management of accounts receivables

8/4/2019 Management of Accounts Receivables

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1. INTRODUCTION

Firms sell goods on credit to increase the volume of sales. In the present era of intense

competition, business firms, to improve their sales, offer to their customers relaxed conditions of

payment. When goods are sold on credit, finished goods get converted into receivables. Trade

credit is a marketing tool that functions as a bridge for the movement of goods from the firms

wear house to its customers. When a firm sells goods on credit, receivables are created. The

receivables arising out of trade credit have three features:

1. It involves an element of risk. Therefore, before sanctioning credit, careful analysis of the risk

involved needs to be done

2. It is based on economic value. Buyer gets economic value in goods immediately on sale, while

the seller will receive an equivalent value later on and

3. It has an element of futurity. The buyer makes payment in a future period.

Amounts due from customers, when goods are sold on credit, are called trade debits or

receivables. Receivables form part of current assets. They constitute a significant portion of the

total current assets of the buyers next to inventories. Receivables are asset accounts

representing amounts owing to the firm as a result of sale of goods/services in the ordinary

course of business.

The purpose of receivables is directly connected with the companys objectives of making credit

sales, which are:

Increasing total sales as, if a company sells goods on credit, it will be in a position to sell moregoods than if it insists on immediate cash payment.

Increasing profits as a result of increase in sales not only in volume, but also because

companies charge a higher margin of profit on credit sales as compared to cash sales.

In order to meet increasing competition, the company may have to grant better credit facilities

than those offered by its competitors.


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1.1. MEANING OF ACCOUNTS RECEIVABLE MANAGEMENT

Receivables are a direct result of credit sales are resorted to, by a firm to push up its sales which

ultimately result in pushing up the profits earned by the firm. At the same time, selling goods on

credit results in blocking of funds in accounts receivables.

Additional funds are, therefore, required for the operating needs of the business which involve

extra costs in terms of interest. Moreover, increase in receivables also increases the chances of

bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the firm.

The financial manager needs to follow a policy of using cash funds economically to the extent

possible in extending receivables without adversely affecting the chances of increasing sales and

making more profits. Management of accounts receivables may, therefore, be defined as, the

process of making decision relating to the investment of funds in receivables which will result in

maximizing the overall return on the investment of the firm.

Thus, the objective of receivables management is to promote sales and projects until the levelwhere the return on investment in further finding of receivables is less than the cost of funds

raised to finance that additional credit.

1.2. COSTS ASSOCIATED WITH MAINTAINING

RECEIVABLES

Costs of maintaining receivables are:

1)Capital costs: A firm when sells goods credit achieves higher sales. Selling goods on credit

has consequences of blocking the firms resources in receivables as there is a time lag between a

credit sale and cash receipt from customers. To the extent the funds are held up in receivables,

the firm has to arrange for additional funds to meet its own obligation of monthly as well as daily

recurring expenditure. Additional funds may have to be raised either out of profits or from

outside. In both the cases, the firm incurs a cost. In the former case there is the opportunity cost

of the income the firm could have earned had the same been invested in some other profitable

avenue. In the latter case of obtaining funds from outside, the firm has to pay interest on the loan

taken. Therefore, sanctioning credit to customers on sale of goods on credit has a capital cost.

2) Administration Cost: When a firm sells goods on credit it has to incur two types of

administration cost viz

a. Credit investigation and supervision costs and

b. Collection Costs.


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Before sanctioning credit to any customer the firm has to investigate the credit rating of the

customer to ensure that credit given will recovered on time. Therefore, administration costs have

to be incurred in this process. Costs incurred in collecting receivables are administrative in

nature. These include additional expenses on staff for administering the process of collection of

receivables from customers.

3) Delinquency Costs: The firm incurs this cost when the customer fails to pay the amount to it

on the expiry of credit period. These costs take the form of sending remainders and legal charges.

4) Bad Debts or Default cost: When the firm is unable to recover the amount due from its

customers, it results in bad debts. When a firm relaxes its credit policy, selling to customers with

relatively low credit rating occurs. In this process a firm may make credit sales to its customers

who do not pay at all.


