Lecture Notes on Receivables Management

Background:

Trade credit arises when a firm sells its products or services on credit and does not
receive cash immediately. Trade credit is used by the firm to protect its sales from the
competitors and to attract potential customers to buy its products at favourable terms.
Trade credit creates receivables or book debts that the firm is expected to collect in the
near future. The customers from whom book debts have to be collected in the future are
known as trade debtors.

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Receivables help the firm in increasing the sales level as clients will prefer credit sales to
cash sales. It also helps the firm in maintaining the sales at an appropriate level in

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situations where there is intense competition. As credit sales comprise a high profit
margin, they generate more profit than cash sales.

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Objective:

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The objective of receivables management is to help the firm to manage the receivables in
an efficient manner such that the benefits arising as a result of extending credit sales

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should be more than the costs associated with it.
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Costs involved in Maintaining Receivables :
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Cost of Receivables = Cost of Financing + Administrative Cost + Delinquency Cost +

Cost of Default by the Customers
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(1) Capital cost or Cost of Financing: Increase in the level of accounts receivables
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implies an investment in current assets. There is a time gap between the sale of goods on
credit and payment by the customers. During this time gap, the firm’s funds are blocked
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in the form of receivables and so it will have to arrange for additional finance for meeting
its own obligations. The cost associated with the use of additional capital to support
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credit sales, which could have been profitably employed in other alternatives, is a part of
the cost of extending trade credit.
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(2) Administrative costs: These are the costs related to the maintenance of records
related to receivables and also the expenses incurred for obtaining information about the
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creditworthiness of the customer before sale and maintaining the record of credit sale and
collection thereof.
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(3) Collection costs or Delinquency Costs: These are the costs that are incurred while
collecting the receivables from the debtors. For example cost of reminders, phone calls,
postage, legal notices etc.

(4) Cost of Default by the Customers: If the customer does not pay the dues within the
specified period, then the receivables are treated as bad-debts and have to be written-off
as they cannot be realized. The amount of bad debt is known as cost of default by the
customers.

Receivables management can be analyzed with respect to four aspects:

(a) Credit Policy.
(b) Credit evaluation.
(c) Credit granting decision.
(d) Monitoring receivables.

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A) Credit Policy: The credit policy of a firm provides the framework to determine
whether or not to extend the credit to a customer and also on the amount of credit that

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should be extended.

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Variables associated with the credit policy:

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1. Credit Standards: Credit standards are the criteria that a firm follows while

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choosing customers to whom credit could be extended. A firm having very
stringent credit standards will have less credit sales granted to customers with a

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high credit rating and consequently it will have lower bad debts and
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administrative costs along with lower investment in receivables. But this implies
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that the firm will not be able to expand its sales.
On the other hand, if the firm has lenient credit standards, it will have increased
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sales but with a high probability of bad debt losses, administrative costs and the
amount of funds locked up in receivables. Hence the manager should decide the
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optimal credit standards by weighing the incremental costs associated with credit
standards against the incremental benefits.
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Practical Problems on Credit Policy

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Q.1 The Management of Ashish Ltd. is considering to change its present credit policy.
The details of the options are given below :
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Credit Policy Present A B C

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Sales Rs. Rs. 56,000 Rs.60,000 Rs.62,000

50,000
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Variable Cost ( 80% 40,000 44,800 48,000 49,600

of Sales)
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Fixed Cost 6,000 6,000 6,000 6,000

Average Collection 30 Days 45 Days 60 Days 75 Days
Period

Firm’s rate of investment is 20%. Assuming 360 Days in a Year, advise which option is
best and why?
Ans.: Option B Profit Rs 4200, Incremental Surplus Rs 967
Note : Average Debtors at Cost = Total Cost X DCP/360
Q.2 Mohit Ltd is currently engaged in the business of manufacturing computer
components which is being sold out at Rs 1000 per unit and its variable cost is Rs 800. In
the year 2015 the company sold on an average 500 components per month.
Presently, Company grants one month credit to its customers. As of now, it is thinking of
extending the credit period to two months on account of which following changes are
expected :
Increase in Sales - 25%
Increase in Stock - Rs 2,00,000

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Increase in Creditors – Rs 1, 00,000
You are required to advise the company whether or not to extend the credit terms. If all

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customers avail the credit period of two months, the company expects a minimum return
of 40% on Investment.

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Ans. Incremental Loss – Rs 2, 55,000

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Q.3 A Company named Wiki intends to produce product with its selling price of Rs.

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1000 per unit and expected annual sales of 5000 Units. Variable costs amount to Rs 750
per unit and 2 month’s credit is given to its customers.

