5 receivables management

8/2/2019 5 Receivables Management

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Management ofReceivables


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Introduction

Liquid asset after Cash

Credit sales

Sundry Debtors

Why to manage?


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Size and Trends in Receivables

Engineering Industry

Year End

TotalCurrentAssets

SundryDebtors % of CA

Y2010 61857.07 14990.62 24.23

Y2009 145500.08 42801.28 29.42

Y2008 126300.37 38503.85 30.49

Y2007 96936.66 31153.93 32.14

Y2006 77363.00 29279.25 37.85

Y2005 61206.62 24104.23 39.38

Y2004 51113.34 18811.56 36.80

Y2003 47550.10 16326.07 34.33

Y2002 36172.95 12615.32 34.88

Textile Industry

Year End

TotalCurrentAssets

SundryDebtors % of CA

Y2010 16994.55 4675.38 27.51

Y2009 332138.52 96054.26 28.92

Y2008 309076.82 83128.70 26.90

Y2007 273062.19 69223.58 25.35

Y2006 299699.17 61274.61 20.45

Y2005 181011.66 53982.78 29.82

Y2004 156072.06 51531.12 33.02

Y2003 136201.81 47845.64 35.13

Y2002 129824.57 44721.95 34.45

Rs. In million


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Factors Affecting Credit Terms

Competition Operating cycle

Type of good (raw materials vs finished

goods, perishables, etc.) Seasonality of demand

Consumer acceptance

Cost and pricing

Customer type

Product profit margin


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Trade Credit:

Marketing and Finance Trade off Goals of Mktg.:

Meeting Demands

Choice of Distribution system

Long term impact

Goals of Fin.: Optimum Investment


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Distribution Channel

Direct Impact of Receivables and Inventory

Direct Marketing Vs Traditional Chain

Direct Marketing: Best from Receivables Management point of view

Mfg. has direct control over distribution system

Close monitoring

Less distortion in credit information

Better understanding of creditworthiness of customers

Example Go to page No. 46


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Competitive Market From Sellers Market to Buyers Market

There is an inherent conflict between a

manufacturer who typically produce a large

quantity of a limited variety of goods and the

customer who usually desire to buy only a

limited quantity of a wide variety of goods

Requires Dedicated Marketing and

Distribution System


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Motive for Extending Trade Credit

Operating Motive Allow receivables to absorb shocks of demand fluctuations Meet deficit in demand by relaxing credit terms or standards

Respond to variable and uncertain demand Change credit terms rather than:

install extra capacity, building or depleting inventories,

or forcing customers to wait.

Marketing Motive Attract Customers, New Market, Increase in Market share,

occupy display space of distribution outlet etc. Financial Motive

Exploitation of opportunities thrown up by marketimperfections is the source of financial motive for extendingtrade credit


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Financial Motive Trade credit: Lending through receivables

This is an alternative lending opportunity

beyond the money market

Recovering Financial Market Tariff

Difference in lending and borrowing rates

Go to Page No. 52 Example

Price Discrimination

Pushing the Product

Motivating Distribution Channel Member


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Limitations The time period at which marginal cost of fund of a

seller equals the market borrowing rate of the

customer, is the maximum period for which trade

credit can be extended. Tax Consideration: Full profit is booked at the time of

sales under accrual system and quarterly advance tax is

paid on that. Go to Page No. 57 for example

The constraints discussed above limit the Maximum

Length of Trade Credit that a firm can allow on its

receivables.


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A/R Management andShareholder Value

Marketing Strategy

Market Share Obj.

Aggregate Inv. in A/R Credit Terms Credit Standards

Total Dollar Investment Length of Time to Pay Acceptance of Marg Cust.