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2. ASPECTS OF RECEIVABLE MANAGEMENT

The various aspects considered in management of accounts receivable are:

1. Credit Policy

2. Credit evaluation

3. Credit Granting Decisions

4. Control/ Monitoring of Receivables.

2.1. CREDIT POLICY:

Definition: Guidelines that spell out how to decide which customers are sold on open account,

the exact payment terms, the limits set on outstanding balances and how to deal with delinquent

accounts

Credit policy means the decisions with regard to the credit standards, i.e. who gets credit and up

to what amount and on what specific terms. A credit policy of the firm provides a framework to

determine whether or not to extend credit to a customer and how much credit to extend. The

firms credit policy influences the sales level, the investment .level, in cash, inventories, accounts

receivables and physical equipments, bad debt losses and collection costs.

In addition to specific industrial attributes like the trend of industry, pattern of demand, pace of

technology changes, factors like financial strength of a company, marketing organization, growth

of its product etc. also influence the credit policy of an enterprise. Certain considerations demand

greater attention while formulating the credit policy like a product of lower price should be sold

to customer bearing greater credit risk. Credit of smaller amounts results in greater turnover of

credit collection. New customers should be least favored for large credit sales.

Credit policy of every company is at large influenced by two conflicting objectives irrespective

of the native and type of company. They are liquidity and profitability. Liquidity can be directly

linked to book debts. Liquidity position of a firm can be easily improved without affecting

profitability by reducing the duration of the period for which the credit is granted and further by

collecting the realized value of receivables as soon as they fails due.


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To improve profitability one can resort to lenient credit policy as a booster of sales, but the

implications are: -

1. Changes of extending credit to those with week credit rating.

2. Unduly long credit terms.

3. Tendency to expand credit to suit customer's needs and

4. Lack of attention to over dues accounts.

In establishing an optimum credit policy, the Firm should consider the important decision

variables which influence the level of receivables which influence the level of receivables. As

stated in the preceding section, the major controllable decision variables include the following:

Credit standards and analysis

Credit term

Collection policy and procedures

I) Credit standards and analysis:

Credit standards: These are the criteria which a firm follows in selecting customers for the

purpose of credit extension. The firm may have tight credit standards: that is, it may sell mostly

on cash basis, and may extend credit only to the most reliable and financially strong customers.

Such standards will result in no bad-debt losses, and less cost of credit administration. But the

firm may not be able to increase its sales. The profit on lost sales may be more than the costs

saved by the firm. On the contrary, if credit standards are loose, the firm may have larger sales.

But the firm will have to carry larger receivable. The costs of administering credit and bad- debt

losses will also increase. Thus, the choice of optimum credit standards involves a trade- off

between incremental return and incremental costs.

Example of relaxing credit standards:

Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their

credit standards will enhance profitability. The firm is currently producing a single product withvariable costs of $20 and selling price of $25. Relaxing credit standards is not expected to affect

current customer payment habits. Additional annual credit sales of $120,000 and an average

collection period for new accounts of 3 months is expected. The before-tax opportunity cost for

each dollar of funds tied-up in additional receivables is 20%. Ignoring any additional bad-debt

losses that may arise, should Basket Wonders relax their credit standards?


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Profitability of additional sales ($5 contribution) x (4,800 units) =$24,000

Additional receivables ($120,000 sales) / (4 Turns) =$30,000

Investment in add. receivables ($20/$25) x ($30,000) =$24,000

Req. pre-tax return on add. investment (20% opp. cost) x $24,000 =$4,800

Yes! Profits > Required pre-tax return

Credit analysis: Credit standards influence the quality of the firms customers. There are two

aspects of the quality of customer:

The time taken by customers to repay credit obligation

The default rate

The average collection period determines the speed of payment by customers. It measures the

number of days for which credit sales remain outstanding. The longer the average collection

period, the higher the firms investment in accounts receivable. Default rate can be measured in

terms of bad-debt losses ratio- the proportion of uncollected receivable. Bad-debt losses ratio the

proportion of uncollected receivable. Bad- debt losses ratio indicated default risk. Default risk is

the likelihood that a customer will fail to repay the credit obligation. On the basis of past practice

and experience, the firm should be able to form a reasonable judgment regarding the chances of

default.

To estimate the probability of default, the firm should consider three C's

a. Character

b. Capacity

c. Condition

This method of evaluating a customer incorporates both qualitative and quantitative measures.

The first factor is character, which refers to a customers willingness to pay. The moral factor is

of considerable importance in credit evaluation practice.

