UNIT FIVE: RECEIVABLES MANAGEMENT

Nature of receivables
Accounts receivables are asset accounts representing amounts owed to the firm as result of sale of
goods or services in the ordinary course of business. These are claims of the firm against its
customers and form part of its assets. When a firm allows customers to pay for goods and services
at a later date, it creates accounts receivable. By allowing customers to pay some time after they
receive the goods or services, you are granting credit, which we refer to as trade credit. Trade
credit, also referred to as merchandise credit or dealer credit, is an informal credit arrangement.
Unlike other forms of credit, trade credit is not usually evidenced by notes, but rather is generated
spontaneously: Trade credit is granted when a customer buys goods or services. Accounts
receivable management involves the careful consideration of the following core aspects:

 Forming a credit policy.

 Executing the credit policy.
 Formulating and executing collection policy.
Objectives of Receivables Management
The objective of receivables management is to promote sales and profits until that point is reached
where the returns that the company gets from of receivables is less than the cost that the company
has to incur in order to fund these receivables. Hence, the purpose of receivables is less than the
cost that the company has to incur in order to fund these receivables. Hence, the purpose of
receivables is directly connected with the company’s objectives of making credit sales
Objectives of credit policy
Firms extend credit to customers to help stimulate sales. Suppose you offer a product for sale at
$20, demanding cash at the time of the sale. And suppose your competitor offers the same product
for sale, but allows customers 30 days to pay. Who’s going to sell the product? If the product and
its price are the same, your competitor, of course. So the benefit from extending credit is the profit
from the increased sales.
Extending credit is both a financial and a marketing decision. When a firm extends credit to its
customers, it does so to encourage sales of its goods and services. The most direct benefit is the
profit on the increased sales. If the firm has a variable cost margin (that is, variable cost/sales) of
80%, then increasing sales by $100,000 increases the firm’s profit before taxes by $20,000.
Another way of stating this is that the contribution margin (funds available to cover fixed costs) is
20%: For every $1 of sales, 20 cents is available after variable costs. The benefit from extending
credit is:

Benefit from extending credit = Contribution Margin X Change in sales

For example: If a firm liberalizes its credit it grants to customers, increasing sales by $5 million
and if its contribution margin is 25%, the benefit from liberalizing credit is 25% of $5 million or
$1.25 million.

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Costs of Credit
But like any credit, it has a cost. The firm granting the credit is forgoing the use of the funds for a
period—so there is an opportunity cost associated with giving credit. In addition, there are costs
of administering the accounts receivable—keeping track of what is owed. And, there is a chance
that the customer may not pay what is due when it is due.
The Cost of Discounts
Do firms grant credit at no cost to the customer? No, because as we just explained, a firm has costs
in granting credit. So they generally give credit with an implicit or hidden cost:

 The customer that pays cash on delivery or within a specified time thereafter—called a
discount period—gets a discount from the invoice price.
 The customer that pays after this discount period pays the full invoice price.
Other Costs
There are a number of costs of credit in addition to the cost of the discount. These costs include:
 The carrying cost of tying-up funds in accounts receivable instead of investing them
elsewhere.
 The cost of administering and collecting the accounts.
 The risk of bad debts.
Component of credit policy
The major controllable determinants of demand are sales prices, product quality, advertising, and
the firm’s credit policy.
Credit policy, in turn, consists of these four variables:
1. Credit period, which is the length of time buyers are given to pay for their purchases.
2. Discounts given for early payment, including the discount percentage andhow rapidly payment
must be made to qualify for the discount.
3. Credit standards, which refer to the required financial strength of acceptable credit customers.
4. Collection policy, which is measured by its toughness or laxity in attempting to collect on slow-
paying accounts.
The credit manager is responsible for administering the firm’s credit policy.However, because of
the pervasive importance of credit, the credit policy itself is normally established by the executive
committee, which usually consists of the president plus the vice-presidents of finance, marketing,
and production. For efficient utilization of accounts receivable, a firm must adopt a credit policy.
A credit policy is a set of decisions that include a firm’s;
 credit standards,
 credit terms,
 collection procedures and
 Discount offered.

