MODULE IV RECEIVABLES MANAG M Receivables mean the book debts or debtors and these arise, if the goods are sold on credit. Debtors form about 30% of current assets in India. Debt involves an element of risk and bad debts also. Hence, it calls for careful analysis and proper management. The goal of receivables is to maximize the value of the firm by achieving a tradeoff between risk and profitability. For this purpose, a finance manager has: ato obtain optimum (non-maximum) value of sales; b. to control the cost of receivables, cost of collection, administrative expenses, bad debts and opportunity cost of funds blocked in the receivables. ¢. to maintain the debtors at minimum according to the credit policy offered to customers. dw offer cash discounts suitably depending on the cost ‘of receivables, bank rate of interest and opportunity cost of funds blocked in the receivables. COSTS OF MAINTAINING RECEIVABLES. The costs with respect to maintenance of receivables can be iden! ified as follows 1, Capital costs - Maintenance of accounts receivable results in blocking of the firm’s financial resources in them. This is because there is a time lag between the sale of goods to customers and the payments by them. The firm has, therefore, to arrange for additional funds to meet its own obligations, such as payment to employees. suppliers of raw materials, etc., while awaiting for from its customers. Additional funds may either be raised from outside or out of profits retained in the business. In first the case, the firm has to pay interest to the outsider while in the Iatier case, there is an opportunity cast to the firm, i.<., the money which the firm could have eamed otherwise by investing the funds elsewhere. 2, Administrative costs - The firm has to incur additional administrative costs for maintaining accounts receivable in the form of salaries o the staff kept for maintaining accounting records relating to customers, cost of conducting investigation regarding potential credit customers 1 determine their credit worthiness etc, 3. Collection costs - The firm has to incur costs for collecting the payments from its credit customers. Sometimes, additional steps may have to be taken to recover money from defaulting customers. 4, Defaulting costs « Sometimes after making all serious efforts to collect money from defaulting ‘customers, the firm may not be able to recaver the over ‘dues because of the inability of the customers, Such debts are treated as bad debts and have to be written off since they cannot be realized, TT WORKING CAPITAL MANAGEMENTBENEFITS OF MAINTAINING RECEL VABLES a. Increase in Sales - Except a few monopolistic firms, most of the firms are required to sell goods ‘on credit, either because of trade customers or other conditions. The sales can further be increased bby liberalizing the credit terms. This ‘will attract more customers to the firm resulting in higher sales and growth of the firm. b. Increase in Profits - Increase in sales will help the firm (i) to easily recover the fixed experises and attaining the break-even level, and (ii) increase the operating profit of the firm. In a normal situation, there is a positive relation between the sales volume and the profit. c. Extra Profit - Sometimes, the firms make the credit sales at a price which is higher than the usual cash selling price. This brings an opportunity to the firm to make extra profit over and above ‘the normal profit. FACTORS AFFECTING THE SIZE OF RECEIVABLES The size of accounts receivable is determined by a number of factors. Some of the important factors are as follows 1. Level of sales - This is the most important factor in determining the size of accounts receivable. Generally in the same industry, a firm having a large volume of sales will be having 2 larger level of receivables as compared to a firm with a small volume of sales. Sales level can also be used for forecasting change in accounts receivable. For example, if a firm predicts that there will be an increase of 20% in its credit sales for the next period, it can be expected that there will also be a 20% increase in the level of receivables. 2. Credit policies - The term credit policy refers to those decision variables that influence the amount of trade credit, iLe., the investment in receivables. These variables include the quantity of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. A firm’s credit policy, as a matter of fact, determines the amount of risk the firm is willing to undertake in its sales activities, Ifa firm has a lenient or a relatively liberal credit policy, it will experience a er level of receivables as compared to a firm with a more rigid or stringent credit policy. This is because of the two reasons: iA lenient credit policy encourages even the financially strong customers to make delays in payment resulting in increasing the size of the accounts receivables. Lenient credit policy will result in greater defaults in payments by financially weak customers thus resulting in increasing the size of receivables. 3, Terms of trade - The size of the receivables is also affected by terms of trade (or credit tens) offered by the firm, The two important components of the credit terms are (i) Credit period (ii) ‘Cash discount. CREDIT PERIOD The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of “Net days”. For example, if a firm's credit terms are “Net 15°, it means the customers are expected to pay within 15 days from the date of credit sale. —————— Te WORKING CAPITAL MANAGEMENT Page 45ee Etta — CASH DISCOUNT Most firms offer cash discount to their customers for encouraging them to pay their dues before the expiry of the credit period, The terms of cash discount indicate the rate of discount 68 well as the period for which the discount has been ‘offered, For example, if the terms of cash discount are changed from “Net 30” to “2/10 Net 3 veans the credit period is of 30 days but in ‘case customer pays in 10 days, he would get 2 % discount on the amount due by him. Of course, allowing cash discount results in a loss to the firm because of recovery of fewer amounts than what is due from the customer but it reduces the volume of receivables and puts exis funds at the of the firm for alternative profitable investment The amount of loss thus suffered is, therefore, compensated by the income otherwise eared by the firm OPTIMUM SIZE OF RECEIVABLES. ‘The optimum investment in receivables will be at a level where there is a trade-off between costs and profiubility. When the firm resorts to a liberal credit policy, the profitability of the firm increases on account of higher sales. However, such a policy results in increased investment in feceivables, inereased chances of bad debts and more collection cots The total investment in Feceivables increases and, thus, the problem of liquidity is created, ‘On the other hand, a stringent ‘ccdit poticy reduces the profitability but increases the liquidity of the firm. Thus, optimum credit policy occurs at a point where there is a “Trade-ofT” between liquidity and profitability. DETERMINANTS OF CREDIT POLICY The following are the aspects of credit policy: |, Level of credit sales required to optimize the profit 2. Credit period i.. duration of credit, whether it may be 15 days or W or 45 days etc 3, Cash discount, discount period and seasonal offers. 