CHAPTER-4

MANAGEMENT OF RECEIVABLES
MEANING OF RECEIVABLES
Receivables arise when goods or services of a firm are sold on credit basis. According to
Hampton “Receivables are asset accounts representing amount owed to the firm as the result
of the sale of goods or services in the ordinary course of business.”
Van Horne “Account receivables represent the extension of open account credit by one firm
to another firm and to individuals.” As proceeds of credit sales are collected, receivables are
reduced.
Transactions leading to the occurrence of receivable include:
i) Credit sales of goods and services
- Account receivable (Trade receivables)
- Notes receivables
- Installment receivables
ii) Loans advanced to individuals and other entities
- Loan receivable
- Notes receivable
- Advance to affiliates
- Advance to employees
iii) Leasing property to others
- Lease contract receivables
iv) Other revenue transactions
- Interest receivables
- Dividend receivables
- Rent receivables
- Commissions receivables etc…..
v) Claims in insurance, tax, litigations, etc…
- Claims receivables
- Tax refund receivables
- Damage claims receivables
Receivable management involves decisions concerning the extension of credit to customers,
protection of the investment in receivables, achievement of timely collections and
maintenance of appropriate records. These tasks are accomplished through the establishment
of sound credit policies. Credit policies involve the duties and responsibilities of the credit

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manager, general guidelines as to the credit terms, collections and write-off procedures, etc…
The policies are usually specified in writing as part of the firm’s internal control procedures.
IMPORTANCE OF RECEIVABLES
A) Sales growth: - Credit sales are a powerful stimulant for increasing sales. Especially
during the period of inflation accompanied by recession and stagnation in the industry. In
such situation many customers may not have sufficient cash for cash purchases. If a firm
doesn’t sale on credit it will have fewer customers and decline in sales. Hence, receivable
help growth of sales.
B) Increase in profit: - Increase in profitability by striking a balance between the cost of
extending credit and the gains from sales expansion. The decision to extend credit to
customers involves consideration of the profit to be gained from the sale against the cost
of granting credit (time value of money, collection cost and risk & loss.)
C) Capability to face competition: - If competitors sale on credit, the firm will be able to
face the competition only by selling on credit. The firm should adopt similar credit
policies with its competitors to retain customers.
D) Protection of Company’s Liquidity: - Slow collection procedures and efforts lead to rapid
deterioration in the company’s cash position.
FACTORS INFLUENCING THE SIZE OF RECEIVABLES
The amount and the level of receivables is affected by
 Influence of economic condition and
 Credit policy of the firm
The common influences of economic condition are cyclical and seasonal variances. Credit
policies include credit standards, credit terms, default risk (risk of bad debt), collection
policies and procedures of collection of the receivables.
Symbolically
R = f (Cs, Ct, CR, CPP , SC)
R – Level of receivables
Cs – Amount and size of credit
Ct – Credit term (discount period, & credit period)
Cr – Credit risk (credit standing of individual customers who purchase on credit)
Cpp - Collection policies and procedures
Sc – Seasonal fluctuation in business
Influence of economic condition on amount of receivables by and large beyond the control of
a single firm particularly in the short period but credit policy can be managed to a significant
effect.

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OBJECTIVES OF RECEIVABLE MANAGEMENT
The main objectives of receivables management are to maximize profit. As a general rule a
firm should extend credit facilities as long as the profitability of sales generated is greater
than the increase in cost of maintaining accounts receivable.

Additional Profit = (USP – UVC) x no. of additional units sold

In the above it is assumed that additional sales due to attractive credit policy can be effected
without increasing fixed cost. However, if fixed costs are incurred for selling such fixed costs
will also have to be deducted. Such credit policy is normally formulated to utilize existing
capacity and for short period of time.
FUNCTIONS OF RECEIVABLES MANAGEMENT
1. Formulation of credit policy
2. Evaluation of credit policy
3. Implementation of credit policy
4. Administration and control of credit policy
1. Formulation of credit policy
This function if concerned with the decision making about the three credit terms namely cash
discount, credit period and cash discount period. It considers
 Change in credit period
 Change in discount rate
 Change in discount period
While credit terms are relatively fixed because of customers usage and practice of firms in an
industry, a particular firm may have some scope of decision making for credit terms i.e. firms
are likely to have freedom of choice but to a limited extent.
The following effects of the credit terms are to be considered when formulating credit
policies
 Cash discount affects
 Cost of capital
 Average collection period
 The demand, i.e., sales
 Credit period affect
 The sales
 Average collection period
 Bad debts losses.

