Introduction

Accounts receivables (also properly termed as receivables) constitute a

significant portion of the total currents assets of the business next after
inventories. They are a direct consequences of “trade credit” which has
become an essential marketing tool in modern business.

When a firm sells goods for cash, payments are received immediately and,
therefore, no receivables are credited. However, when a firm sells goods or
services on credit, the payments are postponed to future dates and
receivables are created. Usually, the credit sales are made on open account,
which means that, no, formal acknowledgements of debt obligations are
taken from the buyers. The only documents evidencing the same are a
purchase order, shipping invoice or even a billing statement. The policy of
open account sales facilities business transactions and reduces to a great
extent the paper work required in connection with credit sales.

In most of business enterprises, investments in accounts receivable form a

major part of their assets. Accounts receivables is on of the major
components of working capital.
The financial executives, should, therefore, pay due attention to the
management of receivables so that each rupee invested in accounts
receivables may contribute to the net worth of the organization.
Meaning of receivables

Receivables are assets accounts representing amounts owed to the firm as a

result of sale of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and are
carried to the “assets side” of the balance sheet under titles such as accounts
receivables, customer receivables or book debts. They are, as stated earlier,
the result of extension of credit facility to then customers a reasonable
period of time in which they can pay for the goods purchased by them.
Accounts receivables are created because of credited sales. Hence the
purpose of receivables is directly connected with the objectives of making
credited sales.

The objectives of credited sales are as follows:

• Achieving growth in sales: If a firm sells goods on credit, it will

generally be in a position to sell more goods than if it insisted on
immediate cash payments. This is because many customers are either
not prepared or not in a position to pay cash when they purchase the
goods. The firm can sell goods to such customers, in case it resorts to
credit sales.

• Increasing profits: Increase in sales results in higher profits for the

firm not only because of increase in the volume of sales but also
because of the firm charging a higher margin of profit on credit sales
as compared to cash sales.
 • Meeting competition: A firm may have to resort to granting of
credit facilities to its customers because of similar facilities being
granted by the competing firms to avoid the loss of sales from
customers who would buy elsewhere if they did not receive the
expected output.
The overall objective of committing funds to accounts receivables is to
generate a large flow of operating revenue and hence profit than what would
be achieved in the absence of no such commitment.

Costs of maintaining receivables

The costs with respect to maintenance of receivables can be identified as

follows:
• Capital costs: Maintenance of accounts receivables results in
blocking of the firm’s financial resources in them. This is because
there is a time lag between the sale of goods to customers and the
payments by them. The firm has, therefore, to arrange for additional
funds top meet its own obligations, such as payment to employees,
suppliers of raw materials, etc., while awaiting for payments from its
customers. Additional funds may either be raised from outside or out
of profits retained in the business. In both the cases, the firm incurs a
cost. In the former case, the firm has to pay interest to the outsider
while in the latter case, there is an opportunity cost to the firm, i.e.,
the money which the firm could have earned otherwise by investing
the funds elsewhere.
• Administrative costs: The firm has to incur additional
administrative costs for maintaining accounts receivable in the form
of salaries to the staff kept for maintaining accounting records relating
to customers, cost of conducting investigation regarding potential
credit customers to determine their creditworthiness, etc.

• Collection costs: The firm has to incur costs for collecting the
payments from its credit customers. Sometimes, additional steps may
have to be taken to recover money from defaulting customers.

• Defaulting costs: Sometimes after making all serious efforts to

collect money from defaulting customers, the firm may not be able to
recover the overdues because of the of the inability of the customers.
Such debts are treated as bad debts and have to be written off since
they cannot be realized.

• Delinquency Costs: Sometimes, the financial position of the

customer is not “bad” but it is “doubtful”. Such customer does make
the payment but after due date. Thus, funds are unnecessarily from the
due date to the date of payment. The enterprises has to incur certain
expenses for arranging the funds for that period and such expenses are
known as delinquency cost.
Determinants of the Size of Investment in Receivables
The level of investment in receivables is determined by the following two
factors.
(a) General factors
(b) Specific factors

General Factors
General factors are those factors which are common to all firms and to the
investment in all types of assets-fixed and current.
These include type and nature of the business, volume of anticipated sales,
volume of the business, price-level variations, availability of funds, and the
attitude of executives etc.

