35180438 Account Receivable Managemnt

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Introduction

The term Receivables is defined as debt owned to the firm by customers arising from

sale of goods or services in the ordinary course of businesses. When a firm makes an

ordinary sale of goods or services and does not receive payment, the firm grants trade

credit and creates accounts receivable which could be collected in the future.

Receivables management is also called trade credit management. Thus, accounts

receivable represent an extension of credit to customers, allowing them a reasonable

period of time in which to pay for the goods received.

In other words, A Receivable is the money owed to a company by a consumer for

products and services purchased on credit. This is usually treated as a current asset of

accounts receivable after the customer is sent an invoice. Accounts receivable are known

by various names, such as accounts receivable aging, days receivable, accounts

receivable turnover and invoice factoring.

Accounts receivable are reported on the balance sheet of the seller at net realizable

value, which is the net amount the seller expects to collect.

According to the experts, receivable or invoice factoring is one of a series of accounting

transactions. These accounting transactions deal with the billing of customers who owe

money to a person, company or organization for goods and services purchased.

With businesses looking for improved bottom line performance, better receivables

management, collections is a key focus area along with timely and accurate billing for

organizations across industries.

The sale of goods on credit is an essential part of the modern competitive economic

systems. In fact, credit sales and, therefore, receivables are treated as a marketing tool to

aid the sale of goods. The credit sales are generally made on open account in the sense

that there are no formal acknowledgements of debt obligations through a financial

instrument. As a marketing tool, they are intended to promote sales and thereby profits.

However, extension of credit involves risk and cost. Management should weigh the

benefits as well as cost to determine the goal of receivables management. The objective


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of receivables management is to promote sales and profits until that point is reached

where the return on investment in further funding receivables is less than the cost of

funds raised to finance that additional credit (i.e. cost of capital).

It can be argued that revenue generation is the most critical function of a company.

Every company expends substantial resources to generate increasing levels of revenue.

However the revenue must be converted into cash. Cash is the lifeblood of any

company. Every rupee of a companys revenue becomes a receivable that must be

managed and collected in time. Therefore the staff and processes that manage your

receivables are asset to a company.

Why do we need receivables?

To increase total sales.

To increase profits.

To meet increasing Competition.

Operating cycle


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Understanding Receivables

As a part of the operating cycle.

Time lag between sales and receivables creates need for working capital.

COSTS ASSOCIATED WITH

ACCOUNTS RECEIVABLES MANAGEMENT

The major categories of costs associated with the extension of credit and accounts

receivable are:

Collection Cost -

Collection costs are administrative costs incurred in collecting the receivables from the

customers to whom credit sales have been made. Included in this category of costs are:

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.


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Capital Cost

The increased level of accounts receivable is an investment in assets. They have to be

financed thereby involving a cost. There is a time-lag between the sale of goods to, and

payment by, the customers. Meanwhile, the firm has to pay employees and suppliers of

raw materials, thereby implying that the firm should arrange for additional funds to meet

its own obligations while waiting for payment from its customers. The cost o the use of

additional capital to support credit sales, which alternatively could be profitably

employed elsewhere, is, therefore, a part of the cost of extending credit or receivables.

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 costs. The important components of this cost are:

(a) blocking-up of funds for an extended period,

cost associated with steps that have to be initiated to collect the overdues, such as,

reminders and other collection efforts, legal charges, where necessary, and so on.

Default Cost -

Finally, the firm may not be able to recover the overdues because of the inability of the

customers. Such debts are treated as bad debts and have to be written off as they cannot

be realised. Such costs are known as default costs associated with credit sales and

accounts receivable.

Administrative Cost

The costs relating to the administration of receivables is as follows:-

Screening the potential customers for granting credit.

Accounting, recording and processing costs of debtors balances.


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Expenditure incurred for credit control checks.

Cost incurred for sending invoices and statements of accounts to individual

customers.

Chasing up slow paying debtors.

Cost incurred for classification of queries.

Recording receipt of cash and processing on individual customer records.

Use of office space, processing equipment and remuneration of sales force

involved in debtors collection etc.

BENEFITS OF ACCOUNTS RECEIVABLES MANAGEMENT

Apart from the costs, another factor that has a bearing on accounts receivable

management is the benefit emanating from credit sales. The benefits are the increased

sales and anticipated profits because of a more liberal policy. When firms extend trade

credit, that is, invest in receivables, they intend to increase the sales. The impact of a

liberal trade credit policy is likely to take two forms. First, it is oriented to sales

expansion. In other words, a firm may grant trade credit either to increase sales to

existing customers or attract new customers. This motive for investment in receivables is

growth-oriented.

