UNIT FOUR

RECEIVABLES MANAGEMENT
After completing this unit, you should be able to:
 Explain the nature of receivables.
 Understand the objectives of credit policy
 Explain the components of credit policy.
 Understand optimal credit policy.
4. 1: Nature of receivables

Accounts receivables are asset accounts representing amounts owed to the firm as result of sale
of goods or services in the ordinary course of business. These are claims of the firm against its
customers and form part of its assets.
When a firm allows customers to pay for goods and services at a later date, it creates accounts
receivable. By allowing customers to pay some time after they receive the goods or services, you
are granting credit, which we refer to as trade credit. Trade credit, also referred to as mer-
chandise credit or dealer credit, is an informal credit arrangement. Unlike other forms of credit,
trade credit is not usually evidenced by notes, but rather is generated spontaneously: Trade credit
is granted when a customer buys goods or services.

4.2. Objectives of Receivable Management

The objective of receivables management is to promote sales and profits until that point is
reached where the returns that the company gets from funding of receivable is less than the cost
that the company has to incur in order to fund these receivables. Hence, the purpose of
receivables is less than the cost that the company has to incur in order to fund these receivables.
Hence, the purpose of receivables is directly connected with the company’s 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
more goods 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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Accounts receivable management involves the careful consideration of the following core
aspects:

 Forming a credit policy.

 Executing the credit policy.
 Formulating and executing collection policy.
Firms extend credit to customers to help stimulate sales. Suppose you offer a product for sale at
$20, demanding cash at the time of the sale. And suppose your competitor offers the same
product for sale, but allows customers 30 days to pay. Who’s going to sell the product? If the
product and its price are the same, your competitor, of course. So the benefit from extending
credit is the profit from the increased sales.
Extending credit is both a financial and a marketing decision. When a firm extends credit to its
customers, it does so to encourage sales of its goods and services. The most direct benefit is the
profit on the increased sales. If the firm has a variable cost margin (that is, variable cost/sales) of
80%, then increasing sales by $100,000 increases the firm’s profit before taxes by $20,000.
Another way of stating this is that the contribution margin (funds available to cover fixed costs)
is 20%: For every $1 of sales, 20 cents is available after variable costs.
Costs of Credit
There are costs and benefits associated with the extension of credit and account receivable. The
major categories of costs associated with the extension of credit and accounts receivable are

Capital cost. When a firm maintains receivables, some of the firm’s resources remain blocked in
them because there is a time lag between the credit sale to customer and receipt of cash from
them as payment. To the extent that the firm’s resources are blocked in its receivables, it has to
arrange additional finance to meet it own obligations toward its creditors and employees, like
payments for purchases, salaries and other production and administrative expenses. Where this
additional finance is met from its own resources or from outside, it involves a cost to the firm in
terms of interest (if financed from outside) or opportunity costs (if internal resources which could
have been put to some other use are taken).
Collection costs: Collection costs are administrative costs incurred in collecting the receivables
from the customers to whom credit sales have been made. Therefore, these are costs which the
firm has to incur for collection of the amount at the appropriate time from he customers.
Included in this category are:
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 Additional expenses on the creation and maintenance of a credit department with staff,
accounting records, stationery, postage and other related items;
 Expenses involved in acquiring credit information either through outside specialist agencies
or by the staff of the firm itself.
These expenses would not be incurred if the firm does not sell on credit.

Delinquency cost. This cost arises out of the failure of the customers to meet their obligations
when payment on credit sales becomes due after the expiry of the credit period. Such costs are
called delinquency cost. The important components of these costs are:
 Blocking-up of funds for an extended period,
 Cost associated with steps that have to be initiated to collect the overdue, such as,
reminders and other collection efforts, legal charges, where necessary, and so on.
Defaulting cost: Finally, the firm may not able to recover the overdue because of the inability
of the customers. Such debts are treated as bad debts and have to be written off as they cannot be
realized. Such costs are known as default costs associated with credit sales and accounts
receivable.

Apart from the cost, another factor that has a bearing on account receivables management is the
benefit emanating from credit sales. The benefits are the increased sales and profits anticipated
because of a more liberal policy.