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Credit standards
Credit standards refer to the financial strength and credit worthiness a customer must exhibit in
order to qualify for credit. If a customer does not qualify for the regular credit terms, it can still
purchase from the firm, but under more restrictive terms. The firm’s credit standards would be
applied to determine which customers qualified for the regular credit terms and how much credit
each should receive. The major factors considered when setting credit standards relate to the
likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.
Credit terms
Credit terms specify the length of time over which credit is extended to a customer and a discount
given for early payment. For example, one firm’s credit terms might be expressed as “2/10, net
30.” The term “2/10 “ means that a 2 percent cash discount is given if the bill is paid within 10
days of the invoice date. Thus cash discount period is 10 days. It is the period of time during which
a cash discount can be taken for early payment. Cash discount is (a 2 percent reduction in sales or
purchases price) allowed for early payment of invoices. It is an incentive for credit customers to
pay invoices in a timely fashion. The term “net 30” implies that if a discount is not taken, the full
payment is due by the 30th day beginning from invoice date. Thus the credit period is 30 days.It is
the total length of time over which credit is extended to a customer to pay a bill. There is nobinding
rule on fixing the terms of credit. Credit terms vary and even within the same industries.
Differences are linked to product characteristics as well as market competition.
Executing Credit Policy
After formulating the credit policy, its proper execution is very important. Having established the
terms of sale to be offered, the firm must evaluate individual credit applicants and determine the
applicant’s credit worthiness. The credit evaluation procedure involves three related steps:
 Collecting information on the credit applicant
 Analyzing the credit information
 Making the credit decision.
Collecting Credit Information
The first step in implementing credit policy will be to gather credit information about the credit
applicant /customers/. When a customer desiring credit terms approaches a business firm, the credit
department typically begins the evaluation process by requiring the applicant to fill out various
forms that request financial and credit information and references.
Analyzing Credit Information
After gathering the required information, the finance manger should analyze it to find out the credit
worthiness of potential credit customers and also to see whether they satisfy the credit standards
of the firm or not. The credit analysis will determine the degree of risk associated with the account,
the capacity of the credit customer to get goods and /or services and its ability and willingness to
repay. Often the selling firm not only must determine the creditworthiness of a customer, but also
must estimate the maximum amount of credit the customer is capable of supporting
It is the credit analyst’s job to synthesize and analyze all information that has been collected and
reach a judgment regarding the applicant’s credit worthiness. To perform this synthesis and

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analysis, it is useful to have some mechanism for organizing the information that has been
collected. One traditional way of organizing this information is by characterizing the applicant
along five dimensions. These dimensions are called the Five Cs of Credit - capital, character,
collateral, capacity and conditions.

A firm's credit analysts often use these five Cs of credit to focus their analysis on the key
dimensions of an applicant's creditworthiness. Each of these five dimensions is briefly described
in the following list.

Character: It is the applicant's record of meeting past obligations - financial, contractual, and
moral. Past payment history as well as any pending or resolved legal judgments against the
applicant would be used to evaluate its character. In assessing character, the credit analyst
considers all the information that relates to willingness to pay debts.

Capacity: It is related to the applicant's ability to repay the requested credit. This dimension has
two aspects: management’s capacity to run the business and the applicant’s plant capacity.
Management’s capacity to run the business relates to the competency (ability) of the management
personnel in the applicant’s operations. Physical capacity refers to the value and technology of the
applicant’s production or service facilities. Financial statement analysis with particular emphasis
on liquidity and debt ratios is typically used to assess the applicant's capacity. The applicant's
ability to generate cash to meet obligations is assessed.

Capital: It is the financial strength of the applicant as reflected by its ownership position. To assess
the capital dimension, analysis of the applicant's debt relative to equity and its profitability ratios
are frequently used. The credit analyst considers the data obtained from the applicant‘s financial
statements. The usual procedure is to perform extensive ratio analysis, comparing the applicant’s
financial ratios to ratios for the applicant’s industry and performing trend analysis of the
applicant’s ratios over time.

Collateral: The amount of assets the applicant has available for use in securing the credit is called
collateral. The larger the amount of available assets, the greater the chance that a trade creditor
will recover its funds if the applicant defaults.