Specific Factors
The main determinants of level of receivables are as under

(i) Volume of Credit Sale: Volume of credit sale is the main determinant
of the level of receivables. Other things being equal, accounts receivables
vary directly with the volume of sales. If sales, increase, receivables expand.
As sales, decline, investment in receivables also declines.

(ii) Terms of Sales: It is the most important variable in determining the

level of investment in receivables. If a firm takes a decision on not to sell
goods on credit in order to avoid blocking up of funds in receivables and risk
of bad debts, this item shall not appear in the balance sheet at all. Some large
retail stores such as departmental stores, chain stores or super bazaars may
take such decisions. But such decisions cannot be enforced by a business
enterprise. Trade customs, competitions, and business practices force the
company to sell goods on credit otherwise their existence will be threatened.
The company, therefore, should establish a sound credit policy to suit its
needs.

(iii) Policy of Credit Sales: Policy of credit sales also determines the
size of investment in receivables. If credit is allowed only for the short term,
its ratio with sale shall remain at lower ebb. If long-term credit is allowed,
its ratio with sales may be higher moreover, the present value of money will
always be higher hence, every businessman will like to collect the money as
early as possible.

(iv) Stability of Sales: In the business of seasonal character, total sales

and the credit sales will go up in the season and therefore volume of
receivables will also be large. On the other hand, if a firm supplies goods on
instalment basis, its balances in receivables will be high.

(v) Size and Policy of Cash Discount: It is also an important variable

in deciding thee level of investment in receivables. Cash discount affects the
cost of capital and the investment in receivables. If cost of capital of the firm
is lower in comparison to the cash Discount to be allowed, investment in
receivables will be less. If both are equal, it will not affect the investment at
all. If cost of capital is higher than cash Discount, the investment in
receivables will be larger.
(vi) Credit and Collection Policy: Credit and collection policy of the
firm affects to a large extent the amount of investment in receivables. It
should be decided by the sales department of the concern to whom credit
should be granted. If credit policy of the concern is liberal, the investment in
receivables will be larger otherwise the amount in this account will be
limited. Moreover, if collection is make within stipulated time or a sound
collection policy is enforced, the investment in receivables will naturally be
lower.

(vii) Bill discounting and Endorsement: If firm has any arrangement

with the banks to get the bills discounted or if they re endorsed to third
parties, the level of investment in is asset will be automatically low. If bills
are honored on due dates, the investment will be larger.

Steps Involved In Management Of Receivables

When an enterprises offers to sell its goods/services on credit it must give
serious thought as:
 To which customer the enterprises is prepared to offer credit ?
 What factor should be taken in to account while analyzing the
customers who are interested to purchase goods on credit ?
 What should be the credit terms for selling on credit ?
 What collection policies should be adopted ?
 What should be the system of monitoring and controlling the
receivables account ?
 The following steps are involved in considering the preceding matters in
the case of receivables management :
 Credit analysis
 Credit standards
 Credit terms

 Collections policies
 Control and Monitoring

Credit analysis: No enterprise can sell goods on credit blindly to each

and every customer. It has to evaluate and examine the ability of the
customer whether he can make the payment on time as per promise or not.
If an enterprises ignore the analysis of customer’s financial position and his
status, it finds itself in trouble because adequate resources may not be
generated to meet the daily requirement for funds. Therefore, an analysis of
those risks, which may arise on account of non payment or late payment,
must be undertaken before granting credit facilities to the customers. Credit
analysis involves the study of three aspects ---
1-Collection of information about the customers: there are various
sources of information available to the enterprise to help in assessing the
financial health of customer.
a. Financial Statements
b. Trade References
c. Bankers Enquires
d. Credit Rating Agencies
e. Market Reports
f. Own Expenses of the concern
2-Analysis of Collected Information: The analysis attempts to
measure the creditworthiness of the customer as well as risk involved.
Normally, following six C’s are considered in analyzing the
creditworthiness.
a. Character
b. Capacity
c. Capital
d. Conditions
e. Cost
f. Collateral
3-Decision on the basis of analysis