4, Credit standard of a customer ,5 C's of credit: ‘a. Character of the customer ie. ‘willingness to pay: b. Capacity —ability to pay. c, Capital—financial resources ofa customer. d. Conditions—special conditions for extension of credit to doubtful customers and prevailing economic and market conditions and, ¢. Collateral security. 5. Profits. 6, Market and economic conditions. 7. Collection policy. 8. Paying habits of customers, 9. Billing efficiency, record-keeping etc, 10, Grant of credit —size and age of receivables. WORKING CAPITAL MANAGEMENT Page 46SCHOOL OF DISTANCE EDUCATION OPTIMUM CREDIT POLICY A firm should establish receivables ; k o policies after carefully considering both benefits and costs of different policies. These policies relate to: i : (i) Credit Standards, Credit Terms, and Collection Procedures. Each of these have been explained below: 4. Credit standards - The term credit standards represent the basic criteria for extension of credit to customers. The levels of sales and receivables are likely to be high if the credit standards are relatively loose, as compared to a situation when they are relatively tight. The firm's credit standards are generally determined by the five “C’s”. Character, Capacity, Capital, Collateral and Conditions. Character denotes the integrity of the customer, i.e. his willingness to pay for the goods purchased. Capacity denotes his ability to manage the business. Capital denotes bis. financial soundness. Collateral refers to the assets which the customer can offer by way of security: Conditions refer to the impact of general economic trends on the firm or to special developments in certain areas of economy that may affect the customer's ability to mect his obligations. Information about the five C’s can be collected both from internal as well as external sources. Internal sources include the firm's previous experience with the customer supplemented by its own well developed information system, External resources include customer's references, trade associations and credit rating organisations such as Don & Brad Street Inc. of USA. This ‘Organisation has more than hundred years experience in ‘the field of credit reporting. It publishes a reference book six times a year containing information about important business firms region wise. It also supplies credit reports about different firms on request. ‘An individual firm can translate its credit information into risk classes or groups according to the probability of loss associated with each class. On the basis of this information, the firm can decide whether it will be advisable for it to extend credit toa particular class of customers. TL Credit terms - It refers to the terms under which a firm sells goods on credit to its customers. ‘As stated earlier, the two components of the credit terms are (a) Credit Period and (b) Cash Discount. The approach to be adopted by the firm in respect ‘of each of these components ts discussed below: iod - Extending the credit period lates sales but increases the cost on account of more tying up of funds in receivables. Similarly, shortening the credit period reduces the profit on account of reduced sales, but also reduces the cost of tying up of funds im receivables. Determining the optimal credit period, therefore, involves locating the period where the marginal profits on increased sales are exactly offset by the cost of carrying the higher amount of accounts receivable. f «The effect of allowing cash discount can also be analysed on the same pattern as that of the credit period, ‘Attractive cash discount terms reduce the average collection period resulting in reduced investment in accounts receivable. Thus, there ts @ saving in capital costs, On the other hand, cash discount itself is a loss 10 the firm. Optimal discount is established at the point where the cost and benefit are exactly offsetting. fil. Collection procedures - A stringent collection procedure is expensive for the firm because of high out-of-pocket costs and loss of goodwill of the firm among its customers However, it ‘WORKING CAPITAL MANAGEMENTSCHOOL OF DISTANC UCATION minimizes the loss cn aceount of bad debts as well as increases savings in terms of lower capital costs on account of reduction in the size of receivables. A balance has therefore to be stuck between the costs and benefits of different collection procedures or policies. CREDIT EVALUATION OF CUSTOMER Credit evaluation of the customer involves the following 5 stages i. Gathering credit information of the customer through: . financial statements of a firm, . bank references, |. reports of credit rating agencies, a. b. c. references from Trade and Chamber of Commerce, d ‘¢. credit bureau reports, f firm's own records (Past experience), g. other sources such as trade journals, Income-tax returns, wealth tax returns, sales tax returns, Court cases, Gazette notifications etc. ii. Credit analysis - After gathering the above information about the customer, the credit- worthiness of the applicant is to be analyzed by a detailed study of 5 C’s of credit as mentioned above. iii. Credit decision - After the credit analysis, the next step is the decision to extend the credit facility to potential customer. If the analysis of the applicant is not upto the standard, he may be offered cash on delivery (COD) terms even by extending trade discount, if necessary, instead of rejecting the credit to the customer. iv. Credit limit - If the decision is to extend the credit facility to the potential customer, a limit may bbe prescribed by the financial manager, say, Rs. 25,000 or Rs. 1,00,000 or so, depending upon th credit analysis and credit-worthiness of the customer. y. Collection procedure - A suitable and clear-cut collection procedure is to be established by a firm and the same is to be intimated to every customer while granting credit facility. Cash discounts may also be offered for the early payment of dues, This facilitates faster recovery