Financial Management

Unit 14

Unit 14

Receivable Management

Structure: 14.1 Introduction Learning Objectives Meaning of receivable management 14.2 Costs Associated with Maintaining Receivables 14.3 Credit Policy Variables 14.4 Evaluation of Credit Policy 14.5 Summary 14.6 Terminal Questions 14.7 Answers to SAQs and TQs

14.1 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 relaxed conditions of payment to their customers. 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 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 out of trade credit involves 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 will receive an equivalent value later on Receivables out of trade credit have 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.
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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 main objective of selling goods on credit is to promote sales for increasing the profits of the firms. Customers will always prefer to buy on credit rather than buying on cash basis. They always go to a supplier who gives credit. All firms therefore grant credit to their customers to increase sales, profit and to beat competition. 14.1.1 Learning objectives
After studying this unit, you should be able to:

Understand the meaning of receivables management Recognise the costs associated with maintaining receivable Understand the credit policy variables Understand the process of evaluation of credit policy

14.1.2 Meaning of receivables management Receivables are a direct result of credit. Sales are resorted 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 maximising the overall return on the investment of the firm. Thus, the objective of receivables management is to promote sales and projects until the level where the return on investment in further finding of receivables is less than the cost of funds raised to finance that additional credit.
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14.2 Costs Associated with Maintaining Receivables

There are four different varieties of costs associated with maintaining receivables (see figure 14.1): capital cost, administration cost, delinquency cost and bad-debts or default cost.

Figure 14.1: Costs associated with maintaining receivables

Capital cost When firm sells goods, credit on that good 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.

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Administration cost When a firm sells goods on credit it has to incur two types of administration costs: Credit investigation and supervision costs Collection Costs. Before sanctioning credit to any customer, the firm has to investigate the credit rating of the customer to ensure that credit given will be 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. Delinquency cost 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. Bad-debts or Default costs 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. Therefore, assessing the effect of a change in credit policy of a firm involves examination of Opportunity Cost of lost contribution Credit administration Cost Collection Costs Delinquency Cost Bad debt loses

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Self Assessment Questions Fill in the blanks:

1. Costs of maintaining receivables are _____________, _________ cost and _______.

2. A period of Net 30 means that it allows to its customers 30 days of credit with ____ for ___________. 3. Selling goods on credit has consequences of blocking the firms resources in receivables as there is a time lag between _____________ and ____________. 4. When a firm sells goods on credit it has to incur two types of administration cost _____ and _________________. 5. The four different varieties of costs associated with maintaining receivables are _________, ________, _____ and ____. 6. Define receivable management 7. Define receivables.

14.3 Credit Policy Variables

The following are the four varieties of credit policy variables (see figure 14.2): Credit standards Credit period Cash discounts and Collection programme

Figure 14.2: Credit policy variables

Credit standards The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are: o Credit ratings o References o Average payment period
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o Ratio analysis There is always a benefit to the company with the extension of credit to its customers, but with the associated risks of delayed payments or non-payment, the funds get blocked in receivables. The firm may have light credit standards. The firm may sell on cash basis and extend credit only to financially strong customers. Such strict credit standards will bring down bad debt losses and reduce the cost of credit administration. However, the firm will not be able to increase its sales. The profit on lost sales may be more than the costs saved by the firm. The firm should evaluate the trade-off between cost and benefit of any credit standards. Credit period Credit period refers to the length of time allowed to its customers by a firm to make payment, for the purchases made by customers of the firm. Credit period is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period. If a firm follows a credit period of net 20 it means that it allows its customers 20 days of credit with no inducement for early payments. 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 investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales, increases investment in receivables and increases the incidence of bad debt loss. The effects of increasing the credit period on the profits of the firms are similar to that of relaxing the credit standards. Cash discount Firms offer cash discounts to induce their customers to make prompt payments. Cash discounts have implications on sales volume, average collection period, investment in receivables, incidence of bad debts and profits.
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A cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the payment is made by the tenth day; otherwise full payment will have to be made by 20th day. Collection programme The success of a collection programme depends on the collection policy pursued by the firm. 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 consists of the following. o Monitoring the receivables o Reminding customers about due date of payment o On line interaction through electronic media to customers about the payments due around the due date o Initiating legal action to recover the amount from overdue customers as the last resort to recover the dues from defaulted customers o Collection policy formulated shall not lead to bad relationship with the customers

