Lesson 42

Chapter-13
Accounts-Receivables Management
Unit 5
Management of Working Capital

Today’s class is for discussion on article given below.

Article

Debtors, Bloody Debtors

The following is a copy of an article, which appeared in the "Professional Manager" in

MAR 94. It was written by Edward Kerr, the author of THE "F FILES".
Although written under the title "Debtors, Bloody Debtors", the editor chose to publish it
under the title "Debtors, Wretched Debtors" (together with several spelling and grammar
errors !!) - maybe I will write another article called "Editors, Bloody Editors".
Although the article is written from a somewhat humorous standpoint, the messages are
valid and heartfelt.

I'd like to borrow some money from your company. I'd like the loan to be for at least 90
days. There is a one percent chance that I won't actually get around to paying you and, if
I do, it will be after you have spent a considerable amount of time, effort and money
chasing me - and, maybe, finding me. If I do pay you, I don't want to pay any interest on
the amount borrowed and, incidently, I'm not giving you any decision about whether you
are going to let me have the loan. I've just taken it.
Am I a crook ? No, just an everyday customer and you've probably got plenty like me.
Giving loans is not just something that banks do. Every business loans money to its
customers - it's called "debtors" and it is excused as normal business practice. The only
real difference between bank loans and debtors is that banks get paid interest (usually) on
the money that they have lent.
The one contribution that debt collectors do make is that every time they telephone me, I
have to think up an even more imaginative reason for further delaying the payment -
"you'll never believe this, but a funny thing happened to me on the way to the post office
!!".
A lighthearted look maybe, but the problem is very real, very costly and has resulted in
the failure of many otherwise viable organisations, particularly in the last few, difficult
years. It is not the lack of profit flow that has caused the failure of many organisations - it
is the lack of cash flow caused by poor and slow payment by customers.
Let's quantify the problem. If a company's annual sales revenue is £ 12 million and
customers take, on average, 90 days to settle their invoices, £ 3 million is outstanding at
any one time. Let us assume that cash availablility is not a problem - the company either
has a positive cash flow or a friendly bank manager. The company still has to fund the
outstanding amount. If the company's cost of funds is only ten per cent, the annual
funding cost will be £ 300,000. Consider, for a moment, what £ 300,000 would do to the
profit of a company of this size and then add the cost of chasing the debt - staff salaries,
salary add-ons, legal fees, postage, telephone, etc. - and, then, just as a sting in the tail,
consider the customers who never pay you - the bad debts.
Ah yes, you may say. It's true that our customers take an average of 90 days to pay us,
but we take 90 days to pay suppliers and our overheads, so it all comes out okay in the
end. This may be so, and it will go some way to offering a compensatory saving, but staff
will not wait three months for their salaries and the Inland Revenue will not wait three
months for payments of income tax and national insurance deductions.
Hopefully, after three months, BT and the electricity company are still only thinking of
cutting their supplies off. Anyway, if you settled with your suppliers within a more
reasonable time, you might be able to negotiate discounts or more attractive terms.
Try delaying the VAT cheque for three months and, unless you qualify for one of the
special cash-based schemes, don't be surprised if you get an immediate outbreak of
official humour-failure from the Customs and Excise, who won't be interested that you
have yet to collect VAT from your customers. And I think that it is very nice of you to
waih three months before receiving the profit on the sales that you have made.
So what is the message arising from this cautionary tale ? It is that selling is not a one-
way transaction - you, certainly, undertake to deliver at a specific time, but the customer
also has the obligation of paying for the goods or service within a reasonable time and not
abusing the system. Successful business is about living up to both sides of these
obligations.
Selling to the Mega-corporation may look good on the client list. Your marketing people
will drool over selling to a "quality name" and talking about the profit and opportunity
that will be forthcoming. However, if Mega-corporation does not pay for 90 days, much
of the profit disappears in funding cost and administrative effort.
If chasing debts is how you want to spend your time, fine. If you want to spend scarce
management time in more productive areas, go for quality of sales, not quantity. Take the
trouble to know your customers. Investigate new customers. If one is a slow payer,
consider dropping him from the customer base - let one of your competitors have the
problems !! Most organisations would drop him from their customer base until he has
settled his 90-day old invoices and then reinstate him so that he can do the same thing
again. As someone once said, the one thing that we can learn from history is that no-one
learns anything from history.
Business in the middle 1990s will be difficult enough without the extra burden of
financing other peoples' businesses. Managers should be aware of the expensive
problems that debtors cause and the threat that they represent.
IMPORTANT
Slide 1

Chapter 13
Accounts
Accounts Receivable
Receivable
Management
Management

10-1

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Slide 2

Accounts Receivable
Management
‹ Credit and Collection
Policies
‹ Analyzing the Credit
Applicant

10-2

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Slide 3

Credit and Collection

Policies of the Firm

Quality of Length of
Trade Account Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program