Capacity measures a borrower's ability to repay. It can be judged by assessing the customers

capital and assets which he may offer as security. Capacity is evaluated by the financial position

of the firm as indicated by the analysis of ratio and trends of the firms cash and working capital

position.


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Condition refers to the prevailing economic and other conditions which may affect the

customers ability to pay. An experienced credit manager will be able to judge the extent and

genuineness to which the customers ability to pay is affected by various conditions.

ii) Credit term:

The stipulation under which the firm sells on credit to customers is called credit terms. These

stipulations include:

a. The credit period

b. The cash discount

a. The credit period:

The length of time for which credit is extended to customers is called the credit period. For

example, net 30 requires full payment to the firm within 30 days from the invoice date.

A firms credit period may be governed by the industry norms. But depending on its objective,

the firm can lengthen the credit period. On the other hand, the firm may tighten its credit period

if customers are defaulting too frequently and bad-debt losses are building up.

Increasing the credit period will bring in additional sales from existing customers and new sales

from new customers. Reducing the credit period will lower sales, decrease investment in

receivables and reduce the bad debt loss. Increasing the credit period increases sales but also

increases investment in receivables and incidence of bad debt loss.

b. The cash discount:

A cash discount is a reduction in payment offered to customers to induce them to repay credit

obligations within a specified period of time, which will be less than the normal credit period. It

is usually expressed as a percentage of sales. Cash discount terms indicate the rate of discount

and the period for which it is available. If the customer does not avail the offer he must make

payment within the normal credit policy.

For example, 2/10 allows the customer to take a 2% cash discount during the cash discount

period i.e. 10 days.

Credit terms would include:

The rate of cash discount

The cash discount period


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The net credit policy

A firm uses cash discount as a tool to increase sales and accelerate collections from customers.

Thus, the level of receivable and associated costs may be reduced. The cost involved is the

discounts taken by customers.

Example of introducing a cash discount:

A competing firm of Basket Wonders is considering changing the credit period from net 60

(which has resulted in 6 A/R Turns per year) to 2/10, net 60.Current annual credit sales of

$5 million are expected to be maintained. The firm expects 30% of its credit customers (in dollar

volume) to take the cash discount and thus increase A/R Turns to 8.

(30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days

360 days per year / 45 days = 8 turns per year)

The before-tax opportunity cost for each dollar of funds tied-up in additional receivables is

20%. Ignoring any additional bad-debt losses that may arise, should the competing firm

introduce a cash discount?

Receivable level (Original) ($5,000,000 sales) / (6 Turns) =$833,333

Receivable level (New) ($5,000,000 sales) / (8 Turns) =$625,000

Reduction of investment in A/R $833,333 - $625,000 =$208,333

Pre-tax cost of the cash discount 0.02 x 0.3 x $5,000,000 =$30,000.

Pre-tax opp. Savings on reduction in A/R (20% opp. cost) x $208,333 =$41,667.

Yes! Savings > Costs

The benefits derived from released accounts receivable exceed the costs of providing the

discount to the firms customers.


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Example of evaluating a credit policy:

Present

PolicyPolicy A

Demand 2400000 3000000

Incremental Sales 600000

Default losses

Original sales 2%

Incremental Sales 10%

ACP

Original sales 1 mth

Incremental Sales 2 mth

Variable costs is 80% of sales

The before-tax opportunity cost for each dollar of funds tied-up in additional

receivables is 20%.

Policy A

1. Additional sales $600,000

2. Profitability: (20% contribution) x (1) 120,000

3. Add. bad-debt losses: (1) x (bad-debt %) 60,000

4. Add. receivables: (1) / (New Rec. Turns) 100,000

5. Inv. in add. receivables: (.80) x (4) 80,000

6. Required before-tax return on additional investment: (5) x (20%) 16,000

7. Additional bad-debt losses + additional required return: (3) + (6) 76,000

8. Incremental profitability: (2) - (7) 44,000


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iii) Collection policy and procedures:

A collection policy is needed because all customers do not pay the firms bills in time. Some

customers are slow-payers while some are non-payers. The collection efforts should, therefore,

aim at accelerating collections from slow- players and reducing bad-debt losses. A collection

policy should ensure prompt and regular collection. Prompt collection is needed for fast turnoverof working capital, keeping collection costs and bad-debts within limits and maintaining

collection efficiency. Regularity in collections keeps debtors alert, and they tend to pay their

dues promptly.