Credit standards
An important component of credit policy is well defined credit standards
such credit standards provide a base for deciding whether to grant a credit to
a customer or not. These standards also have an important bearing on the
sales of enterprise. Credit standards may be defined and explained in both
conservative or strict manner and aggressive or liberal manner.
In the case of strict credit standards, credit facility is not granted each and
every In fact, marginal customers (i.e., those customer whose financial
position is doubtful through not bad ) are refrained from getting under strict
credit standard. Enterprise, which do not take risk usually follow strict
standards. Alternatively, an enterprise may be very aggressive In a taking the
risks and thus may follow a very Liberal credit standards. In that case even
the marginal customers may avail the credit facility.
Enterprise’s sales (credit) increase which in turn Increase, the profit of the
enterprise. But due to increased level of investment in receivables, costs in
terms of bad debts, collection expenses and administrative expenses also
rise. Thus profit arising due to additional sales must be compared with
possible rise in costs associated with additional investments in receivables
whenever a decision to liberalize the credit standards is being taken. So far
as' the profitability is more than the added cost, the enterprise can lower
down (i.e., liberalized) the credit standards.
It is gathered from the preceding discussion that liberalised credit standards
will affect (i) Collection costs, (ii) Average collection period, (iii) Loss from
bad debts, and (iv) Sales level. The likely effect on all these variables (items)
may be explained as under:
(i) Collection Costs: Liberalized credit standards imply more credit,
increase in the workload of the credit department, and rise in collection
efforts. Just opposite situation would be in the case of strict credit standards.
Due to liberal credit standards, collection costs and other administrative
costs would tend to rise.
(ii) Average Collection Period: When credit standards are made liberal,
receivables rise due to increase in sales on the one hand and there is delay in
collection from customers due to credit sales to below standard customers on
the other hand. Thus, liberal credit standards cause increase in 'average
collection period' as well as in 'investment in receivables'. Contrary to this
will be the effect if strict credit standards are followed.
(iii) Loss of Bad Debts: Due to liberal credit standards, credit facilities
are made available even to those customers, whose financial position or
credit- worthiness is bad and doubtful. As a result, chances for bad debts
increase. Additional bad debts may take place increasing the losses. Just
opposite effect may be in the case of strict credit standards.
(iv)Change in the Volume of Sales: As pointed out earlier, liberal
credit standards may increase the volume of sales and strict ones may reduce
the sales volume. This change (increase or decrease) in turn affects the profit
in a positive Way.
The effects and changes (with reference to profit) ofliberal credit standards
can be presented as under:

Items/Variables Direction of Changes Effect on Profit

1. Average Collection Period Increase Negative
2. Bad Debts Increase Negative
3. Collection Costs Increase Negative
4. Sales Increase Positive

The following approach may be followed in assessing the effects of

lowering down (i.e" liberalising) the credit standards:
(i)Find out profit from additional sales. Since all fixed cost could have been
recovered from the existing sales, hence deduct only variable costs of
additional units from additional sales volume.
Additional Profit =Additional unit of sales x contribution per unit
contribution per unit = selling price per unit − variable cost per unit
(ii) Determine additional bad debts losses, increase in collection expenses
and any other costs arising from relaxing the standards. .
(iii) Determine the increased slowness in average collection period and find
out additional amount of investment. The difference between receivables
before the liberal credit standards and after liberalized credit standards is
known as additional investment. Such investment can be calculated either at
sales price or at cost price. However, cost price shall be taken equal to
variable costs for additional units of sales; for units of sales before
liberalized credit standards cost means total cost (fixed plus variable).
(iv) Find out of the desired return by multiplying required rate of return to
additional investment. This is known as opportunity cost.
(v) compare the profit on additional sales with opportunity cost. If profit is
higher, credit standards must be liberalized, otherwise.