10-3

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Slide 4

Credit Standards
Credit Standards -- The minimum quality
of credit worthiness of a credit applicant
that is acceptable to the firm.
standards?
Why lower the firm’s credit standards?
The financial manager should continually
lower the firm’s credit standards as long as
profitability from the change exceeds the
extra costs generated by the additional
receivables.
10-4

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Slide 5

Credit Standards
Costs arising from relaxing
credit standards
‹ A larger credit department
‹ Additional clerical work
‹ Servicing additional accounts
‹ Bad-debt losses
‹ Opportunity costs
10-5

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Slide 6

Example of Relaxing
Credit Standards
Basket Wonders is not operating at full capacity
and wants to determine if a relaxation of their
credit standards will enhance profitability.

‹ The firm is currently producing a single

product with variable costs of $20 and selling
price of $25.
‹ Relaxing credit standards is not expected to
affect current customer payment habits.

10-6

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Slide 7

Example of Relaxing
Credit Standards
‹ Additional annual credit sales of $120,000 and an
average collection period for new accounts of 3
months is expected.
‹ The before-tax opportunity cost for each dollar of
funds “tied-up” in additional receivables is 20%.

Ignoring any additional bad-

bad-debt losses
that may arise, should Basket Wonders
relax their credit standards?

10-7

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Slide 8

Example of Relaxing
Credit Standards
Profitability of ($5 contribution) x (4,800 units) =
additional sales $24,000

Additional ($120,000 sales) / (4 Turns) =

receivables $30,000

Investment in ($20/$25) x ($30,000) =

add. receivables $24,000

Req. pre-tax return (20% opp. cost) x $24,000 =

on add. investment $4,800

Yes! Profits > Required pre-tax return

10-8

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Slide 9

Credit and Collection

Policies of the Firm

Quality of Length of
Trade Account Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program

10-9

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Slide 10

Credit Terms
Credit Terms -- Specify the length of time
over which credit is extended to a customer
and the discount, if any, given for early
payment. For example, “2/10, net 30.”

Credit Period -- The total length of time over

which credit is extended to a customer to
pay a bill. For example, “net 30” requires
full payment to the firm within 30 days from
the invoice date.
10-10

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Slide 11

Example of Relaxing
the Credit Period
Basket Wonders is considering changing its
credit period from “net 30” (which has resulted
in 12 A/R “Turns” per year) to “net 60” (which is
expected to result in 6 A/R “Turns” per year).
‹ The firm is currently producing a single product
with variable costs of $20 and a selling price of
$25.
‹ Additionalannual credit sales of $250,000 from
new customers are forecasted, in addition to the
current $2 million in annual credit sales.
10-11

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Slide 12

Example of Relaxing
the Credit Period
‹ The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.

Ignoring any additional bad-

bad-debt losses
that may arise, should Basket Wonders
relax their credit period?

10-12

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Slide 13

Example of Relaxing
the Credit Period
Profitability of ($5 contribution)x(10,000 units) =
additional sales $50,000

Additional ($250,000 sales) / (6 Turns) =

receivables $41,667

Investment in add. ($20/$25) x ($41,667) =

receivables (new sales) $33,334

Previous ($2,000,000 sales) / (12 Turns) =

receivable level $166,667

10-13

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Slide 14

Example of Relaxing
the Credit Period
New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333

Investment in $333,333 - $166,667 =

add. receivables $166,666
(original sales)

Total investment in $33,334 + $166,666 =

add. receivables $200,000
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment $40,000

10-14 Yes! Profits > Required pre-tax return

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Slide 15

Credit and Collection

Policies of the Firm

Quality of Length of
Trade Account Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program

10-15

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Slide 16

Credit Terms
Cash Discount Period -- The period of time
during which a cash discount can be taken for
early payment. For example, “2/10” allows a
cash discount in the first 10 days from the
invoice date.

Cash Discount -- A percent (%) reduction in

sales or purchase price allowed for early
payment of invoices. For example, “2/10”
allows the customer to take a 2% cash discount
during the cash discount period.
10-16

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Slide 17

Example of Introducing
a Cash Discount
A competing firm of Basket Wonders is
considering changing the credit period from
“net 60” (which has resulted in 6 A/R “Turns”
per year) to “2/10, net 60.”
‹ Current
annual credit sales of $5 million are
expected to be maintained.
‹ Thefirm expects 30% of its credit customers (in
dollar volume) to take the cash discount and
thus increase A/R “Turns” to 8.
10-17

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Slide 18

Example of Introducing
a Cash Discount
‹ The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.

Ignoring any additional bad-

bad-debt losses
that may arise, should the competing firm
introduce a cash discount?

