Advanced Financial Management 20MBAFM306
Module -5 Receivables Management 7 hours
Receivables Management – Credit management through credit policy variables, marginal
analysis, Credit evaluation: Numerical credit scoring and Discriminate analysis. Control of
accounts receivables, Problems on credit granting decision. (Theory and Problems)
RECEIVABLE MANAGEMENT
The term receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business. Receivables are also one of the major parts
of the current assets of the business concerns. It arises only due to credit sales to customers;
hence, it is also known as Account Receivables or Bills Receivables. Management of account
receivable is defined as the process of making decision resulting to the investment of funds in
these assets which will result in maximizing the overall return on the investment of the firm.
The objective of receivable management is to promote sales and profit 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.
The costs associated with the extension of credit and accounts receivables are identified
as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.
Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales
have been made.
Capital Cost
This is the cost on the use of additional capital to support credit sales which alternatively
could have been employed elsewhere.
Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of
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salaries to the staff kept for maintaining accounting records relating to customers, cost of
investigation etc.
Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be
able to recover the over dues because of the inability of the customers
Factors Considering the Receivable Size
Receivables size of the business concern depends upon various factors. Some of the important
factors are as follows:
1. Sales Level
Sales level is one of the important factors which determines the size of receivable of the firm.
If the firm wants to increase the sales level, they have to liberalise their credit policy and terms
and conditions. When the firms maintain more sales, there will be a possibility of large size of
receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from firm to
firm or even some times product to product in the same industry. Liberal credit policy leads to
increase the sales volume and also increases the size of receivable. Stringent credit policy
reduces the size of the receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon the credit
terms, size of the receivables may increase or decrease. Hence, credit term is one of the factors
which affects the size of receivable.
4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales. Normally
it is expressed in terms of ‘Net days’.
5. Cash Discount
Advanced Financial Management 20MBAFM306
Cash discount is the incentive to the customers to make early payment of the due date. A special
discount will be provided to the customer for his payment before the due date.
6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce the size of
receivable.
Credit Policy Variables
Credit policy variables are an essential feature of every credit policy. These variables impact
the credit policy directly or indirectly. Since the variables have the power to make or break a
credit policy, they are considered indispensable while forming and executing the credit policy.
Management of credit policies requires efficient handling of credit policy variables.
The four types of credit policy variables are as follows −
Credit Standards
Standards of Credit Policy refer to the offering of credit to particular customers and it is purely
institutional in character. A company may decide to grant credit to a company willingly while
it can hold the offer even when the customer is very credit-diligent.
When the standard of a credit policy is liberal the company offers credit to many customers
without considering their credit rating. As is obvious, this increases the sales and may also
increase profitability but it is very risky in nature. As the liberal policies extend credit to
doubtful customers, the chances of bad debt increase, and it may hamper the long-term
profitability of a company.
When the credit policy of a company is tight or more coherent, the company loses some
potential customers. So, a tight credit policy faces a loss of opportunity. However, since the
company is very selective while offering credit, the chances of losing money as bad debt gets
very limited. Therefore, a tight credit standard makes the credit policy considerably less risky.
Credit Period
Another credit policy variable that impacts the policy directly is the duration of time that the
company offers to the customer to pay for the goods and services availed on credit. It is also
called the credit period. The credit period may depend on the industry and nature of customers.
Advanced Financial Management 20MBAFM306
However, a good company that knows its customers should be able to offer a credit period that
is optimum yet restrictive in nature.
In a liberal credit policy, the duration to pay back the accounts receivables is longer. So, the
companies offering a longer credit period enjoy more sales as the customers buy more from
the company because they get extended time to pay back. However, a long credit tenure may
increase the chances of defaults by the customers too.
Cash Discounts
Cash discounts are offered to customers who pay back the accounts receivable prior to the last
date of the credit period. It enhances the collection of the accounts receivable and hence also
increases the chances of sales and profitability. Discounts in credit policy depend on the nature
of the business and the industry. While some industries, such as textiles and real estate offer
large discounts on early payment, the discounts in automobiles and FMCG may be less in
quantity.
Customers usually love to avail discounts on purchased goods and services. So, offering
discounts may reduce the period a company takes to pay for the goods and services. This
allows the company to enjoy more flexibility and profit in the longer term.
Collection Efforts
A company that sells products or services in credit must have a credit policy that includes a
particular form of collection efforts. Without any effort to collect the credits, the companies
may face more bad debts and losses. So, in order to gain more profit, the companies must
employ a strict collection effort for recovering the credits granted to their customers.
Some companies take legal help in recovering the credits when they are due and they inform
the customers about their rules and regulations during the time of sale. A good collection effort
along with legal help can go a long way in making a company profitable and free from
excessive bad debts.
Five Cs of Credit Analysis.
Capital: The term capital here refers to financial position of the applicant firm. It requires an
analysis of financial strength and weakness of the firm in relation to other firms in the industry
to assess the credit worthiness of the firm. Financial information is normally derived from the
financial statements of the firm
Advanced Financial Management 20MBAFM306
and analysed through ratio analysis. The liquidity ratios like current ratio, debtservice coverage
ratio, etc. are often used to get a preliminary idea on the financial strength of the firm. Further
analysis includes trend analysis and comparison with the other industry norm or other firms in
the industry.