Max Shareholder Value


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TERMS OF PAYMENT

Cash Terms

Open Account

Consignment

Bill of Exchange

Letter of Credit


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Nature of Credit Policy

Investment in receivable

volume of credit sales

collection period

Credit policy

credit standards

credit terms collection efforts


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Goals of Credit Policy

Marketing tool

Maximisation of

sales Vs.

incremental profit

production and selling

costs administration costs

bad-debt losses

Profitability

Liquidity

Tight Credit

policy

Loose

Costs & Benefits


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Optimum Credit Policy

Estimation of incremental

profit


investment in receivable


rate of return (IRR)

Comparison of incre-mental

rate of return with required

rate of return (RRR)

Optimum credit policy:

IRR = RRR

Marginal cost of capital

Marginal rate of return

Tight Creditpolicy

Loose

Costs & Return (%)


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CREDIT POLICY VARIABLES

The important dimensions of a firms credit policy are:

Credit standards

Credit period

Cash discount

Collection effort


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CREDIT STANDARDS

Liberal Stiff

Sales Higher Lower

Bad debt loss Higher Lower

Investment Larger Smaller

in receivables

Collection costs Higher Lower


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IMPACT ON RESIDUAL INCOME

OF RELAXATION

RI= [S(1V) - Sbn] (1t )k Iwhere RI = change in residual income

S = increase in sales

V = ratio if variable costs to sales

bn = bad debt loss ratio on new sales

t = corporate tax rate

I = increase in receivables investment


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EXAMPLE

The current sales of pioneer are 100 ml. The companyclassifies its customers into four categories. Companypresently extends unlimited credit to customers incategory 1 and 2, limited credit to 3 and no credit to 4.As a result it forgoing sales of Rs. 10 ml in category

3&4 each. Company is planning to adopt more liberal standards

and to give unlimited credit to 3rd and limited to 4thcategory

Such relaxation would increase sales by 15 ml on which10% would be bad debt. The contribution margin is20%. The Average collection period is 40 days. The costof fund is 10% and tax rate is 40%


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EXAMPLE

Pioneer Limited is considering relaxing its credit

standards.S = Rs.15 million,bn = 0.10, V= 0.80,ACP = 40 days,k = 0.10,t = 0.4

RI= [15,000,000 (10.80)15,000,000 x 0.10] (10.4)15,000,000

0.10 x x 40 x 0.80

360

= Rs.766,667


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CREDIT PERIOD

Longer Shorter

Sales Higher Lower

Investment in Larger Smaller

receivables

Bad debts Higher Lower


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IMPACT ON RESIDUAL

INCOME OF LONGER CREDIT PERIOD

RI= [S(1V) - Sbn

] (1t )k I


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INCREASE IN RECEIVABLES

INVESTMENT

S0 SI= (ACPnACP0) + V(ACPn)

360 360

where: I = increase in receivables investmentACPn = new average collection period (after lengthening

the credit period)

ACP0 = old average collection periodV = ratio of variable cost to sales

S = increase in sales


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EXAMPLE

Zenith Limited is considering extending its credit period

from 30 to 60 days.

S = Rs.50 million, S = Rs.5 million, V= 0.85,bn = 0.08, k = 0.10,t = 0.40

RI= [5,000,000 x 0.155,000,000 x 0.08] (0.6)

0.10 (6030) x + 0.85 x 60 x

= [750,000400,000] (0.6)0.10 [4,166,667 + 708,333]

=277,500

50,000,000

360

5,000,000

360


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Rakesh Enterprises currently provides 30 dayscredit to its customers. Its present sales are Rs.

200 million .Its cost of capital is 12 percent and

the ratio of variable costs to sales is 0.80Rakesh Enterprises are considering extending

the credit period to 45 days which is likely to

push sales up by Rs.60 million. The bad debt

proportion on additional sales would be 15

percent. The tax rate is 33 percent. What will be

the effect of lengthening the credit period on the

residual income of the firm?

Quiz Time


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Solution

RI = [ S(1-V)Sbn](1-t)kI

I = (ACPNACP0){ S0/360} + V(ACPN) S/360

= (45-30) x (200,000,000/360) + 0.80 x 45 x ( 60,000,000/360)

= 14,333,333

RI = (60,000,000 x 0.20 - 60,000,000 x 0.15)(0.67) -0.12 x 14,333,333

= 290,000


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LIBERALISING THE CASH

DISCOUNT POLICY

RI= [S(1V) - DIS] (1t ) +k I


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Example

The present credit terms of Indus Industries are 3/15,net 30. Its sales are Rs.470 million, its averagecollection period is 45 days, its variable costs to salesratio, V, is 0.85, and its cost of capital is 12 percent.