10-18

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Slide 19

Example of Using
the Cash Discount
Receivable level ($5,000,000 sales) / (6 Turns) =
(Original) $833,333

Receivable level ($5,000,000 sales) / (9 Turns) =

(New) $555,556

Reduction of $833,333 - $555,556 =

investment in A/R $277,777

10-19

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Slide 20

Example of Using the

Cash Discount
Pre-tax cost of .02 x .3 x $5,000,000 =
the cash discount $30,000.
$30,000.
Pre-tax opp. savings (20% opp. cost) x $277,777 =
on reduction in A/R $55,555.
$55,555.

Yes! Savings > Costs

The benefits derived from released accounts

receivable exceed the costs of providing the
discount to the firm’s customers.
10-20

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Slide 21

Seasonal Dating
Seasonal Dating -- Credit terms that
encourage the buyer of seasonal products
to take delivery before the peak sales period
and to defer payment until after the peak
sales period.
‹ Avoids carrying excess inventory and the
associated carrying costs.
‹ Accept dating if warehousing costs plus the
required return on investment in inventory exceeds
the required return on additional receivables.
10-21

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Slide 22

Credit and Collection

Policies of the Firm

Quality of Length of
Trade Account Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program

10-22

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Slide 23

Default Risk and

Bad-Debt Losses
Present
Policy Policy A Policy B

Demand $2,400,000 $3,000,000 $3,300,000

Incremental sales $ 600,000 $ 300,000
Default losses
Original sales 2%
Incremental Sales 10% 18%
Avg. Collection Pd.
Original sales 1 month
Incremental Sales 2 months 3 months

10-23

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Slide 24

Default Risk and

Bad-Debt Losses
Policy A Policy B
1. Additional sales $600,000 $300,000
2. Profitability: (20% contribution) x (1) 120,000 60,000
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000
5. Inv. in add. receivables: (.80) x (4) 80,000 60,000
6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-
bad-debt losses +
additional required return: (3) + (6) 76,000 66,000

8. Incremental profitability: (2) - (7) 44,000 (6,000)

10-24 Adopt Policy A but not Policy B.

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Slide 25

Collection Policy
and Procedures
The firm should increase collection
Collection expenditures until the marginal
Procedures reduction in bad-
bad-debt losses equals
the marginal outlay to collect.
‹ Letters

Bad--Debt Losses
‹ Phone calls
‹ Personal visits Saturation
Point
‹ Legal action

Bad Collection Expenditures

10-25

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Slide 26

Analyzing the
Credit Applicant
‹ Obtaining information on the
credit applicant
‹ Analyzing this information to
determine the applicant’s
creditworthiness
‹ Making the credit decision
10-26

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Slide 27

Sources of Information
The company must weigh the amount
of information needed versus the time
and expense required.
required
‹ Financial statements
‹ Credit ratings and reports
‹ Bank checking
‹ Trade checking
‹ Company’s own experience
10-27

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Slide 28

Credit Analysis
A credit analyst is likely to utilize
information regarding:
regarding:

‹ the financial statements of the firm

(ratio analysis)
‹ the character of the company
‹ the character of management
‹ the financial strength of the firm
‹ other individual issues specific to
the firm
10-28

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Slide 29

Sequential
Investigation Process
The cost of investigation (determining
the type and amount of information
collected) is balanced against the
expected profit from an order.

An example is provided in the following

three slides 10-30 through 10-32.

10-29

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Slide 30

Sample Investigation
Process Flow Chart (Part A)
Pending Order

Bad
Stage 1
$5 Cost
No past credit Yes
Reject
experience

No prior experience whatsoever

Stage 2
$5 - $15
Dun & Bradstreet
Cost report analysis*

* For previous customers only a Dun & Bradstreet reference book check.
10-30

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Slide 31

Sample Investigation
Process Flow Chart (Part B)

Credit rating
“limited” and/or other Yes
damaging information
Reject
unearthed?

No

Credit rating
No “fair” and/or other
Accept close to maximum
“line of credit”?

Yes
10-31

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Slide 32

Sample Investigation
Process Flow Chart (Part C)

Bank, creditor, and financial

Stage 3
$30 Cost
statement analysis
Good Fair Poor

Accept Reject
Accept, only upon
domestic irrevocable
letter of credit (L/C)**
** That is, the credit of a bank is substituted for customer’s credit.
10-32

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Slide 33

Other Credit
Decision Issues
Credit-
Credit-scoring System -- A system used to
decide whether to grant credit by assigning
numerical scores to various characteristics
related to creditworthiness.

Line of Credit -- A limit to the amount of credit

extended to an account. Purchaser can buy on
credit up to that limit.
‹ Streamlines the procedure for shipping
goods.
10-33

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Slide 34

Other Credit
Decision Issues
Outsourcing Credit and Collections
The entire credit and/or collection function(s)
are outsourced to a third-party company.

‹ Credit decisions are made

‹ Ledger accounts maintained
‹ Payments processed
‹ Collections initiated
Decision based on the core
competencies of the firm.
10-34

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