Conditions: It includes current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. For example, if the firm has excess
inventory of the items the applicant wishes to purchase on credit, the firm may be willing to sell
on more favorable terms or to less creditworthy applicants. Analysis of general economic and
business conditions as well as special circumstances that may affect the applicant or firm is
performed to assess conditions.

The Credit analyst typically gives primary attention the first two Cs - character and capacity-
because they represent the most basic requirements for extending credit to an applicant.
Consideration of the last three Cs capital, collateral, and conditions-is important in structuring the

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credit arrangement and making the final credit decision, which is affected by the credit analyst's
experience and judgment.

Making Credit Decisions

After analyzing the credit worthiness of the customer, decisions should be made whether the credit
is to be extended to the credit applicant customer. If the analyst decides to extend credit to the
applicant, what amount of credit to extend will be the next issue to decide. To do this, it is necessary
to match the creditworthiness of the customer already determined based on the credit analysis with
the credit standards of the credit granting firm. If the customer’s credit worthiness isabove the credit
standards then there is no problem in taking a decision. In cases where the customer’s credit
worthiness is below the firm’s credit standards then they should not be outright refused. Rather
they should be offered to pay on delivery of goods or some third party guarantee may be insisted.

Formulating and Executing Collection Policy

The collection policy refers to the procedures the firm follows to collect past due accounts. A
number of collection procedures are employed. For example, a letter might be sent to customers
when a bill is 10 days past due; a more severe letter, followed by telephone call, would be sent if
payment is not received within 30 days, and the account would be turned over to a collection
agency after 90 days. As an account receivable becomes more and more overdue, the collection
effort becomes more personal and more intense. The popular procedures are briefly described in
Table3.1 listed in the order typically followed in the collection process.

Table 3.1 Popular Collection Techniques

Techniques* Brief Description

Letter After an account receivable becomes overdue a certain number of days, the
firm normally sends a polite letter reminding the customer of its obligation.
If the account is not paid within a certain period after the letter has been
sent, a second, more demanding letter is sent. Yet another letter may follow
this letter, if necessary. Collection letters are the first step in the collection
process for overdue accounts.

Telephone calls If letters prove unsuccessful, a telephone call may madeto

the customer to personally request immediate payment. Such a call is

typically directed to the customer's accounts payable department where the
responding employee acts on instructions of his or her boss. If the customer
has a reasonable excuse, arrangements may be made to extend the payment
period. A call from the seller's attorney may be used if all other discussions
seem to fail.

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Personal visits This technique is much more common at the consumer credit

level, but it may also be effectively employed by industrial suppliers.

Sending a local salesperson or a collection person to confront the customer
can be a very effective collection procedure. Payment may be made on the
spot.

Collection agencies A firm can turn uncollectible accounts over to a collection agency or an
attorney for collection. The fees for this service are typically quite high; the
firm may receive less than 50 cents on the dollar from accounts collected in
this way.
Legal action Legal action is the most stringent step in the collection process. It is an
alternative to the use of a collection agency. Not only is direct legal action
expensive, but also it may force the debtor into bankruptcy, thereby
reducing the possibility of future business without guaranteeing the ultimate
receipt of the overdue amount.

* Techniques are listed in the order typically followed in the collection process.

Monitoring Credit and Collection Policies

Accounts receivable management does not stop with the establishment of a credit terms, collection
policy and credit standards, for the individual customer or for the entire firm. Credit and collection
policies must be monitored continually, not only for indications of deterioration in the individual
customer’s ability to pay, but also for signs of overextended credit to all customers. The financial
officer must also troubleshoot for mechanical and procedural failures on the part of the credit
department’s equipment and personnel. The effectiveness of credit and collection policies can be
partly evaluated by looking at the level of bad debts expenses. This level depends not only on
collection policy, but also on the policy on which the extension of credit is based. If one assumes
that the level of bad debts attributable to credit policy is relatively constant, increasing collection
expenditures can be expected to reduce bad debts. Popular approaches used to evaluate credit and
collection policies include:

 Average collection period and

 Aging accounts receivable.
Average collection period

The average collection period or average age of accounts receivable is useful in evaluating credit
and collection policies. It is arrived at by dividing the accounts receivable balance by the average
daily sales:

Average collection period = Accounts receivable

Average Credit Sales per day

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 = Accounts receivable
Annual Credit sales /360 days

For example, assume Ethio-Food Company’s ending accounts receivable balance and its annual
credit sales are Br. 503, 000 and Br. 3,074,000 respectively, its average collection period will be:

= Br. 503,000
Br. 3,074,000/ 360 days
= 59 days

This means that on average it takes the firm’s 59 days to collect an accounts receivable. The
average collection period is meaningful only in relation to the firm‘s credit terms. If, for instance,
Ethio- Food Company extends 30-day credit terms to customers, an average collection period of
59 days may indicate a poorly managed credit or collection department or both. Of course, the
lengthened collection period could be an intentional relaxation of credit term enforcement by the
firm in response to competitive pressures from other suppliers of the product. If the firm had
extended 60- day credit terms, the 59-day average collection would be quite acceptable. Clearly,
comparison of the firm’s average collection period and credit terms (credit period provided) would
help to draw definitive conclusions about the effectiveness of the firm’s credit and collection
policies. However, a major weakness of average collection period for this purpose is that it is quite
sensitive to seasonal variations in sales. Consequently, unless sales are quite stable overtime, the
collection period can mask fundamental changes in collection experience.

Aging Accounts Receivable

Aging Accounts receivable is a technique that indicates the proportion of the accounts receivable
balance that has been outstanding for a specified period of time. By highlighting irregularities, it
allows the analyst to pinpoint the cause of credit or collection problems. Aging requires that the
firm's accounts receivable be broken down into groups based on the time of origin. This breakdown
is typically made on a month-by-month basis, going back 3 or 4 months. Let us look at an example.

Assume that Ethio- Food Company extends 30-day EOM credit terms to its customers. The firm's
December 31, 1997, balance sheet shows Br. 200,000 of accounts receivable. An evaluation of the
Br. 200,000 of accounts receivable results in the following breakdown:

Day Current 0-30 31-60 61-90 Over 90

Month Dec. Nov. Oct. Sept. Aug. Total

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 Accounts Br.60,000 Br.40,000 Br.66,000 Br.26,000 Br.8,000 Br.200,000
Receivable

Percentage
of total
30 20 33 13 4 100

Because it is assumed that Ethio- Food gives its customers 30 days after the end of the month in
which the sale is made to payoff their accounts, any December receivables that are still on the
firm's books are considered current. November receivables are between zero and 30 days overdue,
October receivables still unpaid are 31 to 60 days overdue, and so on.

The above breakdown shows that 30 percent of the firm's receivables are current, 20 percent are 1
month late, 33 percent are 2 months late, 13 percent are 3 months late, and 4 percent are more than
3 months late. Although payment seems generally slow, a noticeable irregularity in these data is
the high percentage represented by October receivables. This indicates that some problem may
have occurred in October. Investigation may find that the problem can be attributed to the hiring
of a new credit manager, the acceptance of a new account that has made a large credit purchase it
has not yet paid for, or ineffective collection policy. When accounts are aged and such a
discrepancy is found, the analyst should determine its cause.

By comparing aging schedules for different periods, the credit manager can get some idea of any
changes in collection experience; additionally, he/she can identify those individual accounts
requiring attention. Like the collection period, however, a weakness of the aging schedule is that
it is influenced by changes in sales.

Change in credit policy

Once a credit policy is set, it doesn’t mean it is not subject for change. Since market environment
is not static, there is a need to assess the credit policy and make adjustments accordingly. The
change might be made on:
 Credit period
 Discount rate
 Discount period
 Credit limit, etc.
Optimal Credit policy
The amount of trade credit that is affected by the variables in the decision is known as Optimal
Credit Policy, for example the receivables in an investment. Assignment help shows that many
factors such as the internal factors in an organization, the present situation in the economy and the
competition that is faced by the firm in the market are some of the external factors that affect the
credit policy of the firm. It’s the credit policy which helps the firm to get its level of credit. One
should work on the credit policy costs and variables In order to understand both jointly and
individually it’s the maximization profit and the goals and its varied impacts.