Receivables Management

Introduction
When a firm sells its products or services on credit, payments are postponed to
future dates and thereby receivables/debtors are created.

However, no receivables are created when a firm conducts cash sales as

payments are received immediately. A firm conducts credit sales to protect its
sales from the competitors and to attract the potential customers to buy its
products at favourable terms.

Receivables or accounts receivable constitute a substantial portion of the total

current assets of several firms after inventories.
Purpose of Receivables
1. Attaining growth in sales

When a firm conducts credit sales, it can sell more goods than sales on
immediate payment. This is because many customers are unable to pay cash
immediately on purchase. But such customers can buy goods if payments are
postponed.

2. Enhancing profits

Usually, a firm can earn higher profit through increase in sales. This is
because of increase in the volume of sales and a higher margin of profit on
credit sales than cash sales
3. Facing Competition

Sometimes a firm resorts to granting credit facilities to its customers as

similar facilities are being granted by the competing firms. This helps to avoid the
loss of sales from customers who would buy elsewhere unless they receive the
expected credit.
Receivables Management - Meaning
A firm resorts to credit sales to push up sales which ultimately results in enhancing
its profit. But credit sales results in blocking of funds in accounts receivable.
Consequently, a firm requires additional funds for meeting its operational needs
which involve extra cost by way of interest.

When receivables increase, the chance of bad debts also go up. Therefore the
creation of receivables is both beneficial and dangerous to a firm.

Receivables Management may be defined as “the process of making decisions

relating to the investment of funds in this asset which will result in maximising the
overall return on the investment of the firm.”
The objective of receivables management is to promote sales and profits until that
point is reached where the return on investment in further funding of receivables is
less than the cost of funds raised to finance the additional credit.
Cost of Maintaining Receivables
1. Costs of Capital
2. Costs of Administration
3. Cost of Collection
4. Defaulting Costs
Costs of Capital
● Maintenance of receivables results in blocking of financial resources in them
as there is a time lag between the sale of goods and its payment.
● Consequently, a firm should make some alternative arrangements for
additional funds to meet its own obligations while awaiting payments from its
customers.
● A firm can raise additional funds either from outside or out of retained
earnings. However, a firm incurs a cost in both these cases, i.e., it has to pay
interest to the outsider in the former case and there is an opportunity cost to
the firm in the latter case.
Costs of Administration
● When a firm maintains accounts receivables, it has to incur additional
administrative costs by way of salaries to the staff kept for this purpose.

Cost of Collection
● Usually, the collection of payments from credit customers incurs additional
cost to a firm. Sometimes, the firm resorts to take additional steps for
recovering money from defaulting customers.

Defaulting Costs
● If a firm cannot recover overdues from the defaulting customers in spite of its
serious efforts, such debts are treated as bad debts and have to be written
off.
Factors Affecting the Size of Receivables
1. Sales Level
2. Credit Policies
3. Credit Terms
a. Credit Period
b. Cash Discount
Sales Level
● The size of accounts receivable relates to the level of sales. Usually even in
the same industry, a firm which has a large volume of sales should have a
higher level of receivables than a firm having a small volume of sales.
Changes in accounts receivable can also be predicted with the help of sales
level.
Credit Policies
● Credit is one of the many factors that influence the demand for a firm’s
product. Thus credit policy of a firm can have a significant influence on sales.
The term credit policy refers to those decision variables that influence the
investment in receivables. (i.e., the amount of trade credit). These variables
consist of (i) the quantity of the account accepted (ii) the length of the credit
period (iii) the size of the cash discount given (iv) any special terms, such as
seasonal datings and (v) the level of collection expenditures.
● In each case, the decision should involve a comparison of possible gains
from a change in policy with the cost of the change.

● However, a firm’s credit policy determines the amount of risk the firm is
willing to undertake in its sales activities.

● In case a firm has a liberal or lenient credit policy, it will experience a higher
level of receivables than a firm having a stringent credit policy on account of
the following reasons:
○ Liberal credit policy results in enhancing the size of the account receivable since it
encourages even the financially strong customers to make delays in payment.

○ As a result of the liberal credit policy, the financially weak customers make further default in
payment. This, in turn, results in enhancing the size of the receivables.
Credit Terms
The size of receivables also depends on the terms of credit. Credit terms specify
the length of time over which credit is extended to a customer and the discount,
if any, given for early payment. Thus the two important components of the credit
terms are: (a) Credit period, and (b) Cash discount.

(a) Credit Period:

The total length of time over which credit is extended to a customer to pay a bill
is called the credit period. Usually, it is expressed in terms of a ‘net date’. For
instance, in case a firm’s credit terms are “net 10”, it means that the customers
are expected to pay within 10 days from the date of credit sale.
(b) Cash Discount:
A per cent (%) reduction in sales or purchase price allowed for early payment of
invoices is called the cash discount. The terms of cash discount contain both the
rate of discount and the period for which the discount is allowed. For instance, in
case the terms of cash discount are changed from “net 20” to “2/10 net 20”, it
implies that the credit period is of 20 days but if a customer pays within 10 days,
he would get 2% discount on the amount due from him.