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Seasonal dating means extension of credit period during the period of slack sales or off-
season. When a firm sales to customers allowing them to pay in the later part of the season it
is called seasonal dating. For example, a firm may sale in April to June and gets payment in
July.

Delinquent Account: - are those accounts, which are due but unpaid. The important factor is
that there should be some policy for such accounts. The policy may relate to two actions
1. Eliminating such customers account (treating as bad debts) and
2. Charging such customers additional interest, which may be equal to the firm’s cost of
capital for the period of delinquency and forcing them to make payment.

Exercise-1: Problem on length of the credit period that affects the profit
The following data are available to the financial manager of a firm for evaluating the credit
policy for different credit period.
Cost of capital -------------------- 12% per annum
Sales, 10 units at birr 170 per unit
Fixed and variable cost is birr 153 per unit
Recent credit period 90 days
Proposed credit period under consideration
A – No credit period
B – 30 days
C – 180 days
D – 270 days
E – 330 days
F – 360 days
Show the impact of different credit period on profits.

Solution
Cash sales 30 days 180 days 270 days 330 days 360 days
Sales 1,700 1,700 1,700 1,700 1,700 1,700
Cost (FC +VC) 1,530 1,530 1,530 1,530 1,530 1,530
Interest at 12% - 17 102 153 187 204
Total Cost 1,530 1,547 1,632 1,683 1,717 1,734
Profit (loss) 170 153 68 17 (17) (34)

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As the credit period increases the profit decreases. The break-even point will be 300 days
credit period.
Break-even = 1,700 x 0.12 x 10/12 = 170
Interest income (opportunity cost) or interest expense + cost (FC + VC) = 170 + 1530 = 1,700
The finance manger should evaluate the impact of credit policies on cost of capital.

Exercise-2: Cash discounts and profits

A firm’s cost of capital is 10% of sales per month. Its credit terms are 2/10, n /30. The firm’s
sales at birr 15 per unit and cost is birr 13.50 per unit what is the impact on profit?
a. When discount is taken by customers
b. When discount is not taken by customers
Solution
A. When discount is taken B. When discount is not taken
Sale ---------------------- 15 Sale ----------------- 15
Cash discount 2%-------0.3 Cost ----------------- 13.50
Cash received ---------- 14.70 1.50
Cost --------------------- 13.50 Interest (opportunity cost)
Profit ------------------- 1.20 15 x 0.01 x 20------- (3)
Profit (loss) ----------- (1.50)
2. Evaluation of credit policy
There are two important concerns (Trade-offs) in a credit policy.
 Investment in receivables (funds blocked in receivables)
 Increase in sales
Investment in receivables may involve additional bad debt expenses from delinquent account.
Increased in sales may result in additional profit. So the additional profit will have to be
compared with additional expenses on cost of capital, bad debts etc.
Example: In order to increase sales from the present annual sales of Br 240,000 AMASSA
Chemical Company is considering a more liberal credit policy. At present the average
collection period of credit sales of the firm is 30 days. It is expected that
A. If collection period is lengthened by 15 days sales will increases by 10,000 birr
B. If collection period is lengthened by 30 days sales will increase by 15,000 birr
C. Investment in receivables:
Plan A = birr 20,000
Plan B = birr 31,250
Plan C = birr 42,500

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The finance manager has estimated that with 15 days increase bad debt losses will be 3% and
30 days increase bad debt losses will be 6%. The present bad debt loss is 1%.
The firm has the following cost pattern at present and the same will be the pattern in the
coming year.
Price per unit --------------- birr 100
VC per unit --------------------- birr 60
Average cost per unit --------- 0.80
Cost of capital (RRR) --------- 20%
Working days in a year -------- 360 days
Which of the credit policies should be pursued?
Solution
Present (30 days) Policy A Policy B
45 days 60 days
Sales 240,000 250,000 255,000
Profit 48,000 50,000 51,000
Bad debts 2,400 7,500 15,300
(*) 45,600 42,500 35,700
Inv’t in receivables 20,000 31,250 42,500
RRR (CoC@20%) (**) 4000 6,250 8,500
Profit (* -**) 41,600 36,250 27,200
Therefore, it is advisable to maintain the current credit policy.
Illustration 2: ABC & Company is making sales of Br.1, 600,000 and it
extends a credit of 90 days to its customers. However, in order to
overcome the financial difficulties, it is considering changing the credit
policy. The proposed terms of credit and expected sales are given
hereunder:

Policy Terms Sales

I 75 days Br.1,500,000

II 60 days Br. 1,450,000

III 45 days Br. 1,425,000

IV 30 days Br. 1,350,000

V 15 days Br.1,300,000

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 The firm has variable cost of 80% and fixed cost of Br.100, 000. The cost
of capital is 15%. Evaluate different policies and which policy should be
adopted?