The proportion of sales on which customers currentlytake discount, is 0.4. Indus is considering relaxing itscredit terms to 5/15, net 30. Such a relaxation isexpected to increase sales by Rs.20 million, increasethe proportion of discount sales to 0.6, and reduce theACP to 40 days. Induss tax rate is 30 percent.

What will be the effect of liberalising the cash discounton residual income?


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Solution

pn (S0 + S) dn - p0S0do

RI = [ S ( IV ) - DIS ] (1 - t ) + R I

DIS =

=

=

0.6 [470,000,000 + 20,000,000 ] x 0.05 - 0.4 x

470,000,000 x 0.03

9,060,000

I

=

=470,000,000 20,000,000

--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (4540) - 0.85 x -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- x 40

360 360360

= 4,638,889

RI =

=[ 20,000,000 x 0.15 - 9,060,000] 0.70 + 0.12 x 4,638,889

- 3,685,333


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Quiz Time

The present credit terms of Globus Corporation are 2/10, net 40.It sales are Rs.650 million, its average collection period is 30days, its variable costs to sales ratio, V, is 0.75, and its cost ofcapital is 10 percent. The proportion of sales on which

customers currently take discount, is 0.3. Globus is consideringrelaxing its credit terms to 3/10, net 40. Such a relaxation isexpected to increase sales by Rs.30 million, increase theproportion of discount sales to 0.5, and reduce the ACP to 20days. Globuss tax rate is 35 percent.

What will be the effect of liberalising the cash discount onresidual income?


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Solution

RI = [S (1 V) DIS] (1 t) + R I

DIS = pn (So + S)dnposo do

= 0.5 [650,000,000 + 30,000,000] .030.30 [650,000,000] .02

= 10,200,0003,900,000 = 6,300,000

650,000,000 30,000,000

I = ------------- (3020)0.75 x ------------- x 20

360 360

= 18,055,5561,250,000 = 16,805,556

R I = [30,000,000 (0.25) 6,300,000] (0.65) + 0.10 x 16,805,556

= 780,000 + 1,680,556

= 2,460,556


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DECREASING THE RIGOUR

OF COLLECTION PROGRAMME

RI= [S(1V) - BD] (1t )k I


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The Credit Decision Process

Marketing contact

Credit investigation

Customer contact for information

Finalize written documents, e.g.. security agreements

Establish customer credit file

Financial analysis

Time


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Components of Credit Policy

Development of credit standards

profile of minimally acceptable credit worthy customer

Credit terms

credit period

cash discount

Credit limit

maximum dollar level of credit balances

Collection procedures

how long to wait past due date to initiate collection efforts

methods of contact

whether and at what point to refer account to collection agency


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Credit Evaluation of Customers

Credit information financial statements

bank references

trade references

Credit investigation and analysis analysis of credit file

financial analysis

analysis of business and management

Credit limit

Collection efforts

ERRORS IN CREDIT EVALUATION


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ERRORS IN CREDIT EVALUATION

In assessing credit risks, two types of errors occur :

Type I error A good customer is misclassified as a

poor credit risk

Type II error A bad customer is misclassified as a good

credit risk

TRADITIONAL CREDIT ANALYSIS


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TRADITIONAL CREDIT ANALYSIS

Five Cs of Credit

Character : The willingness of the customer to honour

his obligations

Capacity : The operating cash flows of the customer

Capital : The financial reserves of the customer

Collateral : The security offered by the customer

Conditions : The general economic conditions that

affect the customer

SEQUENTIAL CREDIT ANALYSIS


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Should

credit be

granted?

Character

Capacity Capacity

Capital Capital CapitalCapital

Excellent risk Fair risk Doubtful risk Dangerousrisk

How much

credit

should be

granted ?