The collection policy should lay down clear-cut collection procedures. The collection procedures

for past dues or delinquent accounts should also be established in unambiguous terms. The slow-

playing customers should be handled very tactfully. Some of them may be permanent customers.

The collection process initiated quickly, without giving any chance to them, may antagonize

them, and the firm may lose them to competitors.

The responsibility for collection and follow-up should be explicitly fixed. It may be entrusted to

the accounts or sales department, or to a separate credit department. The co-ordination between

accounts and sales departments is necessary and must be ensured formally. The accounting

department maintains the credit records and information. If it is responsible for collection, it

should consult the sales department before initiation an action against non- paying customers.

Similarly, the sales department maintain must obtain past information about a customer from the

accounting department before granting credit to him.

Through collection procedures should be firmly established, individual cases should be dealt

with on their merits. Some customers may be temporarily in tight financial position and in spiteof their best intentions may not be able to pay on due date. This may be due to recessionary

conditions, or other factors beyond the control of the customers.

Such cases need special considerations. The collection procedure against the m should be

initiated only after they have overcome their financial difficulties and do not intend to pay

promptly. The firm should decide about offering cash discount for prompt payment. Cash

discount is a cost to the firm for ensuring faster recovery of cash. Some customers fail to pay

within the specified discount period, yet they may make payment after deduction the amount of

cash discount. Such cases must be promptly identified and necessary action should be initiated

against them to recover the full amount.

In practice, companies may take certain precautions vis--vis collections. Some companies

require their customers to give pre-signed cheques. Bills discounting is another practice in India.

Unfortunately, it is not very popular with a number of companies. Some companies provide for

penal rate of interest for debtors who fail to pay in time.


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The collection policies maybe classified into

o Strict and

o Liberal.

The effects of tightening the collection policy would be

1. Decline in debts

2. Decline in collection period resulting in lower interest costs,

3. Increase in collection costs

4. Decline in sales.

The effects of lenient policy would be exactly the opposite.

Another aspect of collection policies relates to the steps that should be taken to collect over dues

from the customers. The effort should in the beginning be polite but with the passage of time, it

should gradually become strict.

The steps usually taken are

Letters, including reminders to expedite payment

Telephone calls for personal contact

Personal visits

Help of collection agencies

Legal action

The firm should take very stringent measure, like legal action only after all other avenues have

been fully exhausted. They not only involve a cost but also affect the relationship with the

customers. The aim should be to collect as early as possible genuine difficulties of the customers

should be given due consideration.

Collection of sales tax declaration (STD) forms from the customers is very important but mostly

neglected area in receivables management. The onus lies on the selling companies to collect

these forms or else bear the sales tax burden themselves. The financial implication of this is

generally 6% to 8%. This means non-collection of STD forms would take away more than the

profits earned in sales, in most cases.


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2.2. CREDIT EVALUATION OF INDIVIDUAL ACCOUNTS:

For effective management of credit, the firm should lay down clear cut guidelines and

procedures for granting credit to individual customers and collecting individual accounts. Thefirm need not follow the policy of treating all customers equal for the purpose of extending

credit. The credit evaluation of individual accounts should involve the following steps:

1. Credit information

2. Credit investigation

3. Credit limits

4. Collection procedure

1. Credit information

The firm would ensure that receivables will be collected in full and on due date. Credit should be

granted to those customers who have the ability to make the payment on time. To ensure this, the

firm should have credit information concerning each customer to whom the credit will be

granted.

The decision to grant cannot be delayed for long because the time involved in collecting the

credit information. Depending on these two factors of time and cost, any, or a combination of the

following sources may be employed to collect the information.

a. Financial statement

b. Bank references

c. Trade references

d. Other sources

These are the sources are avail to investigate the customer position which is has been the

repayment process.


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2. Credit investigation and analysis:

After having obtained the credit information, the firm will get an idea regarding the matters

which should be further investigated.

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

The type of customer, whether new or existing.

The customers business line, background and the related trade risks.

The nature of the product- perishable or seasonal.

Size of customers order and expected further volumes of business with him.

Companys credit policies and practices.