Solution:
figures in Br.
Particulars Present I II III IV V

Sales 1,600,00 1,500,000 1,450,00 1,425,00 1,350,000 1,300,000

0 0 0
-Variable cost
1,200,000 1,080,000 1,040,000
1,280,00 1,160,00 1,140,00
-Fixed Cost 0 0 0
100,000 100,000 100,000

Profit (A) 100,000 100,000 100,000

200,000 170,000 160,000

Total Cost 220,000 190,000 185,000

1,300,000 1,180,000 1,140,000

Average Receivable(at cost) (B) 1,380,00 1,260,00 1,240,00

270,833 98,333 47,500
0 0 0
(Cost/360xcredit period
345,000 210,000 155,000
Cost of debtors @ 15% (B)
40,625 14,750 7,125

Net profit (A – B)
159,350 155,250 152,875
51,750 31,500 23,250

168,250 158,500 161,750

3. Implementation of Credit Policy

After formulation and evaluation of credit policy the most suitable policy is adopted and use.
The use of a credit policy is implementation of that credit policy. Implementation of credit
policy involves the following two functions.
A. Evaluation of credit applicant (credit analysis) and
B. Financing of the investment in receivables
A. Evaluation of credit applicant: - this function is concerned with assessment of the
customers for selling to them on credit. The assessment of customer is made keeping in due
the possible bad debt risk and possible delay in getting payment. If a customer is financially
week and no payment is anticipated then the customer has significant bad debt risk and the
same to that customer should be avoided.
Similarly potentially late or difficult customer may be given small amount credit. Sale to such
customers should be in small quantity involving small payment. If it is possible to have price
discrimination, goods and services may be sold to such customers at higher prices or on
stricter credit terms.

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Request for supply of goods/services on credit generally come from customers. Such
customers provide information and trade references to support their credit worthiness but
such information mayn’t be adequate and such credit references mayn’t reveal much needed
information. It is therefore desirable to collect and analyze detailed financial and non-
financial information. The major sources of information are trade references, bank references,
credit agencies, personal interviews and marketing executive’s contracts.

A firm’s credit selection activity involves deciding whether to extend credit to a customer
and how much credit to extend. Appropriate sources of credit information and methods of
credit analysis must be developed.

The five C’s of Credit

A firm’s credit analysts often use the five C’s of credit to focus their analysis on the key
dimensions of an applicant’s creditworthiness.
1. Character: 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.
2. Capacity: the applicant’s ability to repay the requested credit. Financial statement
analysis with particular emphasis on liquidity and debt ratio is typically used to assess
the applicant’s capacity.
3. Capital: the financial strength of the applicant as reflected by its ownership position.
Analysis of the applicant’s debt relative to equity and its profitability ratios are
frequently used to assess its capital.
4. Collateral: the amount of assets the applicant has available for use in securing the
credit. The larger the amount of available assets, the greater the chance that a firm
will recover its funds if the applicant defaults. A review of the applicant’s balance
sheet, asset value appraisals, and any legal claims filed against the applicant’s assets
can be used to evaluate its collateral.
5. Conditions: the 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 item 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.

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B. Financing investment in receivables: - When the payment is received from debtors the
amount of receivable is reduced and funds are available for working capital purposes. If
debtors settled their dues, taking short period credits the amount of receivables will be very
much less in relation to the sales volume. A firm should try to minimize the amount of
receivables, but such an effort shouldn’t adversely affect sales and profit. One of objectives
of minimizing the investment in receivables is to reduce the need for arranging additional
fund for working capital purposes. Generally large amount of receivables cost paucity of
liquid resources for persuading current operations. Quick collection of dues reduces the
average amount of investment in receivables. Quick collection is an action for financing the
investment in receivables.

Receivables, billing current asset are generally financed by short term sources. The principal
source is short term borrowing from banks.
An important factor, which significantly affects the financing of investment in receivables, is
inflation. During the inflationary periods a firm decide incurring normal cost of maintaining
receivables, also loses some part of the money i.e., the firm receipts money having less value
than at the time of sales. For example, if a firm sales goods at the value of 100,000 birr, if the
rate of inflation is 20% per annum and if the credit period extends to one year, the real value
of the money the firm receives will be only 80,000.