Secondly, the firm may extend credit to protect its current sales against emerging

competition. Here, the motive is sales-retention. As a result of increased sales, the profits

of the firm will increase and other benefits of effectively managing the receivables are

like Increased Cash Flow, Reduced Bad debt loss, Lower Administrative cost in the

entire revenue cycle, Decreased deduction and concession losses, Reduced Interest loss.

COST BENEFIT TRADE-OFF

We all know that investments in receivables involve both benefits and costs. The

extension of trade credit has a major impact on sales, costs and profitability. Other


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things being equal, a relatively liberal policy and, therefore, higher investments in

receivables, will produce larger sales. However, costs will be higher with liberal policies

than with more stringent measures. Therefore, accounts receivable management should

aim at a trade-off between profit (benefit) and risk (cost). That is to say, the decision to

commit funds to receivables (or the decision to grant credit) will be based on a

comparison of the benefits and costs involved, while determining the optimum level of

receivables. The costs and benefits to be compared are marginal costs and benefits. The

firm should only consider the incremental (additional) benefits and costs that result from

a change in the receivables or trade credit policy.

While it is true that general economic conditions and industry practices have a

strong impact on the level of receivables, a firms investments in this type of current

assets is also greatly affected by its internal policy. A firm has little or no control over

environmental factors, such as economic conditions and industry practices. But it can

improve its profitability through a properly conceived trade credit policy or receivables

management.

Importance

In marketing operations receivable management assumes paramount importance due to

two reasons:

a) No sale is complete until money is collected from the customer and

responsibility for such collection should generally rest with concerned sales

personnel. Substantial delay or even non-collection of receivables invariably

results in steady erosion of profits generated through sales.

b) If a large part of companys working capital gets blocked up in the receivables

outstanding then it would adversely affect the marketing margin (the numerator)


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because of higher interest charges and increase the level of marketing investment

(the denominator), thus depressing the ROI significantly.

PROCESS OF ACCOUNTS RECEIVABLES MANAGEMENT

The following process will help in efficient management of the receivables:-

Take the opinion of the sales force and internal staff.

Frame the credit terms for the customer if credit is sanctioned.

Establish the initial creditworthiness.


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Check the credit before the dispatch of consignment.

Close monitoring of the credit terms and customer compliance.

Review the customer credit, if required.

Develop the reports for internal appraisal of the customer.

Credit Policy

The credit policy of a company can be regarded as a king of trade-off between increased

credit sales leading to increase in profit and the cost of having larger amount of cash

locked up in the form of receivables and the loss due to the incidence of bad debts.

A Firms investment in accounts receivable depends on:

a) The volume of credit sales

b) The collection period


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Firms average investment = Daily credit sales X Average collection period

Credit policy is evaluated in terms of return and costs of additional sales.

Credit policy refers to

a) Credit standards: Criteria to decide the types of customers to whom goods

could be sold on credit. Slow paying customers will increase investment in

receivable and is exposed to high default risk

b) Credit terms: The duration of credit and terms of payment by customers.

Extended time period for making payments will increase investment in

receivables.

c) Collection efforts: Determine the actual collection period. The lower the

collection period, the lower the investment in accounts receivables and vice

versa.

GOALS OF CREDIT POLICY

a) A firm following a lenient credit policy will grant credit in liberal terms and

standards and grant credit to longer period and also to customers whose

creditworthiness is not fully known.

b) A firm following a stringent credit policy sells on credit on a highly selective

basis only to customers with proven creditworthiness.

CREDIT POLICY AS MARKETING TOOL

Firms use credit policy as a marketing tool during expansion sales.

In a declining market, it is used to maintain market share.It helps to retain old

customers and to create new customers.

In a growing market, it is used to increase firms market share.


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Under a highly competitive situation or recessionary economic conditions, firm

loosen its credit policy to maintain sales or to minimize erosion of sales.

Necessity of Granting Credit

Companies in India grant credit for:

1. Competition: Higher the degree of competition, the more the credit grant

2. Bargaining power: Higher bargaining power leads to less credit or no credit

3. Buyers status and requirement: Large buyers demand easy credit terms.

4. Dealer relationship

5. Marketing tool

6. Industry practice & past practice

7. Transit delays: Forced reason for granting credit.

OPTIMUM CREDIT POLICY

Optimum credit policy is one which maximizes the firms value. Value of firm is

maximized when the incremental or marginal rate of return of an investment is equal to

the incremental or marginal cost of funds used to finance the investment.