The benefit from extending credit is:

Benefit from extending credit = Contribution margin × Change in sales

For example: If a firm liberalizes its credit it grants to customers, increasing sales by $5 million
and if its contribution margin is 25%, the benefit from liberalizing credit is 25% of $5 million or
$1.25 million.

Example 1. A firm is selling a product for $10 per unit and sales are about 60,000 units (all on
credit). The variable cost is $6 per unit and total fixed costs are $120,000. The credit standard
change will result in the following:
Present New (proposed)
Sales: 60,000 63,000

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 ACP 30 days 45 days (average collection period)
Bad debt 1% 2%
The firm’s capital opportunity cost is 15%. Should the firm relax its credit standards?

Solution: Fixed costs are unaffected by the change in the sales level. Only variable costs are
relevant to a change in sales.
a. Profit on additional sales = (10-6) × 3,000 = $12,000
b. Average investment in accounts receivable
= Increased investment associated with original sales_ Increased investment associated with
incremental sales
= (ACP New-ACP old)* Sales Old + V (ACP new) *Sales new-sales old
365 days 365 days
=
(45 days_30 days ) * 600,0000 + 0.6 (45 days) *30,000
365 days 365
= 24,657.5 +2219.17 = $26876.67
Additional funding cost per year = 15% × 26876.67= Br 4031.42
c. Cost of marginal bad debt:
Under present plan: (1% × 10 × 60,000) = Br. 6,000
Under new plan: (2% × 10 × 63,000) = Br. 12,600
Additional bad-debt expense = 12,600 – 6,000 = Br. 6,600
4. 3: Component of credit policy

The major controllable determinants of demand are sales prices, product quality, advertising, and
the firm’s credit policy.
Credit policy, in turn, consists of these four variables:
1. Credit period, which is the length of time buyers are given to pay for their purchases.
2. Discounts given for early payment, including the discount percentage and how rapidly
payment must be made to qualify for the discount.
3. Credit standards, which refer to the required financial strength of acceptable credit
customers.
4. Collection policy, which is measured by its toughness or laxity in attempting to collect on
slow-paying accounts.
The credit manager is responsible for administering the firm’s credit policy. However, because
of the pervasive importance of credit, the credit policy itself is normally established by the
executive committee, which usually consists of the president plus the vice-presidents of finance,
marketing, and production.
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For efficient utilization of accounts receivable, a firm must adopt a credit policy. A credit policy
is a set of decisions that include a firm’s;
 credit standards,
 credit terms,
 collection procedures and
 Discount offered.
Credit standards

Credit standards refer to the financial strength and credit worthiness a customer must exhibit in
order to qualify for credit. If a customer does not qualify for the regular credit terms, it can still
purchase from the firm, but under more restrictive terms. The firm’s credit standards would be
applied to determine which customers qualified for the regular credit terms and how much credit
each should receive. The major factors considered when setting credit standards relate to the
likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.

Credit terms

Credit terms specify the length of time over which credit is extended to a customer and a
discount given for early payment. For example, one firm’s credit terms might be expressed as
“2/10, net 30.” The term “2/10 “ means that a 2 percent cash discount is given if the bill is paid
within 10 days of the invoice date. Thus cash discount period is 10 days. It is the period of time
during which a cash discount can be taken for early payment. Cash discount is (a 2 percent
reduction in sales or purchases price) allowed for early payment of invoices. It is an incentive for
credit customers to pay invoices in a timely fashion. The term “net 30” implies that if a discount
is not taken, the full payment is due by the 30 th day beginning from invoice date. Thus the credit
period is 30 days. It is the total length of time over which credit is extended to a customer to pay
a bill.

There is no binding rule on fixing the terms of credit. Credit terms vary and even within the same
industries. Differences are linked to product characteristics as well as market competition.

Executing Credit Policy

After formulating the credit policy, its proper execution is very important. Having established
the terms of sale to be offered, the firm must evaluate individual credit applicants and determine
the applicant’s credit worthiness.
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The credit evaluation procedure involves three related steps:

 Collecting information on the credit applicant

 Analyzing the credit information
 Making the credit decision.
Collecting Credit Information

The first step in implementing credit policy will be to gather credit information about the credit
applicant /customers/. When a customer desiring credit terms approaches a business firm, the
credit department typically begins the evaluation process by requiring the applicant to fill out
various forms that request financial and credit information and references.