Although, allowing cash discount results in a loss to the firm, it reduces the
volume of receivables and puts extra funds at the disposal of the firm for
alternative profitable investment. Thus the amount of loss suffered due to cash
discount is compensated by the income otherwise earned by the firm.
Optimum Size of Receivables
Optimum investment in receivables is the level where there is trade-off between
costs and profitability. A liberal credit policy enhances the profitability of the firm on
account of higher sales. But such a credit policy results in increased investments
in receivables, more risk of bad debts and higher cost of administration of
receivables.

In short, a liberal credit policy leads to an increase in the total investment in

receivables and, thereby, the problem of liquidity is created.

On the contrary a stringent credit policy declines the profitability, but enhances the
liquidity of the firm.
Optimum credit policy arises at a point where there is a “tradeoff” between liquidity
and profitability.
Techniques of Determining Credit Policy
A firm’s credit policy should be an optimum one, i.e., neither too liberal nor too
stringent. A firm can determine its nature of credit policy with the help of the
following techniques.

1. Computation of Average Age of Receivables

2. Aging Schedule of Receivables
Computation of Average age of Receivables
Computation of average age of receivables involves the computation of average
collection period.

It can be computed using the following equation:

Average Age of Receivables = Months or days in the period/Accounts

Receivable Turnover

Accounts Receivable Turnover = Credit Sales in the Period/Average Accounts

Receivable
Example

Particulars Amount (Rs)

Credit Sales for the year 100000

Accounts Receivable as on 1-1-2019 12000

Accounts Receivable as on 31-12-2019 8000

Compute the average age of receivables

Increase in the average age of receivables or debt collection period is a sign of
liberal credit policy or inefficiency in collection. On the other hand, a decrease in
the average age of receivables implies a stringent credit policy or efficiency in
collection.

Limitation

The technique of average age of receivables should be used with caution. If there
are fluctuations in sales pattern then this may give misleading indication.
Aging Schedule of Receivables

Aging schedule breaks down receivables in accordance with the length of time for
which they have been outstanding. It is prepared to have a closer look over the
quality of individual accounts. It can be prepared by checking the receivables
ledger for ascertaining the sales made to and payments received from each
customer.
Policies of Managing Receivables
A firm is required to establish the policies of managing receivables after
considering both benefits and costs of different policies. These policies relate to

(i) Credit Standards

(ii) Credit Terms

(iii) Collection Procedures

Credit Standards
● The basic criteria for extension for credit to the customers are called credit
standards. It is the minimum quality of creditworthiness of a credit applicant that
is applicable to the firm.

● In case a firm’s credit standards are relatively loose, its levels of sales and
receivables are likely to be high.

● Usually the decision concerning the degree of credit standard is largely a matter
of judgement. In reaching the credit decision, the credit manager should keep in
mind the basic criteria, i.e., five “C’s” of credit-capital, capacity, character,
collateral and condition.
Capital refers to the financial soundness of the firm as indicated primarily by its
financial statements.

Capacity denotes the ability of the customer to operate successfully as indicated

by its profit record.

Character relates to the reputation of management for honest and fair dealings.

Collateral refers to the security available with the customer in paying the debt.

Condition denotes the economic position of the customer.

A firm can collect information about five C’s both from internal and external
sources. While the internal sources consist of a firm’s previous experience with the
customer supplemented by its own well developed information system, the
external sources comprise a customer’s references, trade associations and credit
rating organisations.

After collecting all the information about the credit standards of customers, an
individual firm can translate its credit information into risk classes or groups in
accordance with the probability of loss associated with each class. Hereafter, the
firm can determine whether it will be advisable for it to extend credit to a particular
class of customers.
Credit Terms
The terms under which a firm sells goods on credit to its customers are called the
credit terms. They specify the length of time over which credit is extended to a
customer and the discount, if any, given for early payment. Thus the two
components of credit terms are

(i) Credit Period

(ii) Cash Discount

Credit Period

● The total length of time over which credit is extended to a customer to pay a bill
is called the credit period.

● Although extending the credit period stimulates sales, it enhances the cost on
account of more funds held up in receivables.

● At the same time, shortening the credit period declines sales, but reduces the
cost of held up funds in receivables.

● By virtue of these situations, there arises the problem of determining the

optimum credit period where the marginal profits on increased sales are exactly
offset by the cost of carrying the higher amount of account receivables.
Cash Discount

● Cash discount is per cent (%) reduction in sales or purchase price allowed for
early payment of invoices. It is an incentive for credit customers to pay invoices
in a timely fashion.

● Varying the cash discount involves an attempt to speed up the payment of

receivables. Here, the firm should determine whether a speed up in collection
would more than offset the cost of an increase in the discount. If it would, the
present discount policy should be altered.
Collection Procedure
● A firm determines its overall collection policy by the combination of collection
procedures it undertakes. These procedures include such things as letters,
phone calls, personal visits and legal action.

● A stringent collection procedure is expensive for the firm on account of high out-
of-pocket costs and loss of goodwill of the firm among its customers. But it
minimises the loss due to bad debts. It also enhances savings in terms of lower
capital costs because of reduction in the size of receivables. However the firm’s
collection policy should be such that it should strike a balance between the
costs and benefits of different collection procedures.