C) Credit Terms: Another important decisional area in receivable

management is terms of credit which must be decided in advance. After
analysing the customers creditworthiness and setting up enterprise's credit
standards, one has to determine the terms and conditions on which trade
credit will be made available to the customers. Credit terms include the
terms on which payment from receivables may be received and it has three
variables/components :
(i) Credit Period, (ii) Cash Discount, (Hi) Cash Discount Period.
All these three components of credit terms are written in a brief note
as '2/10 net 30' which means that if the customer pays within 10 days, he
will get a cash discount of 2% otherwise he has to pay full within 30 days
without any discount. Remember if the customer fails to pay within 30 days,
he is called defaulter. Like credit standards, credit terms also affect the
profitability and costs. As such, credit terms should be framed out on the
basis of balancing the profit and costs. How does each component of credit
terms affect profit and costs? Let us examine separately for each component.
(i) Credit Period: Credit period is the time for which an enterprise allows
its customers not to pay their bills. It is length of credit period by the end of
which enterprise expects that the customers would pay their bills. Normally,
sales increase, when credit period is extended, the effect of which on profit
is positive. But the extension of credit period also means more investment in
receivables. It also increases the average collection period and losses due to
bad debts. The additional profit due to positive effect of increase in sales
caused by c edit period extension must be compared with cost of additional
investment (ie., desired return on additional investments) and an optimum
balance has to be struck between the two by the financial manage.
Thus, credit period may be extended.
(ii) Cash Discount: An enterprise may decide to offer a cash discount in
Order to encourage prompt payment from its customers, particularly when it
finds itself short of cash resources and is facing liquidity problem. Cash
discount offer does not affect the demand because it does not amount to
reduction in price. Cash discount offer is only a mechanism through which
some benefit is given to it those customers who are ready to pay early. There
is also remote possibility that all customers will take advantage of cash
discount period. Only few customers with sound financial position and good
liquidity position do avail cash discount facility. It must be remembered that
offering cash discount as a policy will also affect those customers who used
to pay promptly in the past.
The policy of cash discount world result into loss of revenue to the
enterprise. However, average collection period becomes lower due to quick
collections. Lower collection period in turn would reduce the investment in
receivables. Thus, while deciding the cash discount policy, the returns on
funds released due to reduction in investment in receivables should be
compared with the loss of revenue. Not only this, liquidity also increases due
to cash discount leading to reduction in bad debts also. On account of
increase in liquidity and reduction in average collection period, credit-rating
ofthe enterprise goes up in the market ultimately affecting the volume of
sales to increase further. This is explained in the following example:
(iii) Cash Discount Period: A cash discount period is the time period
allowed to the debtors within which the debtors are encouraged to pay their
dues and to «Vail the cash discount. It is' within the time period of net credit
days. For example if the cash discount policy of the concern is 2/10 net 30
days, then the cash discount period is available for the first 10 days. If the
payment is made with In this time period then only cash discount will be
allowed.
Collection Policies
Another aspect of receivables management is related to collection policy,
which is basically concern with the procedure to be followed in connecting
the accounts not realized within the credit period allowed. What should the
enterprises do if customer do not pay within the set credit period? The
enterprises has to asses the chances of collecting the receivables by putting
some efforts. What type of efforts should be made and to what extent are
really issues related to collection policy.
(i) Types of collection efforts: Such efforts may include dunning letters,
telephones, personal visits, help from collecting agencies and ultimately
legal action. But one has tyo take lot of care before taking all these steps.
One should also look into customer’s problem and assess its genuineness
before taking certain action.
(ii) Degree of collection efforts: degree of collection efforts in one
sense refers to the policy which is being adopted in pursuing credit policy i.e
whether conservative or aggressive. we have already indicated earlier with
reference to credit standards that nature of policy(conservative or
aggressive ) would affects the profit as well as cost. What is needed is to
maintain a balance between two types of effects.

Control and Monitoring

Ones the business concern has set credit standards, credit terms, collection
policies, etc…it is important for the financial manager to control and
monitor the effectiveness of the collections. For this purpose sum targets in
terms of average collection period as well as ratio of bad debts to sales may
be set up by the finance manager and he may monitor the receivables
particularly the debtors with reference to these ratios. These targets are how
ever subject to revision due to changes in credit policies and/or credit
standards.
One traditional method for monitoring collection from a/c receivables is
aging schedule. This aging schedule provides the primary basis for
controlling or monitoring a/c receivables. The age-wise distribution of a/c
receivables a given movement of time is depicted in aging schedule. Such
schedule may be prepared for diff broken parts of the year. A comparison of
such schedules may help in identifying the changes in the payment behavior
of the customers. The aging schedule can also be compared with the credit
period allowed to the customers. Average collection period and aging
schedule suffer from some limitations, i.e. these are influenced by sales
pattern as well as the payment behavior of the customers.
 Bibliography

 Financial Management by Dr.S.P. Gupta

 Financial Management by Dr.R.S.kulshrestha and Dr.A.M
Rathi