Analyzing Credit Information

After gathering the required information, the finance manger should analyze it to find out the
credit worthiness of potential credit customers and also to see whether they satisfy the credit
standards of the firm or not. The credit analysis will determine the degree of risk associated with
the account, the capacity of the credit customer to get goods and /or services and its ability and
willingness to repay. Often the selling firm not only must determine the creditworthiness of a
customer, but also must estimate the maximum amount of credit the customer is capable of
supporting

It is the credit analyst’s job to synthesize and analyze all information that has been collected and
reach a judgment regarding the applicant’s credit worthiness. To perform this synthesis and
analysis, it is useful to have some mechanism for organizing the information that has been
collected. One traditional way of organizing this information is by characterizing the applicant
along five dimensions. These dimensions are called the Five Cs of Credit - capital, character,
collateral, capacity and conditions.

A firm's credit analysts often use these five Cs of credit to focus their analysis on the key
dimensions of an applicant's creditworthiness. Each of these five dimensions is briefly described
in the following list.

Character: It is the applicant's record of meeting past obligations - financial, contractual, and
moral. Past payment history as well as any pending or resolved legal judgments against the

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applicant would be used to evaluate its character. In assessing character, the credit analyst
considers all the information that relates to willingness to pay debts.

Capacity: It is related to the applicant's ability to repay the requested credit. This dimension has
two aspects: management’s capacity to run the business and the applicant’s plant capacity.
Management’s capacity to run the business relates to the competency (ability) of the
management personnel in the applicant’s operations. Physical capacity refers to the value and
technology of the applicant’s production or service facilities. Financial statement analysis with
particular emphasis on liquidity and debt ratios is typically used to assess the applicant's
capacity. The applicant's ability to generate cash to meet obligations is assessed.

Capital: It is the financial strength of the applicant as reflected by its ownership position. To
assess the capital dimension, analysis of the applicant's debt relative to equity and its profitability
ratios are frequently used. The credit analyst considers the data obtained from the applicant‘s
financial statements. The usual procedure is to perform extensive ratio analysis, comparing the
applicant’s financial ratios to ratios for the applicant’s industry and performing trend analysis of
the applicant’s ratios over time.

Collateral: The amount of assets the applicant has available for use in securing the credit is
called collateral. The larger the amount of available assets, the greater the chance that a trade
creditor will recover its funds if the applicant defaults.

Conditions: It includes current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. For example, if the firm has excess
inventory of the items the applicant wishes to purchase on credit, the firm may be willing to sell
on more favorable terms or to less creditworthy applicants. Analysis of general economic and
business conditions as well as special circumstances that may affect the applicant or firm is
performed to assess conditions.

The Credit analyst typically gives primary attention the first two Cs - character and capacity-
because they represent the most basic requirements for extending credit to an applicant.
Consideration of the last three Cs capital, collateral, and conditions-is important in structuring
the credit arrangement and making the final credit decision, which is affected by the credit
analyst's experience and judgment.

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Making Credit Decisions

After analyzing the credit worthiness of the customer, decisions should be made whether the
credit is to be extended to the credit applicant customer. If the analyst decides to extend credit to
the applicant, what amount of credit to extend will be the next issue to decide. To do this, it is
necessary to match the creditworthiness of the customer already determined based on the credit
analysis with the credit standards of the credit granting firm. If the customer’s credit worthiness
is above the credit standards then there is no problem in taking a decision. In cases where the
customer’s credit worthiness is below the firm’s credit standards then they should not be outright
refused. Rather they should be offered to pay on delivery of goods or some third party guarantee
may be insisted.

Formulating and Executing Collection Policy

The collection policy refers to the procedures the firm follows to collect past due accounts. A
number of collection procedures are employed. For example, a letter might be sent to customers
when a bill is 10 days past due; a more severe letter, followed by telephone call, would be sent if
payment is not received within 30 days, and the account would be turned over to a collection
agency after 90 days. As an account receivable becomes more and more overdue, the collection
effort becomes more personal and more intense. The popular procedures are briefly described in
Table4.1 listed in the order typically followed in the collection process.