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It is estimated that 10% of customers will default; others will pay on the due date. Interest
Rate is 15% per annum. ty
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A Credit agency has offered the company a system which, it claims can help identify
possible bad debts. It will cost Rs 2,50,000 per annum to run and will identify 20% of
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customers as being potential bad debts. If these customers are rejected, no actual bad
debts will result. Should the credit system be used ?
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Ans : Yes, Net Profit Rs 18,750

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Q.4 Mittal Ltd reports a Current Sales of Rs 15,00,000 per annum and average collection
period is 30 Days. It wants to pursue a more liberal credit policy to improve sales. A
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Study made by a consultant firms reveals the followings :

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Credit Policy Increase in Collection Increase in Sales

Period
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A 15 Days Rs 60,000
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B 30 Days 90,000
C 45 Days 1,50,000
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D 60 Days 1,80,000
E 90 Days 2,00,000
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The selling price per unit is Rs 5. Average cost per unit is Rs 4 and variable cost per unit
is Rs 2.75 per unit. The Required rate of return on investment is 20%. Assume360 Days a
Year and also assume that there are no bad debts. Which of the above policies will you
recommend for adoption ?
Ans. Policy D

Q.5 Shreya Ltd has provided the following projections for the year :
Sales 21,000 Units
Selling Price Per Unit Rs 40
Variable Cost Per Unit Rs 25
Total Cost Per Unit Rs 35
Credit Period Allowed 1 Month
The Company proposes to increase the credit period allowed to its customers from 1
month to two months. It is envisaged that the change in the policy will increase in Sales
by 8%. The Company desires a return of 25% on its investment. You are required to
examine and advise whether the proposed credit policy should be implemented or not ?

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Ans . Yes Incremental Profit Rs 8138

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Q.6 The existing sales for Jayant Ltd. are Rs. 30 lakhs and the company is currently
having an average collection period of ‘Net 20 days’. The contribution to sales ratio for

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the company is 30%. It is planning to increase the average collection period to ‘Net 30

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days.’ Though this will increase the sales by Rs. 3 lakh, the bad debt losses which were
previously 2% would increase to 5%. If the cost of capital for the company is 10%,

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determine whether the company should extend the credit period or not?

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2. Cash Discount: A cash discount is reduction in the amount payable, offered to
the customers in order to induce them to repay the trade credit within the specified
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period of time which is less than the normal credit period. Cash discount terms
indicate the rate of discount and the cash discount period and the net credit period.
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For example, “ 2/15 Net 30” indicates that the customer will be granted a discount
of 2% if he pays within 15 days, otherwise he will have to pay the entire amount
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within 30 days.
A firm that introduces a cash discount policy will have benefits in the form of
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additional sales and reduction in the amount locked up in receivables but the cost
involved would also increase due to the cash discounts offered. Hence a company
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should evaluate the incremental benefits and costs associated with introducing cash
discount policy (or liberalizing the existing cash discount policy) and should
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implement it only if the incremental benefits are greater than the incremental costs.
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4. Collection Policy: A proper collection policy is needed for ensuring timely collection
of receivables so that funds are not locked up in receivables for a longer period and for
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reducing the incidence of bad debt losses. Some of the activities that form a part of the
collection policy include monitoring the state of receivables– postal, telegraphic or
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telephonic reminders to customers for whom the due date is nearing, threat of legal
action to overdue accounts etc. The firm should be careful about choosing the right kind
of collection policy as too stringent a collection policy will decrease the incidence of bad
debt losses and the average collection period but it might adversely affect the company’s
relationship with the clients; whereas a lenient collection policy will increase sales but at
the same time will increase average collection period and the proportion of bad debt
losses.
II. Credit Evaluation
Credit evaluation is done to analyze the ability and willingness of the customer to
honor his financial obligations. The analysis is done based on three factors popularly
known as 3C’s:
- Character: It is a moral attribute reflecting the integrity of the person and his
willingness to repay the credit obligation.

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- Capacity: It refers to the customer’s ability to pay and it can be judged on the
basis of his capital and asset base. It also depends upon the prevailing economic

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conditions that might affect a firm’s ability to pay.
- Collateral: It refers to the assets that are offered by the customer as a security.

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There are various sources and techniques that help in evaluating the credibility of a
customer. Some of them are:

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1. Financial statements and ratios: Information in the form of balance sheet and
profit and loss account help the firm in analyzing the financial credibility of the

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customer. Certain ratios like the current ratio, quick ratio, average payment period,
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debt-equity ratio etc., indicate the ability of the client to pay the receivables on time.
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2. Bank references: A customer’s bank can serve as a major source in obtaining
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information that is required to assess the financial strength of the firm.