Self Assessment Question

Fill in the blanks: 8. Credit period is a ______________. 9. _______ refer to the criteria for extending credit to customers. 10. _________ refers to the length of time allowed to its customers by a firm to make payment for purchase made by customers of the firm. 11. A cash discount of 2 / 10 net 20 means that a ____________ is offered if the payment is made __________________ 12. The four varieties of credit policy variables are ____, ______, _____ and _____.

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14.4 Evaluation of Credit Policy

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. Therefore, credit policy of a firm can be regarded as Trade off between higher profits from increased sales and The incremental cost of having large investment in receivables The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for companys products. Individual evaluation of all the four credit policy variables of a firm are as shown: Credit Standard The effect of relaxing the credit standards on profit can be estimated as under: Change in profit = P Increase in sales = S Contribution = c = 1 V Where V = Variable cost to sales Bad Debts on new sales = S x bn K = post tax cost of capital Increase in receivables investment = I Therefore
Change in profit = (Additional contribution on increase in sales Bad Debts on new sales) (1 tax rate) cost of incremental investment. (1 tax rate) cost of capital x Incremental investment in receivables.

Increase in profit i.e. change in profit = [Incremental contribution Bad debts on new sales]

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Solved Problem - 1 The details shown in table 14.1 are regarding the statistics of the company X Ltd.
Table 14.1: Statistics of X Ltd Current sales Rs.100 million Increase in sales Rs.15 million Bad-debt losses 10% Contribution margin ratio 20% Average collection period 40 days Post-tax cost of funds 10% Tax-rate 30%

Examine the effect of relaxing the credit policy on the profitability of the organisation. (MBA) adopted. Solution Incremental contribution = 15 x 0.20 = Rs 3 million Bad debts on new sales = 15 x 0.10 = Rs 1.5 million Cost of capital is 10% Incremental investment in receivables =
Increase in Sales Average Collection period Variable cos t to Sales ratio No. of days in the year

[15 / 360] 40 0.8 Rs.1.33million 10 Cost of Incremental Investment 1.33 = 0.133 100 Therefore, change in profit is calculated using the table 14.2
Table 14.2: Change in profit ( in millions) Incremental contribution Less: bad-debts on new sales Less: Income tax at 30% Less: Opportunity cost of incremental investment in receivables 3.00 1.50 .45 1.05 0.13

Increase in profit

0.92

Since the impact of change in credit standards on profit is positive, the change in credit standards may be considered.

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Credit period The effect of changing the credit period on profits of the firm can be computed as shown: Change in profit = (Incremental contribution Bad debts on new sales) (1 tax rate) cost of incremental investment in receivables.

Solved Problem 2 A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 100 million. The firms cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 100 million. Bad debts on additional sales would be 8%. Tax rate is 30%. Assume 360 days in a year. Examine the effect of relaxing the credit policy on the profitability of the organisation (MBA) adopted.

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Solution Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000 Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000 Existing investment in receivables =
100,000,000 , 30 Rs.8,333,333 360

Expected investment in receivables after increasing the credit period to 60 days: Expected investment in receivables on current sales =
100,000,000 , 60 Rs.16,666,667 360 60 100,000,000 , 0.80 Rs.13,33,333 360