Table 4.1 Popular Collection Techniques

Techniques* Brief Description

Letter After an account receivable becomes overdue a certain number of days, the
firm normally sends a polite letter reminding the customer of its
obligation. If the account is not paid within a certain period after the letter
has been sent, a second, more demanding letter is sent. Yet another letter
may follow this letter, if necessary. Collection letters are the first step in
the collection process for overdue accounts.

Telephone calls If letters prove unsuccessful, a telephone call may madeto

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 the customer to personally request immediate payment. Such a call is
typically directed to the customer's accounts payable department where the
responding employee acts on instructions of his or her boss. If the
customer has a reasonable excuse, arrangements may be made to extend
the payment period. A call from the seller's attorney may be used if all
other discussions seem to fail.

Personal visitsThis technique is much more common at the consumer credit

level, but it may also be effectively employed by industrial suppliers.

Sending a local salesperson or a collection person to confront the customer
can be a very effective collection procedure. Payment may be made on the
spot.

Collection agenciesA firm can turn uncollectible accounts over to a collection

agency or an attorney for collection. The fees for this service are typically
quite high; the firm may receive less than 50 cents on the dollar from
accounts collected in this way.

Legal action Legal action is the most stringent step in the collection process. It is an
alternative to the use of a collection agency. Not only is direct legal action
expensive, but also it may force the debtor into bankruptcy, thereby
reducing the possibility of future business without guaranteeing the
ultimate receipt of the overdue amount.

* Techniques are listed in the order typically followed in the collection process.

Monitoring Credit and Collection Policies

Accounts receivable management does not stop with the establishment of a credit terms,
collection policy and credit standards, for the individual customer or for the entire firm. Credit
and collection policies must be monitored continually, not only for indications of deterioration in
the individual customer’s ability to pay, but also for signs of overextended credit to all
customers. The financial officer must also troubleshoot for mechanical and procedural failures
on the part of the credit department’s equipment and personnel. The effectiveness of credit and

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collection policies can be partly evaluated by looking at the level of bad debts expenses. This
level depends not only on collection policy, but also on the policy on which the extension of
credit is based. If one assumes that the level of bad debts attributable to credit policy is relatively
constant, increasing collection expenditures can be expected to reduce bad debts. Popular
approaches used to evaluate credit and collection policies include:
 Average collection period and
 Aging accounts receivable.
Average collection period

The average collection period or average age of accounts receivable is useful in evaluating credit
and collection policies. It is arrived at by dividing the accounts receivable balance by the average
daily sales:
Average collection period = Accounts receivable
Average Credit Sales per day
= Accounts receivable
Annual Credit sales /360 days
For example, assume Ethio-Food Company’s ending accounts receivable balance and its annual
credit sales are Br. 503, 000 and Br. 3,074,000 respectively, its average collection period will be:
= Br. 503,000
Br. 3,074,000/ 360 days
= 59 days
This means that on average it takes the firm’s 59 days to collect an accounts receivable. The
average collection period is meaningful only in relation to the firm‘s credit terms. If, for instance,
Ethio- Food Company extends 30-day credit terms to customers, an average collection period of
59 days may indicate a poorly managed credit or collection department or both. Of course, the
lengthened collection period could be an intentional relaxation of credit term enforcement by the
firm in response to competitive pressures from other suppliers of the product. If the firm had
extended 60- day credit terms, the 59-day average collection would be quite acceptable. Clearly,
comparison of the firm’s average collection period and credit terms (credit period provided)
would help to draw definitive conclusions about the effectiveness of the firm’s credit and
collection policies. However, a major weakness of average collection period for this purpose is

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that it is quite sensitive to seasonal variations in sales. Consequently, unless sales are quite stable
overtime, the collection period can mask fundamental changes in collection experience.