MARGINAL COST- BENEFIT ANALYSISTo achieve the goal of maximization of firms value, the evaluation of investment in

accounts receivable should involve:

Estimation of incremental operating profit (change in contribution additional

costs)

Estimation of incremental investment in accounts receivable

(Investment in accounts receivable = credit sales per day X Average

Collection Period)

Estimation of the incremental rate of return of investment

(Operating profit after tax / Investment in accounts receivable)

Comparison of the incremental rate of return with the required rate of return.

Credit Policy Variables


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In establishing an optimum credit policy, the financial manager must consider the

important decision variables which influence the level of variables. The major

controllable decision variables include the following:

Credit standards and analysis

Credit terms

Collection policy and procedures.

CREDIT STANDARDS

The two aspects of quality of customers are

Time taken by customers to repay credit obligation.

The average collection period (ACP) determines the speed of payment by customers.

The default rate: It can be measured in terms of bad debt losses ratio.

The customers are categorized as good, bad and marginal accounts.

DEFAULT RISK

To estimate the probability of default the following three Cs are considered.

1. Character : It refers to the customers willingness to pay. The manager should

judge whether the customers will make honest efforts to honour their creditobligations.

2. Capacity : It refers to the customers ability to pay. It is judged by assessing the

customers capital and assets offered as security. This is done by analysis of

ratios and trends in firms cash and working capital.

3. Condition : It refers to the prevailing economic and other conditions that affect

the customers ability to pay.

CREDIT ANALYSIS

A firm can do credit analysis using

Numerical credit scoring models: It includes

1. Adhoc approach: The attributes identified by the firm may be assigned weights

depending on their importance and combined to create an overall score or index.


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2. Simple discriminant analysis: A firm use more objective methods of

differentiating between good and bad customers.(Eg:- ratio of EBDIT to sales).

3. Multiple discriminant analysis: It combines many factors according to the

importance (weight) given to each factor and determine a score to differentiate

customers as good and bad.

CREDIT GRANTING DECISION


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CREDIT TERMS

The stipulations under which the firm sells on credit to customers are called credit terms.

These include

1. Credit period : The length of time for which credit is extended to customers is

called the credit period.

2. Cash discount : It is a reduction in payment offered to customers to include them

to repay credit obligations within a specified period of time, which will be less

than the normal credit period. It is expressed as a percentage of sales. It is a cost

to the firm for faster recovery of cash.

COLLECTION POLICY

1. Collection policy is needed to accelerate collections from slow payers and reduce

bad debt losses.

2. It should ensure prompt and regular collection.

3. It should lay down clear cut collection procedures.

4. The responsibility for collection and follow up should be explicitly fixed.

( Accounts or sales)

5. The firm should decide on cash discounts to be allowed for prompt payment

6. It should be flexible

CREDIT EVALUATION

For effective management of credit, clear cut guidelines and procedures for granting

credit to individual customers and collecting individual accounts should be laid down.

The credit evaluation procedure includes:

1. Credit information.

2. Credit investigation.

3. Credit limits.

4. Collection procedures.

CREDIT INFORMATION


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To ensure full and prompt collection of receivables, credit should be allowed only to

customers who have the ability to pay in time. For this the firm should have credit

information of customers.

Collecting credit information involves cost. The cost should be less than the

potential profitability.

Depending on cost and time, the following sources can be employed to collect

credit information.

SOURCES OF CREDIT INFORMATION

Financial statement: One of the easiest ways to obtain information on the

financial condition of the customer is to scrutinise his financial statements.

(Balance sheet & P&L a/c).

Bank references: Bank where the customer maintains his account is another

source of collecting credit information.

Trade references: Contacting the persons or firms with whom the customer has

current dealings is an useful source to obtain credit information at no cost.

Other sources: Credit rating organisations such as CRISIL, CARE,ICRA, KPMG

etc.

CREDIT INVESTINGATION AND ANALYSIS

The factors that affect the nature and extent of credit investigation of an individual

customer are:

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 the customers order and expected further volumes of business with them.

Companys credit policies and practices.

Steps involved in credit analysis are:


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1. Analysis of the credit file: A credit file updated regularly is maintained for each

customer, who gives information on his trade experiences, performance report

based on financial statements, credit amount etc.

2. Analysis of financial ratios: The evaluation of the customers financial

conditions should be done very carefully. Ratios should be calculated to

determine the customers liquidity position, ability to repay debts etc.,

3. Analysis of business and its management: The firm should also consider the

quality of management and the nature of the customers business. For this a

management audit.

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.

The decision on the magnitude of credit, the time limit etc depends on the

amount of sales, industry norms and customers financial strength.

MONITORING RECEIVABLEFor the success of collection efforts, the firm needs to monitor and control its

receivables.

The methods used for evaluation are:

1. Average collection period.

2. Aging schedule.

3. Collection Experience Matrix.


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35180438 Account Receivable Managemnt

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