Additional investment in receivable on new sales = Rs. 13,33,333 Expected total investment in receivables on increasing the period of credit = 1 80 00 000 Incremental investment in receivables = 18000000 8333333 = Rs. 9666667 Opportunity cost of Incremental investment in receivables = 0.10 x 9666667 = Rs.966667 Statement showing the effect of increasing the credit period from 30 days to 60 days as firms project (see table 14.5)
Table 14.5: Effect of increase in credit period Incremental contribution Less: Bad debts on new sales Less: Income tax at 30% Less: Opportunity cost of incremental in receivables Change in profit 20,00,000 8,00,000 12,00,000 3,60,000 8,40,000 9,66,667 (1,26,667)

Since the impact of increasing the credit period on profits of the firm is negative, the proposed change in credit period is not desirable.
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Cash discount For assessing the effect of cash discount the following formula can be used. Change in profit = (Incremental contribution increase in discount cost) (1 - t) + opportunity cost of savings in receivables investment Collection policy Computation of the effect of new collection programme can be evaluated with the help of the following formula.
Change in profit = (Incremental contribution Increase in bad debts) (1 tax rate) cost of increase in investment in receivables.

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Solved Problem -3 A company is considering relaxing its collection effort. Its present sales are Rs 50 million, ACP = 20 days, variable cost to sales ratio = 0.8, cost of capital 10%. Its bad debt ratio is 0.05. The relaxation in collection programme is expected to increase sales by Rs 5 million, increase ACP to 40 days and bad debts ratio to 0.56. Tax rate is 30%. Examine the effect of change in collection programme on firms profits. Assume 360 days in a year. (MBA adopted and also ACS Solution Increase in Contribution = 5, 000, 000 x 0.2 = Rs.1, 000, 000 Increase in bad debts Bad debts on existing sales = 50, 000, 000 x 0.05 = 25, 00, 000 Bad debts on total sales after increase in sales = 55, 000, 000 x 0.56 = 33, 00, 000 Increase in bad debts = Rs.8, 00, 000 Incremental investment in receivables
50,000,000( 40 20) 5,000,000 40 0.8 360 360

= 2777778 + 444444 = Rs.3222222 Opportunity cost of incremental investment in receivables = 0.1x 3222222 = Rs.322222

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Statement showing the impact of new collection programme on profits of the organisation
Table 14.8: Impact of new collection Incremental contribution Less: increase in bad debts 1,00,000 8,00,000 2,00,000 Less: Income tax at 30% 60,000 1,40,000 Less: opportunity cost of increase in investment in receivables Profit/loss 3,22,222 (1,82,222) negative

Since the change will lead to decrease in profit (a loss of Rs.182222) it is not desirable to relax the collection programme of the firm.

Self Assessment Questions Fill in the blanks:

13. Credit policy of a firm can be regarded as a trade-off between ___________ and _______.

14. 15.

16.

Optimum credit policy maximises the __________. Value of a firm is maximised when the incremental rate of return on investment in receivable is ________________ to the incremental cost of funds used to finance that investment. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitors. (True/False).

14.5 Summary
Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will result in maximising the overall return on the investment of the firm. Cost of maintaining receivables are of three types -

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capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and collection programme. Optimum credit policy is that which maximises the value of the firm.

14.6 Terminal Questions

1. 2. 3. 4. Examine the meaning of receivable management. Examine the costs of maintaining receivables. Examine the variables of credit policy. What are the features of optimum credit policy?

14.7 Answers to SAQs and TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. Capital costs, administration, Delinquency costs No inducement for early payments Credit sale, Cash receipt from customers Credit investigation and supervision cost, collection costs Capital cost, administration cost, delinquency cost and bad-debts or default cost Management of accounts receivables may be defined as the process of making decision relating to the investment of funds in receivables that will result in maximising the overall return on the firms investment Receivables are asset-accounts representing amounts owing to the firm as a result of sale of goods/services Credit policy variable Credit standards Credit period Cash discount of 2% , on the tenth day Credit standards, credit periods, cash discounts and collection programme Higher profits from increased sales, incremental cost of having large investment in receivable. Value of the firm. Equal True
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7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

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Answers to Terminal Questions 1. 2. 3. 4. Refer to 14.1 Refer to 14.2 Refer to 14.3 Refer to 14.4

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