Unit 14 Receivables Management: Structure

Financial
Management Unit 14
Unit 14 Receivables Management
Structure
14.1 Introduction
14.2 Costs associated with maintaining receivables
14.3 Credit policy variables
14.4 Evaluation of credit policy
14.5 Summary
Terminal Questions
14.6 Answer 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 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 firm’s 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.
Objectives: The main objective of selling goods on credit is to promote sales for
increasing the profits of the firm. Customers will always prefer to buy on credit to buying
Sikkim Manipal University 218
Financial Management Unit 14
on cash basis. They always go to a supplier who gives credit. All firms therefore grant
credit to their customers to increase sales, profits and to meet competition.
Learning Objectives:
After studying this unit, you should be able to understand the following.
1.Understand the meaning of receivables management.
2. What are the costs associated with maintaining receivable ?
3. Understand the credit policy variables.
4. Understand the process of evaluation of credit policy.
Meaning of Receivables 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 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 then the cost
of funds raised to finance that additional credit.
14.2 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 firm’s 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 same 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.
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.
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.
Therefore, the assessing the effect of a change in credit policy of a firm involves
examination of
a. Opportunity Cost of lost contribution
b. Credit administration Cost
c. Collection Costs
d. Delinquency Cost
e. Bad – debt loses
Self Assessment Questions 1
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 firm’s 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 viz
_____ and _________________ .
14.3 Credit policy Variables
1. Credit standards.
2. Credit period.
3. Cash discounts and
4. Collection programme.
1. Credit standards: The term credit standards refer to the criteria for extending credit to
customers. The bases for setting credit standards are.
a. Credit rating.
b. References
c. Average payment period
d. 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, funds blocked in
receivables etc. The firm may have light credit standards. It may sell on cash basis and
extend credit only to financial strong customers. Such strict credit standards will bring
down bad – debt losses and reduce the 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. The firm should evaluate the trade – off between cost and benefit of
any credit standards.
2. 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. It 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 to 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 profits of the firm are similar to that of
relaxing the credit standards.
3. 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. 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;
other wise full payment will have to made by 20 th day.
4 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. Timely collection of receivables,
there by releasing funds locked in receivables and minimizes the incidence of bad debts.
The collection programmes consists of the following.
1. Monitoring the receivables
2. Reminding customers about due date of payment
3. On line interaction through electronic media to customers about the payments due
around the due date.
4. Initiating legal action to recover the amount from overdue customers as the last resort
to recover the dues from defaulted customers.
Collection policy formulated shall not lead to bad relationship with customers
Self Assessment Question 2
1. Credit period is a ______________.
2. _______ refer to the criteria for extending credit to customers.
3. _________ refers to the length of time allowed to its customers by a firm to make
payment for purchase made by customers of the firm.
4. A cash discount of 2 / 10 net 20 means that a ____________ is offered if the payment
is made __________________
14.4 Evaluation of Credit Policy: Optimum credit policy is one which would maximize
the value of the firm. Value of a firm is maximized 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 a 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
company’s products.
Credit policy variables of a firm are
1. 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]
Example: Following details are available in respect of x ltd:
Current sales = Rs 100 million
The company is considering relaxation of its credit policy. Such relaxation would
increase the sales by Rs 15 million on which bad debt losses would be 10%. The
contribution margin ratio for the firm is 20%. Average collection period is 40 days. Post –
tax cost of funds is 10%. Tax rate applicable to the firm is 30%. Assume 360 days in a
year.
Examine the effect of relaxing the credit policy on the profitability of the organization.
(MBA) adopted.
Solution:
Incremental contribution = 1,50,00,000 x 0.20 = Rs 30,00,000
Bad debts on new sales = 1,50,00,000 x 0.10 = Rs 15,00,000
Cost of capital is 10%
Incremental investment in receivables =
Investment in sales
= X Average Collection Period X Variable Cost to Sales ratio
No. of days in the year
15 000 000
= X 40 X 0.8 = Rs.13,33,333
360
Cost of Incremental Investment
10
= x 13,33,333
100
Therefore change in profit is calculated as under
Incremental Contribution = 3 000 000
Less: Bad debts on new sales = 15 00 000
Less: Income tax at 30% = 4 50 000
10 50 000
Less: Opportunity cost of
Incremental investment in
Receivables 13,33,333
Increase in profit 9 16 667
Since the impact of change in credit standards on profit is positive the change in credit

