mb0045 slides unit 114

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MB0045-Financial Management

Unit-14 Receivables Management

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Program : MBA

Semester : II

Subject Code : MB0045

Subject Name : Financial Management

Unit number : 114

Unit Title : Receivable Management

Lecture Number : 14

Lecture Title : Receivable Management

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Financial Management

Objectives:

After studying this unit, you should be able to:

• Explain the meaning of receivables management

• Recognise the costs associated with maintaining receivable

• Determine the credit policy variables

• Define the process of evaluation of credit policy

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Lecture Outline

• Introduction

• Meaning of Receivables Management

• Cost Associated with Maintaining Receivables

• Credit Policy Variables

• Collection Programme

• Evaluation of Credit Policy

• Summary

• Check Your Learning

• Activity

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Introduction

Receivables are assets – accounts representing amount due to the firm from sale of goods/services in the ordinary course of business. Trade credit is a marketing tool that functions as a bridge for the movement of goods from the firm’s warehouse to its customers. When a firm sells goods on credit, receivables are created. The receivables arising out of trade credit have three features: • Receivables that arise out of trade credit involve an element of risk.

Therefore, before sanctioning credit, careful analysis of the risk involved needs to be done.

• Receivables out of trade credit are based on economic value. Buyer gets economic value in goods immediately on sale, while the seller receives an equivalent value later on.

• Receivables out of trade credit have an element of futurity. The buyer makes payment in future.

In this session, you will learn about the meaning of receivables management,

the cost associated with maintaining receivables, the credit policy variables

and the process of evaluation of credit policy.

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Management of accounts receivables may, therefore, be defined as the process of making decision related to the investment of funds in receivables for maximising the overall return on the investment of the firm. The purpose of receivables can be directly related to the company’s objectives of promoting credit sales. The objectives are:

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Objectives

To increase sales

To increase profits

To meet increasing

competition

Meaning of Receivables Management




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The four different varieties of costs associated with maintaining receivables are:

Cost Associated with Maintaining Receivables

Costs associated

with receivables

Capital cost

Administration cost

Delinquency cost

Bad debts or default cost




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The credit policy of a firm can be termed as a trade-off between increased credit sales leading to increase in profit and the cost of having larger amount of cash locked up in the form of receivables along with the loss due to the incidence of bad debts. The four aspects of credit policy are:

Credit Policy Variables

Credit policy variables

Credit standards

Credit periods

Cash discounts

Collection programme




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The objective of a collection policy is to achieve a timely collection of receivables. Releasing funds locked in receivables and minimising the incidence of bad debts are the other objectives of the collection policy. The collection programmes consist of the following:

Collection Programme

Monitoring the receivables

Reminding customers about due date of payment

Interaction on-line through electronic media with customers about the payments due, around the due date

Initiating legal action to recover the amount from overdue customers

Formulating collection policy such that it should not lead to bad relationship with the customers




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Evaluation of Credit Policy

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Credit policy of every company is largely influenced by two conflicting objectives, irrespective of the native and type of company. They are liquidity and profitability. 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 realised value of receivables as soon as they fail due. To improve profitability one can resort to lenient credit policy as a booster of sales, but the implications are:

• Chances of extending credit to those with week credit rating

• Unduly lenient credit terms

• Tendency to expand credit to suit customer's needs

• Lack of attention to over due accounts

Optimum credit policy is one which would maximise the value of the firm. Value of a firm is maximised when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the investment.




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Evaluation of Credit Policy (cont.)

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In order to achieve the goal of maximising the value of the firm the evaluation of investment in receivables accounts should involve the following four steps:

Step 1 • Estimation of incremental operating profit

Step 2 • Estimation of incremental investment in accounts receivables

Step 3

Step 4

• Comparison of incremental rate of return with the required rate of return

• Estimation of the incremental rate of return of investment




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Summary

• Receivables are assets – accounts representing amount due to the firm from sale of goods/services in the ordinary course of business.

• Trade credit is a marketing tool that functions as a bridge for the movement of goods from the firm’s warehouse to its customers.

• Management of accounts receivables may, therefore, be defined as the process of making decision related to the investment of funds in receivables for maximising the overall return on the investment of the firm.

• The four different varieties of cost associated with maintaining receivables are capital cost, administration cost, delinquency cost and bad debts or default cost.

• The four aspects of credit policy are credit standards, credit period, cash discount and collection programme.

• The objective of a collection policy is to achieve a timely collection of receivables.

• Credit policy of every company is largely influenced by two conflicting objectives, irrespective of the native and type of company. They are liquidity and profitability.

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Check Your Learning

1. Name any two varieties of cost associated with maintaining receivables.

Ans: The two varieties of cost are:

a. Capital cost

b. Administration cost

2. List the four aspects of credit policy

Ans: The four aspects of credit policy are:

a. Credit standards

b. Credit periods

c. Cash discount

d. Collection programme

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Assume that for a firm ABC Ltd., the credit policy is influenced by two conflicting objectives - liquidity and profitability. What are the steps to be involved in the evaluation of investment in receivables account in order to achieve the goal for maximising the value of the firm?

Activity

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