Aging Accounts Receivable

Aging Accounts receivable is a technique that indicates the proportion of the accounts receivable
balance that has been outstanding for a specified period of time. By highlighting irregularities, it
allows the analyst to pinpoint the cause of credit or collection problems. Aging requires that the
firm's accounts receivable be broken down into groups based on the time of origin. This
breakdown is typically made on a month-by-month basis, going back 3 or 4 months. Let us look
at an example.

Assume that Ethio- Food Company extends 30-day EOM credit terms to its customers. The
firm's December 31, 1997, balance sheet shows Br. 200,000 of accounts receivable. An
evaluation of the Br. 200,000 of accounts receivable results in the following breakdown:

Day Current 0-30 31-60 61-90 Over 90

Month Dec. Nov. Oct. Sept. Aug. Total

Accounts
Receivable
Br.60,000 Br.40,000 Br.66,000 Br.26,000 Br.8,000 Br.200,000
Percentage
of total
30 20 33 13 4 100
Because it is assumed that Ethio- Food gives its customers 30 days after the end of the month in
which the sale is made to payoff their accounts, any December receivables that are still on the
firm's books are considered current. November receivables are between zero and 30 days
overdue, October receivables still unpaid are 31 to 60 days overdue, and so on.

The above breakdown shows that 30 percent of the firm's receivables are current, 20 percent are
1 month late, 33 percent are 2 months late, 13 percent are 3 months late, and 4 percent are more
than 3 months late. Although payment seems generally slow, a noticeable irregularity in these
data is the high percentage represented by October receivables. This indicates that some problem
may have occurred in October. Investigation may find that the problem can be attributed to the

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hiring of a new credit manager, the acceptance of a new account that has made a large credit
purchase it has not yet paid for, or ineffective collection policy. When accounts are aged and
such a discrepancy is found, the analyst should determine its cause.

By comparing aging schedules for different periods the credit manager can get some idea of any
changes in collection experience; additionally, he/she can identify those individual accounts
requiring attention. Like the collection period, however, a weakness of the aging schedule is that
it is influenced by changes in sales.

4.2. Change in credit policy

Once a credit policy is set, it doesn’t mean it is not subject for change. Since market
environment is not static, there is a need to assess the credit policy and make adjustments
accordingly. The change might be made on:
 Credit period
 Discount rate
 Discount period
 Credit limit, etc.
Example 1. Ethio Company is presently having sales of Br 10,800,000. Its existing credit
terms are 1/10 net 45 days and average collection period of 30 days. Fifty percent of
customers in terms of sales revenue are utilizing the cash discount incentive. The
contribution to sales ratio of the company is 20 percent and cost of funds 15 percent. In
order to hasten the collection process, if possible, the company is contemplating
liberalization of its existing credit terms to 2/10 net 45 days. It is expected that sales are
likely to increase by Br 300,000 and average collection period to decline to 20 days.
Eighty percent of customers to terms of sales revenue are expected to avail themselves of
the cash discount under the liberalization scheme. Should the company increase its cash
discount? Assume a 360 days year.

Solution:

In order to answer this question, let us consider the incremental benefit associated with
the liberalization of credit terms. These are:

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  Profit associated with additional sales to be generated
 And cost savings on the release of funds locked up in receivables.
The incremental costs are:
 The cost of funds invested in the receivables arising out of new sales.
 Additional amount to be paid as cash discount.
Profit to be generated by increase in sales
= Amount of Sales X CM Ratio
= Br 300,000 X 0.2
= Br 60,000
Exiting cost of carrying receivables
=Br 10,800,000 x 30/360 x 0.15
= Br 135,000
Cost of carrying receivables after liberalization
=Br 10,800,000 x 20/360 x 0.15
= Br 90,000
Savings in the cost of carrying receivables
= Br. 135,000 – Br. 90,000 = Br. 45,000
Thus, incremental benefits
= Br. 60,000 + Br. 45,000
= Br. 105,000
The cost of funds invested in the receivable arising out of new sales
=Br 300,000 x 20/360 x0.8x 0.15
= Br 2,000
Amount of discount presently paid
=Br 10,800,000 x 0.5 x 0.01
= Br 54,000
Amount of discount payable after liberalization
= Br 11,100,000 x 0.8 x 0.02
=Br 177,600

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The additional amount of discount payable
= Br 177,600 – Br 54,000
= Br 123,600
Thus, incremental costs
= Br. 2,000 + Br. 123,600
= Rs. 125,600
A comparison of the total incremental benefits and incremental costs reveal that the net
incremental benefit is
= Br. 105,000 – Br. 125,600
= Br. 20,600

It is, therefore, not advisable to increase the rate of cash discount from 1 to 2 percent.

