20 crore will be required in

working capital (without taking into account the effect of debtors).

Option 2: Offer a credit term, 2/10 net 30. In this case, sales are

expected to increase by 10 per cent. Fifty per cent of the debtors are

likely to avail of the discount. There would be no change in bad debts.

Option 3:Offer both extended credit to 60 days and cash discount of 2

per cent (2/10 net 30). An increase of 25 per cent in sales could beexpected and cash discount could be availed of by 30 per cent of the

customers. But bad debts will increase to 2 per cent and the additional

investment in working capital of Rs 20 crore will be required (without

taking into account the effect of debtors).

The CEO of Khoobsurat Industries desires the CFO to carry out a

financial evaluation of the above alternative proposals and suggest the

course of action to be taken. The required rate of return of Khoobsurat

is 20 per cent.


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Solution

Financial Evaluation of Credit Proposal (Rs crore)

Option 1 Option 2 Option 3

Incremental sales (Rs 1,400 .20) 280 (1,400 0.10) 140 (1,400 0.25) 350

Less incremental variable

cost

(280 0.55) 154 (140 0.55) 77 (350 0.55) 192.5

Incremental contribution (280 0.45) 126 (140 0.45) 63 (350 0.45) 157.5

Less other relevant costs:

Bad debts 19.6a 1.4c 21d

Cost of investment in

working capital (20 0.20)

4 4

Cost of investment in

debtors

19.97b 12.2e

Cash discount

15.4 10.5

Add savings on account of

reduction in debtors

_____ 4.1f ____

Incremental profit 82.43 50.3 109.8

(R 1 680 0 02) (R 1 400 0 01) R 19 6


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a (Rs 1,680 crore 0.02) (Rs 1,400 crore 0.01) = Rs 19.6 crore

b Proposed investment in debtors [(Rs 1,680 crore 0.55) + Rs 120 crore] 6

(Debtors turnover, 360 days 60 days = 6 days) = Rs 174 crore

Present investment in debtors [(Rs 1,400 crore 0.55) + Rs 120crore] 12 (360 30)

74.2 crore

Incremental investment in debtors 99.8

Cost of incremental investment in debtors (Rs 99.8 crore

0.20)

19.97

c (Rs 1,540 crore 0.01) (Rs 1,400 crore 0.01) = 1.4 crore

d (Rs 1,750 0.20) (Rs 1,400 crore 0.01) = 21 crore

e Proposed investment in debtors [(Rs 1,750 crore 0.55) Rs 120 crore)

8 (360 days 45 days) 135.3Present investment in debtors 74.2

Incremental investment in debtors 61.1

Cost of incremental investment in debtors (Rs 61.1 crore 0.20) 12.2


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f Debtors turnover = 360 days/[(0.5 10 days) + (0.5 30 days) = 20

days] = 18

Proposed investment in debtors [(Rs 1,540 crore 0.55) + Rs 120 crore)

18 = Rs 53.7 crore

Decrease in investment in debtors (Rs 74.2 crore Rs 53.7 crore) = Rs

20.5 croreSavings on account of reduction in debtors (Rs 20.5 crore 0.2) = Rs

4.1 crore

Recommendation

Option 3 which combines extended credit period and cash discount

would result in the maximum incremental profit. The CEO may consider

the proposed policy change due to its beneficial effect.