The finance manager should pay special attention to slow moving accounts and take steps to
collect the amount blocked up. A higher rate of discount may be offered as incentive to
induce the slow paying customer. Another step could be charging an additional interest as a
hedge against inflation.
4. Administration and Control of Credit Policy
The central purpose of administration and control is to insure that the credit policy lay
down and adopted are being followed. The function of administration and control of
accounts receivable includes the following: -
A. Formulating and implementing collection policies and collection procedures
B. Developing and adopting a management information system for account
receivables.

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 A. Formulating and implementing collection policies and procedure:
It is important to know that “The overall collection of the firm is determined by the
combination of collection procedures it adopts, i.e., the collection policy”. Collection
policy should aim at:
I. Reducing the proportion of bad debt losses
II. Shortening the average collection period
Adoption of a collection policy depends upon the trade-off between costs and benefits. A cost
is equal to expenditure on collection. Benefits equal to reduction in bad debt losses and
reduction in receivables.
As long as the benefits exceed the costs of adoption of a collection policy it should be
presumed.
Example A firm wants to evaluate the two collection policy B and C against the present
policy A
A B C
Collection expense 58,000 74,000 100,000
Average collection period 30 days 24 15
Bad debt losses (% age) 1.5 1 0.5
The present sale amount is Br. 2,400,000 it is estimated that the sales volume will not change
with any of the three collection policies. The required rate of return on investment is 20 %
before taxes.
Solution

sales
Sales
Average receivables = Turnoverofreceivable = day sin yearACP
2 , 400 ,000
360
A= 30 = 200,000
2 , 400 ,000
360
B= 24 = 160,000
2 , 400 ,000
360
C= 15 = 100,000

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 Bad debts
A = 2,400,000 x 0.015 = 36,000
B = 2,400,000 x 0.01 = 24,000
C= 2,400,000 x 0.005 = 12,000
Evaluation of policies
A B C
1) Average receivables 200,000 160,000 100,000
2) Reduction in receivables - 40,000 100,000
A: return on reduction of receivables (20%) 8,000 20,000
3). Bad debt losses 36,000 24,000 12,000
B. Reduction in bad debt losses - 12,000 24,000
C. Opportunity saving (additional benefit) 20,000 44,000
(A + B)
D. Additional collection expense 16,000 42,000
Net benefit (C – D) 4000 2,000
1. Additional benefit exceed additional cost on both policy B and C
2. However the additional net benefit in policy B is more than in policy C. Therefore
policy B should be selected.
Note that it is assumed in the above problem that the sales aren’t affected by change in credit
policy but it mayn’t be true in practice. If collection policy is made streakiest some of the
customers are likely irritated. Irritated customer may reduce their purchases. Hence change in
sales should also be considered.
Collection procedures refer to the action which is taken up when customer delay the
payments. This actions may includes
1. Letters to remind the customers
2. Telephone calls
3. Personal visit by firm’s collection personnel
4. Legal notices to the customers
5. Deputing outside collection agency that collect dues on behalf of the firm and charges
fees for its services.
A. Management Information System for Receivables
A firm should have adequate information system for administration and control of investment
in accounts receivable. Following are some of the consequences of not having adequate
information.

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 1. Overdue account may be neglected
2. A customer may get credit facilities for large amount than the amount fixed for him.
To have a proper control for the above, a firm should prepare and analysis the following
important information records
1. Summary analysis of selected ratios
2. Age profile of outstanding accounts
1. Summary analysis of selected ratio
The main control ratios are receivable turnover ratio and average collection period. These
ratios should be compared with previous period. Standard may be set and actual figures of
this ratios should be compared.
Example – If a standard credit days is 40 days. If the actual is 60 days there is warning signal
for investigation.
2. Age profile of outstanding accounts
This is prepared in statement form as follows.
Period No. of Amount % of total Analysis as
(No. of days) accounts (Birr) no. of accounts % of total amount
0-30 300 100,000 55.5 50
31-40 100 40,000 18.5 20
41-50 80 25,000 14.8 12.5
51-60 30 20,000 5.6 10
61-70 20 10,000 3.7 5
71-80 10 5,000 1.9 2.5
540 200,000 100% 100%
With this analysis of age profile of account receivable management can take actions about the
receivables, which are outstanding beyond the average credit period or beyond the standard
credit period.

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