Example 2. Tekeze Inc. is adopting a “net 30” credit policy now and has an ACP of 40
days (32 days + 8 days of processing). The proposed credit term is “2/10, net 30”, which
will result in an ACP of 22 days. Other information include: annual raw material usage
1,100 units, material variable cost per unit $524, production variable cost $1,381 per
unit, finished product price $3,000 per unit, 80% customers will take cash discount,
annual ales will increase 50 units to 1,150 units, and cost of capital 14%. The bad debt
will remain at 2.6% of sales. Should the firm offer the cash discount?
Solution:
a. Additional profit from sales: 50 unit × (3,000 – 524 – 1,381) = Br 54,750
b. Average investment in A/R (present terms)
= [(3,000 x 1,100) / 365] × 40 = Br 361,644
Average investment in A/R (proposed terms)
= [(3,000 x 1,150) / 365] × 22 = Br 207,945
Reduction in A/R investment = 361,644 – 207,945 = Br 153,699
Cost saving in A/R investment = 153,699 × 14% = Br 21,518
c. Cost of cash discount = -2% × 80% × (1,150 × 3,000) = -Br 55,200
d. Reduction in bad debt:

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 Current bad debt = Br (1,100 × 3,000 × 2.6%) = Br 85,800
New bad debt = Br (1,150 × 3,000 × 20% × 2.6%) = Br 17,940
Reduction in bad debt = Br 85,800 – Br 17,940 = Br 67,860
e. Net cost from initiation of cash discount
= Br 54,750 + 21,580 + 67,860 – 55,200
= Br 88,990
Therefore, the firm should initiate the cash discount.
Example 3. Suppose a firm is contemplating an increase in the credit period from 30 to
60 days. The average collection period which is at 45 days is expected to increase to 75
days. It is also likely that the bad debt expense will increase from the current level of 1
percent to 3 percent of sales. Total credit sales are expected to increase from the level of
30,000 units to 34,500 units. The present average cost per unit is Br 8, the variable cost
and sales per unit are Br 6 and Br 10 per unit, respectively. Assume the firm expects a
rate of return of 15 percent. Should the firm extend the credit period?
Solution:
a. Profit on additional sales = Br 4 x 4,500 = Br 18,000

b. Cost of additional investment in receivables

Average investment in receivables with the:
Proposed plan = Credit Sales = 34,500 X 10 =Br 71,875
RTO 360/75
Present plan = Credit Sales = 30,000 X 10 =Br 37,500
RTO 360/45
Additional investment in accounts receivable = 71,875 -37,500= Br 34,375
Cost of additional investment = 0.15 x Br 34,375 = Br 5,156
c. Additional bad debt expense
Bad debt with proposed credit period = 0.03 x 345,000 = Br 10,350
Bad debt with proposed credit period = 0.01 x 300,000 = Br 3,000
Additional bad debt expense =Br 10,350 – Br 3,000 = Br 7,350

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Thus, the incremental cost associated with the extension of the credit period is Br
12,506 =Br 5,156 +Br 7,350. As against this, the benefits are Br 18,000. Therefore, the
net gain of extending the credit period from 30 to 60 days is Br 5,494.
4. 5: Optimal credit policy

Optimal Credit policy 

The amount of trade credit that is affected by the variables in the decision is known as Optimal
Credit Policy, for example the receivables in an investment. Assignment help shows that many
factors such as the internal factors in an organization, the present situation in the economy and
the competition that is faced by the firm in the market are some of the external factors that affect
the credit policy of the firm. It’s the credit policy which helps the firm to get its level of credit.
One should work on the credit policy costs and variables In order to understand both jointly and
individually it’s the maximization profit and the goals and its varied impacts.

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