SEQUENTIAL CREDIT ANALYSIS

Strong Weak

StrongWeak Weak

Strong

StrongStrong

StrongWeakWeak Weak

WeakStrong

NUMERICAL CREDIT RATING INDEX


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NUMERICAL CREDIT RATING INDEX

Factor Factor Rating weight 5 4 3 2 1 score

Past payment 0.30 1.20

Net profit margin 0.20

0.80Current ratio 0.20 0.60Debt-equity ratio 0.10 0.40Return on equity 0.20 1.00

Rating index 4.00

DISCRIMINANT ANALYSIS


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DISCRIMINANT ANALYSIS

Z = 1 Current ratio + 0.1 Return on equity

+

+

+

+

++

+

+

+

+

+

+ +

++

+

Return on equity

Current

ratio

RISK CLASSIFICATION SCHEME


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isk Class Description

1 Customers withno risk of default

2 Customers with negligiblerisk of default (default rate less than 2

percent)3 Customers with littlerisk of default (default rate between 2 percent

and 5 percent)

4 Customers with some risk of default (default rate between 5 percent

and 10 percent)

5 Customers withsignificantrisk of default (default rate in excess of 10percent)

RISK CLASSIFICATION SCHEME


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Credit-Granting Sequence

No

Order and credit

request received

New/increased

credit limit

Material

change in

customer status

Redo credit

investigation

Size of proposed

credit limit

Medium SmallLarge

Indepth

credit invest.

Moderate

credit invest.

Minimal

credit invest.

Check new A/R

total vs credit lmt

No Yes

Yes

Extend CreditNo

Yes

Record

disposition

Set up,post

A/R, ship

CREDIT GRANTING DECISION


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p

RevCost

Cost

0

CREDIT GRANTING DECISION

Expected Pre-tax Profit

p (RevenueCost)(1p) Cost

EXAMPLE


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EXAMPLE

ABC Company is considering offering credit to a customer.

The probability that the customer would pay is 0.8 and theprobability that the customer would default is 0.2. The

revenues from the sale would be Rs.1,200 and the cost of

sale would be Rs.800.

The expected profit from offering credit, given the

above information, is:

0.8 (1,200800)0.2 (800) = Rs.160

REPEAT ORDER


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Expected profit on Probability of payment Expected profit on

initial order and repeat order repeat order

[p1(REV1COST1)(1-p1) COST1]

+p1 x [p2 (REV2COST2)(1-p2) COST2]

[0.9 (2000-1500)0.1(1500)]

+ 0.9 [0.95 (2000-1500)0.05 (1500)]

= 660

+ x

REPEAT ORDER

DECISION TREE FOR GRANTING CREDIT


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DECISION TREE FOR GRANTING CREDIT

CONTROL OF ACCOUNTS


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CONTROL OF ACCOUNTS

RECEIVABLES

Days Sales Outstanding

Ageing Schedule

Collection Matrix

COLLECTION MATRIX


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COLLECTION MATRIX

ercentage of Receivables January February March April May June

Collected During the Sales Sales Sales Sales Sales Sales

Month of sales 13 14 15 12 10 9

First following month 42 35 40 40 36 35

Second following month 33 40 21 24 26 26Third following month 12 11 24 19 24 25

Fourth following month - - - 5 4 5

SUMMING UP


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SUMMING UP

The important dimensions of a firms credit policy are : creditstandards, credit period, cash discount, and collection effort

In general, liberal credit standards tend to push sales up byattracting more customers. However, this is accompanied by ahigher incidence of bad debt loss, a larger investment inreceivables, and a higher cost of collection. Stiff credit standardshave opposite effects.

Three broad approaches are used for credit evaluation :traditional credit analysis, numerical credit scoring, anddiscriminant analysis.

The traditional approach to credit analysis calls for assessing a

prospective customer in terms of the five Cs of credit, viz.character, capacity, capital, collateral, and conditions.

Three methods are commonly employed for monitoring accountsreceivable : days sales outstanding, ageing schedule, and

5 receivables management

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