standards may be considered.
2. Credit period
The effect of changing the credit period on profits of the firm can be computed as under :
Change in profit = (Incremental contribution – Bad debts on new sales) (1 – tax rate) –
cost of incremental investment in receivables.
Example:
A company is currently allowing its customers, 30 days of credit. Its present sales are Rs
100 million. The firm’s 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.
(MBA) adopted.
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 =
30
1 00 000 000 x Rs.8 333 333
360
Expected investment in receivables after increasing the credit period to 60 days:
Expected investment in receivables on current sales =
1 00 000 000
= X 60 = Rs.16 666 667
360
Additional investment in receivable on new sales
60
1 00 000 000 x X 0.80 = Rs.13 33 333
360
Expected total investment in receivables on increasing the period of credit = 1 80 00 000
Incremental investment in receivables = 1 80 00 000 – 8 333 333 = 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
firm’s project
Incremental Contribution 2 00 000
Less: Bad debts on new sales 8 00 000
12 00 000
Less: Income tax at 30 % 3 60 000
8 40 000
Less: Opportunity cost of incremental
Investment in receivables 9 66 667
Change in profit (126667) negative
Since the impact of increasing the credit period on profits of the firm is negative, the
proposed change in credit period is not desirable.
2. 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.
Example
Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average
collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%.
The proportion of sales on which customers currently take discount is 0.5.
The company is considering relaxing its discount terms to 2/10, net 30
Such a relaxation is expected to increase sales by Rs 10 million, reduce Average
collection period to 14 days, increase discount sales to 0.8. Tax rate is 0.30.
Examine the effect of relaxing the discount policy on profits of the organisation
Assume 360 days in a year (MBA adopted).
Solution
Incremental Contribution = 10 000 000 x 0.2 = Rs.2 000 000
Increase in discount
Discount cost before liberalising discount terms =
0.5 x 1 00 000 000 x 0.01 = Rs.5 00 000
Discount cost after liberalisation of discount terms =
0.8 x 110 000 000 x 0.002 = Rs.1760 000
Increase in discount cost = Rs.1260 000
Computation of savings in receivables investment
1 00 000 000 10 000 000
= 20 – 14 – 0.8 x X 14
360 360
1 00 000 000
= 311 111
60
= 1666667 – 311111 = Rs.1355556
Opportunity cost (savings of reduction in investment in receivables
= 0.1 x 135556 = Rs.135556
Statement showing the effect of change in discount policy as profit of the company
Increase in Contribution 2 000 000
Less: increase in discount cost 12 60 000
7 40 000
Less: Tax at 30 % 2 22 000
5 18 000
Add: Benefit of savings due to
Reduction in investment in
Receivables profit 135556
653556
It is desirable to change the discount policy as it will improve the profitability of the firm.
4.Collection policy
For computation of the effect of new collection programme can be evaluated with the help
of following formula .
Change in profit = (Incremental contribution – Increase in bad debts) (1 – tax rate) – cost
of increase in investment in receivables.
Example
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 firm’s 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 = 250 00 00
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 x 40 x 0.8
= +
360 360
= 2777778 + 444444 = Rs.3222222
Opportunity cost of incremental investment in receivables =
0.1 x 3222222 = Rs.322222
Statement showing the impact of new collection programme on profits of the organisation
Incremental Contribution 1 000 000
Less: Increase in bad debts 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 3,22,222
Profit (182222) loss
Since the change will lead to decrease in profit (i,e a loss of Rs.182222) it is not desirable
to relax the collection programme of the firm
1. Credit policy of a firm can be regarded as a tradeoff between ___________ and
_______.
2. Optimum credit policy maximises the __________.
3. 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.
4. Credit policy to be adopted by a firm is influenced by strategies pursued by its
competitions.
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 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.
Terminal Questions
1. Examine the meaning of receivable management.
2. Examine the costs of maintaining receivables.
3. Examine the variables of credit policy.
4. What are the features of optimum credit policy
Answer for self Assessment Questions
1. Capital costs, administration, Delinquency costs.
2. No inducement for early payments
3. Credit sale, Cash receipt from customers.
4. Credit investigation and supervision cost, collection costs
1. Credit policy variable.
2. Credit standards
3. Credit period
4. Cash discount of 2% , on the tenth day.
1. Higher profits from increased sales, incremental cost of having large investment in
receivable.
2. Value of the firm.
3. Equal
Answer for Terminal Questions
1. Refer to unit 14.1

Unit 14 Receivables Management: Structure

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Since the impact of change in credit standards on profit is positive the change in credit

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