Character: A prospective customer may have high liquidity but delay payment to their
suppliers. The character thus relates to willingness to pay the debts.
Some relevant questions relating to character are:
• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honour debts as they
become due?
Information on these areas are useful to assess the applicant’s character.
Collateral: If a debt is supported by collateral, then the debt enjoys lower risk because in the
event of default, the debt holder can liquidate the collateral to recover the dues. The collateral
causes hardship to other debt holders. Thus, the analysts should look into both the availability
of collateral for the debt and the amount of collateral the firm has given to others. In computing
the liquidity of the firm, the analysts should remove the assets used for collateral and take into
account only the free assets. The credit worthiness improves if the customer is willing to offer
collateral assets or the value of collateral asset backed loan is low.
Capacity: The capacity has two dimension - management’s capacity to run the business and
applicant firm’s plant capacity. The future of the firm depends on the management’s ability to
meet the challenges. Similarly, the facility should exist to exploit the opportunity. Since the
assessment of capacity is a judgement on the part of analysts, a lot of care should be taken in
assessing this feature.
Conditions: These are the economic conditions in the applicant’s industry and in the economy
in general. Scope for failure and default is high when the industry and economy are in
contraction phase. Credit policy is required to be modified when the conditions are not
favourable. The policy changes include liberal discount for payment within a stipulated period
and imposing lower credit limit.
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Credit Evaluation
Traditional Credit Analysis
1. Days’ Sales Outstanding (DSO):
The average days’ sales outstanding at a given time may be defined as the ratio of receivables
outstanding at that time to average daily sales. The average daily sales figure is obtained by
taking the average of sales during the preceding 30 days, 60 days, 90 days or some other
relevant period.
According to this method, accounts receivables are deemed to be in control if the DSO is equal
to less than a certain norm.
If the value of DSO exceeds the specified norm, collections are considered to be slow.
2. Aging schedule:
The aging schedule (AS) classified outstanding receivables at a given point of time into
different age brackets. The actual AS of the firm is compared with some standard AS to
determine whether accounts receivables are in control. A problem is indicated if the actual AS
shows a greater proportion of receivables, compared with tile standard AS, in the higher age
groups.
Limitations:
1. DSO and AS are both influenced by the pattern of sales
2. DSO is sensitive to the averaging period
Modern method:
1. Numerical Credit scoring Method
A Variety of factors influences a customer’s credit worthiness. This makes credit investigation
a difficult task. A firm can use numerical credit scoring to appraise credit application when it
is dealing with a larger number of small customers. The based on its past experience or
empirical study may identify both financial and non-financial attributes that measure the credit
standing of a customer. It is more systematic than the traditional credit analysis. Such a system
may involve the following steps:
Advanced Financial Management 20MBAFM306
• Identify factors relevant for credit evaluation
• Assign weights to these factors that reflect their relative importance.
• Rate the customer on various factors, using a suitable rating scale ( usually a 5 point
scale or a 7 point scale is used) For each factor, multiply the factor rating with the factor
weight to get the factor score.
• Add all the factor scores to get the overall customer rating index. Based on the rating
index , classify the customer.
• Construction of a credit rating index(based on a 5-point rating scale)
The numerical credit scoring models may include
A) Adhoc Approach
A firm may develop its own adhoc approach of numerical credit scoring to determine the
credit worthiness of customers. The attributes identified by the firm may be assigned
weights depending on their importance and be combined to create an overall score or index.
B) Discriminant Analysis
A firm can use more objective methods for differentiating between good and bad customers
The nature of this analysis may be discussed with the help of a simple example.
ABC Company manufactures gensets for industrial customers. It considers the
following financial ratios of its customers as the basic determinants of creditworthiness:
current ratio and return on net worth. The plot of its customers on a graph of these two
variable are shown in the figure. X represent customers who have paid their dues and O’s
represent customers who have defaulted. The straight line seems to separate the Xs from
the Os – while it may not be possible to completely separate the Xs and Os with the
help of a straight line, the straight line does a fairly good job of segregating the two
groups. The equation of this straight line is
Z = 1 Current Ratio + 0.1 Return on equity
The higher the Z score, the stronger the credit rating. Since this is the line which
discriminates between the good customers (who pay) and bad customers (defaulters), a
customer with a Z Score of more than 3 is deemed creditworthy( This number 3 is an
arbitrary constant ) We could use any other number just as well. The point to be emphasized
is that the ratio of weights applied to current ratio and return on equity should be
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10:1. In this example we considered a Z function of two variables. In most of the
practical applications a Z function of several variables is considered.
Control Of Accounts Receivables
A firm need to continuously monitor and control its receivables to ensure the success of
collection efforts. The following are the methods used for controlling accounts receivables.
1. Average Collection Period: The Average collection period is compared with the firm’s
stated credit period to judge the collection efficiency. It indicates the speed of
collectability.
2. Aging Schedule: It break down accounts receivables according to the length of time
for which they have been outstanding.
3. Collection Experience Matrix: It can judge whether the collection is improving, stable
or deteriorating. It provides a historical records of collection percentage that can be
useful in projecting monthly receipts for each budgeting period.