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3. Numerical credit scoring: When the firm has a small and regular clientele, it can
conveniently assess the creditworthiness of its customer. But when a company deals
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directly with the consumer or with a large number of small trade accounts, some
streamlining becomes essential. Numerical credit scoring is a technique that is used to
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prescreen the credit applications in such cases. In this technique, the firm may
identify, based on its past experience or empirical study, both financial and non-
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financial attributes that measure the creditworthiness of a customer. The different

attributes are assigned weights and an index is computed for each customer.
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For example, a company considers past trend in payment, current ratio of the
customer’s firm and net profit margin as the factors to be assessed before extending
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credit and it assigns 0.4, 0.3 and 0.2 weights to each of the factors.
The company develops a 3 point rating scale to rate the customer in terms of the three
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factors. If the customer’s past payment trend has been excellent, he will be given
three points, if it is average he will be given two points and if it is below average he
will be given 1 point. In this way, each customer is rated and the weighted average of
the rates is taken in the following manner:
 Points
Attribute Weight 1 2 3 Weighted score
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Past payment trend 0.4 * 0.40 x 2 = 0.80
Current ratio 0.3 * 0.30 x 3 = 0.90
Net profit margin 0.2 * 0.20 x 2 = 0.40
Rating index =
0.80 + 0.90 +
0.40 = 2.1

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Hence, the index assigned to the customer is 2.1.

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The index for various customers will be computed in a similar manner and the
client will then make a choice about extending the credit based on these index

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values.

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4. Firm’s experience: A firm’s previous dealings with a client help the firm in

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making a more valid judgment about the integrity of the customer.

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III Credit Granting Decision
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After assessing the creditworthiness of the customer, the firm has to decide whether it
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should extend credit to the customer or not. Using the decision-tree approach, the firm
can analyze the costs and benefits associated with the granting of credit to its customers.
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If the net benefit (total benefits–total costs) is positive, the firm can grant the trade credit.
In case of a decision tree the following symbols are used:
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It represents a decision node

It represents expected payoff
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Let R represent the additional revenue that will arise if the customer pays, and let C
represent the additional costs that are to be incurred for maintaining the receivables.
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Therefore, (R–C) represents the net gain.

If p is the probability that the customer will pay and (1–p) is the probability that the
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customer will default then the expected payoff arising out of the receivables can be
computed as: p (R–C) – (1–p) C
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The above explanation can be expressed in the form of the following decision tree:
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 R-C

Customer Pays (p)

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Offer Credit

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Customer Defaults (1-p)

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Refuse Credit -C

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IV. Monitoring receivables

The payment of receivables should be constantly monitored by the credit manager for the
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purpose of internal control. The average collection period is computed on the basis of the
year-end balance of receivables; but for better control, monitoring should be done on a
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more frequent basis.

Given below are some methods that are used for monitoring the accounts receivables.
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 Traditional Methods
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(a) Days’ sales outstanding: It is computed as:

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Accounts receivable at the time chosen

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Average daily sales

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If the days’ sales outstanding is within the period specified in the credit policy, then the
position of the receivables is said to be under control. Otherwise, the collection policy has
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to be strengthened further.
(b) Ageing Schedule: The ageing schedule gives the age-wise distribution of the
receivables at a given time. The average collection period does not give any specific
information about the age (from the time the receivables have been outstanding). The
ageing schedule removes this limitation of average collection period by breaking
down the receivables according to the length of time for which they have been
outstanding (i.e. age of the receivables).

Example: Following is the ageing schedule for IQ Ltd. which has Rs. 1,00,000 in
receivables:

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Ageing Schedule
Age of account Amount (in Rs.) Percent of total value of

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outstanding accounts
receivables

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0-10 days 50,000 50%

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11-60 days 25,000 25%
61-80 days 20,000 20%

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Over 80 days 5,000 5%

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Total: 1,00,000
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If a particular firm has a credit period of 60 days, then as per the above ageing schedule,
25% of the firm’s accounts are yet to be collected.
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The traditional methods described above suffer from certain limitations, like:
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(1) They are influenced by the sales pattern as well as the payment behaviour of the
customers. For example, the results indicated by these methods will not hold good,
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when sales are not constant and/or are decreasing or increasing.

(2) They are based on aggregated data and fail to associate outstanding receivables of a
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period with the credit sales of the same period.

The above limitations can be removed by using the collection matrix.
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 Collection Matrix: This method relates the receivables to sales of the same period.
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Under this method, a matrix is formed with the sales over a period of time shown
horizontally and associated receivables shown vertically. With the help of the matrix
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one can judge whether the collections are improving, or are stable or worsening.
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For example, following is the collection matrix for Raju Ltd.

Percentage of receivables January February

collected during
The month of sales 30% 40%
First Month after the sales 48% 35%
Second month after the 22% 25%
sales
In case of Raju Ltd., in the month of January, 30% of the sales were collected in the same
month; 48% were collected in the next month i.e. February; 22% were collected in March
(i.e. the second month after the sales). Similarly, 40% of February’s sales were collected
in that month itself, 35% were collected in March and 25% were collected in the month
of April.

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