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Management of Accounts Receivables
Management of Accounts Receivables
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 firms 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. The purpose of receivables is directly connected with the companys 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.
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. 4) 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.
To improve profitability one can resort to lenient credit policy as a booster of sales, but the implications are: 1. Changes of extending credit to those with week credit rating. 2. Unduly long credit terms. 3. Tendency to expand credit to suit customer's needs and 4. Lack of attention to over dues accounts. In establishing an optimum credit policy, the Firm should consider the important decision variables which influence the level of receivables which influence the level of receivables. As stated in the preceding section, the major controllable decision variables include the following: Credit standards and analysis Credit term Collection policy and procedures
Profitability of additional sales Additional receivables Investment in add. receivables Req. pre-tax return on add. investment
($5 contribution) x (4,800 units) =$24,000 ($120,000 sales) / (4 Turns) =$30,000 ($20/$25) x ($30,000) =$24,000 (20% opp. cost) x $24,000 =$4,800
Yes!
Credit analysis: Credit standards influence the quality of the firms customers. There are two aspects of the quality of customer: The time taken by customers to repay credit obligation The default rate
The average collection period determines the speed of payment by customers. It measures the number of days for which credit sales remain outstanding. The longer the average collection period, the higher the firms investment in accounts receivable. Default rate can be measured in terms of bad-debt losses ratio- the proportion of uncollected receivable. Bad-debt losses ratio the proportion of uncollected receivable. Bad- debt losses ratio indicated default risk. Default risk is the likelihood that a customer will fail to repay the credit obligation. On the basis of past practice and experience, the firm should be able to form a reasonable judgment regarding the chances of default. To estimate the probability of default, the firm should consider three C's a. b. c. Character Capacity Condition
This method of evaluating a customer incorporates both qualitative and quantitative measures. The first factor is character, which refers to a customers willingness to pay. The moral factor is of considerable importance in credit evaluation practice. Capacity measures a borrower's ability to repay. It can be judged by assessing the customers capital and assets which he may offer as security. Capacity is evaluated by the financial position of the firm as indicated by the analysis of ratio and trends of the firms cash and working capital position.
Condition refers to the prevailing economic and other conditions which may affect the customers ability to pay. An experienced credit manager will be able to judge the extent and genuineness to which the customers ability to pay is affected by various conditions.
a. The credit period: The length of time for which credit is extended to customers is called the credit period. For example, net 30 requires full payment to the firm within 30 days from the invoice date. A firms credit period may be governed by the industry norms. But depending on its objective, the firm can lengthen the credit period. On the other hand, the firm may tighten its credit period if customers are defaulting too frequently and bad-debt losses are building up. 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 investment in receivables and reduce the bad debt loss. Increasing the credit period increases sales but also increases investment in receivables and incidence of bad debt loss.
b. The cash discount: A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms indicate the rate of discount and the period for which it is available. If the customer does not avail the offer he must make payment within the normal credit policy. For example, 2/10 allows the customer to take a 2% cash discount during the cash discount period i.e. 10 days. Credit terms would include: The rate of cash discount The cash discount period
The net credit policy A firm uses cash discount as a tool to increase sales and accelerate collections from customers. Thus, the level of receivable and associated costs may be reduced. The cost involved is the discounts taken by customers.
Example of introducing a cash discount: A competing firm of Basket Wonders is considering changing the credit period from net 60 (which has resulted in 6 A/R Turns per year) to 2/10, net 60. Current annual credit sales of $5 million are expected to be maintained. The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R Turns to 8. (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days 360 days per year / 45 days = 8 turns per year) The before-tax opportunity cost for each dollar of funds tied-up in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should the competing firm introduce a cash discount?
Receivable level (Original) Receivable level (New) Reduction of investment in A/R Pre-tax cost of the cash discount Pre-tax opp. Savings on reduction in A/R Yes!
($5,000,000 sales) / (6 Turns) =$833,333 ($5,000,000 sales) / (8 Turns) =$625,000 $833,333 - $625,000 =$208,333 0.02 x 0.3 x $5,000,000 =$30,000. (20% opp. cost) x $208,333 =$41,667.
The benefits derived from released accounts receivable exceed the costs of providing the discount to the firms customers.
Present Policy
Demand Incremental Sales Default losses Original sales Incremental Sales ACP Original sales Incremental Sales Variable costs is 80% of sales 2400000
Policy A
3000000 600000
The before-tax opportunity cost for each dollar of funds tied-up in additional receivables is 20%.
Policy A 1. Additional sales 2. Profitability: (20% contribution) x (1) 3. Add. bad-debt losses: (1) x (bad-debt %) 4. Add. receivables: (1) / (New Rec. Turns) 5. Inv. in add. receivables: (.80) x (4) 6. Required before-tax return on additional investment: (5) x (20%) 7. Additional bad-debt losses + additional required return: (3) + (6) 8. Incremental profitability: (2) - (7) $600,000 120,000 60,000 100,000 80,000 16,000 76,000 44,000
10
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The collection policies maybe classified into o Strict and o Liberal. The effects of tightening the collection policy would be 1. Decline in debts 2. Decline in collection period resulting in lower interest costs, 3. Increase in collection costs 4. Decline in sales. The effects of lenient policy would be exactly the opposite. Another aspect of collection policies relates to the steps that should be taken to collect over dues from the customers. The effort should in the beginning be polite but with the passage of time, it should gradually become strict. The steps usually taken are Letters, including reminders to expedite payment Telephone calls for personal contact Personal visits Help of collection agencies Legal action
The firm should take very stringent measure, like legal action only after all other avenues have been fully exhausted. They not only involve a cost but also affect the relationship with the customers. The aim should be to collect as early as possible genuine difficulties of the customers should be given due consideration. Collection of sales tax declaration (STD) forms from the customers is very important but mostly neglected area in receivables management. The onus lies on the selling companies to collect these forms or else bear the sales tax burden themselves. The financial implication of this is generally 6% to 8%. This means non-collection of STD forms would take away more than the profits earned in sales, in most cases.