In the analysis of credit investigation contains the following steps to evaluate the customer

repayable capacity

1. Analysis of credit file

2. Analysis of financial ratios

3. Analysis of business and its management

3. Credit limit:

A credit limit is a maximum amount of credit which the firm will extend at a point of time. It

indicates the extent of risk taken by the firm by supplying goods on credit to a customer. Once

the firm has taken a decision to extend credit to the applicant, the amount and duration of the

credit will depend upon the amount of contemplated sale and the customers financial strength.

In case of customers who are frequent buyers of the firms goods, a credit limit can be

established. This would avoid the need to investigate each order from the customers. Depending

on the regularity of payment, the line of credit for a customer can be fixed on the basis of his

normal buying pattern. The credit limit must be reviewed periodically. If tendencies of slow

paying are found, the credit can be revised downward.

4. Collection procedure

A collection procedure is would like to followed by the firm as per the credit terms and condition

which is agreed at the time of making contract.


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2.3. CREDIT GRANTING DECISION

Once a firm has assessed the creditworthiness of a customer, it has to decide whether or not

credit should be granted. The firm should use the NPV rule to make the decision. If NPV is

positive, credit should be granted.

If the firm chooses to not grant any credit, the firm avoids the possibility of any loss but loses the

opportunity of increasing its profitability. On the other hand, if it grants credit, then it will

benefit if the customer pays. There is some probability that the customer will default, then the

firm may lose its investment. The expected net pay off of the firm is the difference between the

present value of net benefit and present value of the expected loss.


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2.4. MONITORTING RECEIVABLE:

A firm needs to continuously monitor and control its receivable to ensure the success of

collection efforts.

Two traditional methods of evaluating the management of receivables are:

1. Average collection period

2. Aging schedule

These methods have certain limitations to be useful in monitoring receivable. A better approach

is the Collection Experience Matrix.

1. Average Collection period:

Debtors

Average Collection period = 360

Credit Sales

The average collection period measures the quality of debtors in an aggregative way. The

average collection period so calculated is compared with the firms stated credit period to judge

the collection efficiency.

For example, if a firms stated credit period is 25 days and the actual collection period is 40 days,

then one may conclude that the firm has a lax system of collection. An extended collection

period delays cash inflows, impairs the firms liquidity position and increased the chances of bad

debt losses

2. Aging schedule Analysis

Aging schedule removes one of the limitations of the average collection period. It breaks down

receivables according to the length of time for which they have been outstanding. E.g.

If the firms stated credit is 25 days, the aging schedule indicates that 50% of the receivables

remain outstanding beyond that period. Thus the aging schedule provides more information

about the collection experience. It helps to spot out the slow-paying debtors. However, it also


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suffers from the problem of aggregation, and does not relate receivables to sales of the same

period.

3. Collection Experience Matrix:

The major limitations of the traditional methods is that they are based on aggregated data and fail

to relate outstanding receivables of a period with credit sales of the same period. This problem

can be eliminated by using disaggregated data for analyzing collection experience. The key is to

relate receivables to sales of the same period.

When the sales over a period of time are shown horizontally and associated receivables vertically

in a tabular form, a matrix is constructed. Therefore, this method of evaluating receivables is

called Collection Experience Matrix.

E.g.

Month JulyAug.

Sept.

Oct.

Nov.

Dec.

Sales 400 410 370 220 205 350

%Receivable

s

July82.50

Aug.60.50

78.00

Sept.20.00

59.80

86.50

Oct. 0.0018.50

56.80

73.60

Nov. 0.00 0.0019.50

54.50

78.00

Dec. 0.00 0.00 0.0018.20

53.00

81.40


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3. CONCLUSION

Credit sales results in Accounts Receivables (AR). Selling goods on credit results into increase in

sales and ultimately the profits also. At the same time the funds are blocked in Accounts

Receivables.

Therefore more funds are required to be raised to meet the Working Capital requirements.

Moreover, it involves the risk of Bad Debts. Hence, selling goods on credit is beneficial (return)

as well as dangerous (risk). The Finance Manager has to frame proper credit policies and take

decisions regarding the sanction of credit to the customers.

Therefore, Management of Accounts Receivables is the process of decision-making relating to

the investments of funds in these assets in such a manner that the return on shareholders

investments is maximized.

management of accounts receivables

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