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1. Credit information The firm would ensure that receivables will be collected in full and on due date. Credit should be granted to those customers who have the ability to make the payment on time. To ensure this, the firm should have credit information concerning each customer to whom the credit will be granted. The decision to grant cannot be delayed for long because the time involved in collecting the credit information. Depending on these two factors of time and cost, any, or a combination of the following sources may be employed to collect the information. a. b. c. d. Financial statement Bank references Trade references Other sources
These are the sources are avail to investigate the customer position which is has been the repayment process.
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2. Credit investigation and analysis: After having obtained the credit information, the firm will get an idea regarding the matters which should be further investigated. The factors that affect the extent and nature of credit investigation of an individual customer are: The type of customer, whether new or existing. The customers business line, background and the related trade risks. The nature of the product- perishable or seasonal. Size of customers order and expected further volumes of business with him. Companys credit policies and practices.
In the analysis of credit investigation contains the following steps to evaluate the customer repayable capacity 1. 2. 3. Analysis of credit file Analysis of financial ratios Analysis of business and its management
3. Credit limit: A credit limit is a maximum amount of credit which the firm will extend at a point of time. It indicates the extent of risk taken by the firm by supplying goods on credit to a customer. Once the firm has taken a decision to extend credit to the applicant, the amount and duration of the credit will depend upon the amount of contemplated sale and the customers financial strength. In case of customers who are frequent buyers of the firms goods, a credit limit can be established. This would avoid the need to investigate each order from the customers. Depending on the regularity of payment, the line of credit for a customer can be fixed on the basis of his normal buying pattern. The credit limit must be reviewed periodically. If tendencies of slow paying are found, the credit can be revised downward. 4. Collection procedure A collection procedure is would like to followed by the firm as per the credit terms and condition which is agreed at the time of making contract.
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If the firm chooses to not grant any credit, the firm avoids the possibility of any loss but loses the opportunity of increasing its profitability. On the other hand, if it grants credit, then it will benefit if the customer pays. There is some probability that the customer will default, then the firm may lose its investment. The expected net pay off of the firm is the difference between the present value of net benefit and present value of the expected loss.
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These methods have certain limitations to be useful in monitoring receivable. A better approach is the Collection Experience Matrix. 1. Average Collection period: Debtors Average Collection period = Credit Sales The average collection period measures the quality of debtors in an aggregative way. The average collection period so calculated is compared with the firms stated credit period to judge the collection efficiency. For example, if a firms stated credit period is 25 days and the actual collection period is 40 days, then one may conclude that the firm has a lax system of collection. An extended collection period delays cash inflows, impairs the firms liquidity position and increased the chances of bad debt losses 2. Aging schedule Analysis Aging schedule removes one of the limitations of the average collection period. It breaks down receivables according to the length of time for which they have been outstanding. E.g. 360
If the firms stated credit is 25 days, the aging schedule indicates that 50% of the receivables remain outstanding beyond that period. Thus the aging schedule provides more information about the collection experience. It helps to spot out the slow-paying debtors. However, it also
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suffers from the problem of aggregation, and does not relate receivables to sales of the same period.
3. Collection Experience Matrix: The major limitations of the traditional methods is that they are based on aggregated data and fail to relate outstanding receivables of a period with credit sales of the same period. This problem can be eliminated by using disaggregated data for analyzing collection experience. The key is to relate receivables to sales of the same period. When the sales over a period of time are shown horizontally and associated receivables vertically in a tabular form, a matrix is constructed. Therefore, this method of evaluating receivables is called Collection Experience Matrix. E.g.
Month Sales % Receivable s July Aug. Sept. Oct. Nov. Dec. 82.5 0 60.5 0 20.0 0 0.00 0.00 0.00 78.0 0 59.8 0 18.5 0 0.00 0.00 July 400 Au g. 410 Sep t. 370 Oct . 220 Nov . 205 Dec . 350
78.0 0 53.0 0
81.4 0
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3. CONCLUSION
Credit sales results in Accounts Receivables (AR). Selling goods on credit results into increase in sales and ultimately the profits also. At the same time the funds are blocked in Accounts Receivables. Therefore more funds are required to be raised to meet the Working Capital requirements. Moreover, it involves the risk of Bad Debts. Hence, selling goods on credit is beneficial (return) as well as dangerous (risk). The Finance Manager has to frame proper credit policies and take decisions regarding the sanction of credit to the customers. Therefore, Management of Accounts Receivables is the process of decision-making relating to the investments of funds in these assets in such a manner that the return on shareholders investments is maximized.