Unit 3

Receivables management

What are Receivables?

Account receivables refer to the outstanding invoices or money which is yet to be

paid by your customers. Until it is paid, such invoices or money is accounted
as accounts receivables. Also known as bills receivables. You need cash all the
time to keep your business running smoothly and ensuring the accounts receivables
are paid on time is essential to manage cash flow efficiently.

According to Hampton, ‘Receivables’ are asset accounts representing the amount

owned to the firm as a result of sale of goods or services in ordinary course of
business.

MEANING OF RECEIVABLES MANAGEMENT

Management of receivables refers to planning and controlling of ‘debt’ owed to the

firm from customer on account of credit sales. It is also known as trade credit
Management.

The process of taking decisions regarding the investment in the trade debtors is
known as receivables management.

The basic objective of management of receivables (debtors) is to optimise the

Return on investment on these assets.

Large amounts are tied up in receivables, there are chances of bad debts and there
will Be cost of collection of debts. On the contrary, if the investment in receivables
is low, the sales may be restricted, since the competitors may offer more liberal
terms.

Therefore, management of receivables is an important issue and requires proper

policies and their implementation.

Objectives of receivable management

Even though management of receivables seems to be simple, but it could become a

very tedious task to manage, depending on the nature of your business. As your
business grows, your processes also evolve and become more and more complex,
thus, the accounting software to manage your receivables must mould itself to
match up to your company standards and needs. Now to run a business
successfully, what is that one thing that you need? Money! Right? So, to keep your
cash inflow at its optimum, it is crucial that you keep a close watch your
receivables. Thus, below are some of the primary objectives to receivables
management:

Helps improve cash flow

It is obvious that sound receivable management will help business owners keep
their cash inflow steady. This process will give you a clear picture of where your
cash is stuck while maintaining a systematic record of all sales transactions. It
ensures that you have a sufficient amount of cash to take care of your everyday
transactions, and you do not give credit facilities over and above your credit
policies or credit limit.

Reduces losses incurred due to bad debts

Blocked cash means lack of funds to conduct your everyday activities. No business
would want to face any kind of losses. If receivables aren’t managed efficiently,
they would result in bad debts ultimately resulting in losses. Receivable
management will let you keep a close track on the payment schedule so that you
can regularly follow up with your debtors and maintain optimum levels of cash
flow.

Improved customer satisfaction

Since receivables management also keeps a track of your buyers and their payment
performance, you can improve your relationship with your customers by giving
them discounts and offers for maintaining a steady payment record. This also helps
increase transparency between your business and your customers, thus building a
stronger bond with a lasting relationship.

Boost up sales volume

Receivable management helps increase sales resulting in increased profitability.

Businesses can extend credit facilities to their customers which will help them
boost their sales volume, as more customers would avail this facility by purchasing
products on a credit basis.
Importance & benefits of receivable management

Management of receivables refers to planning and controlling of debt owed to the

customer on account of credit sales. In simple words, the successful closure of
your order to sales is determined only when you convert your sales into cash. Till
your sales are converted into cash, you need to manage ‘how much you need to
receive? from whom? And when?

To do this, you need accounts receivables management, popularly known as a

credit management system in place.

Another reason, accounts receivables are one of the key sources of cash inflow and
given the volume of credit sales, a large amount of money gets tied-up in accounts
receivables. This simply implies that so much of money is not available till it is
paid. If these are not managed efficiently, it has a direct impact on the working
capital of the business and potentially hampers the growth of the business.

COST OF RECEIVABLES

1.Cost of financing :
The credit sales delays the time of sales realization & therefore the time gap
between incurring the cost & the sales realization is extended . This results in
blocking of funds for a longer period. The firm on the other hand , has to arrange
funds to meet its own obligations towards payment to the supplier, employees etc.,
These funds are to be procured at some explicit or implicit cost . This is known as
cost of financing the receivables.

2.Administrative cost:
A firm will also required to incur various costs in order to maintain the record of
credit customers both before the credit sales as well as after the credit sales

3. Delinquency Cost :
The firm have to incur additional costs known as delinquency costs, if there is
delay in the payment by a customer. The firm may have to incur cost on reminders,
phone calls , postages, legal notices etc. There is always an opportunity cost of the
funds tied up in the receivables due to delay in payment.
4.Cost of default by the Customer:
If there is a default by the customer & the receivables becomes partly or wholly,
unrealizable, then this amount is known as bad debt, also becomes cost to the firm.
This cost does not appear in case of cash sales.

BENEFITS OF LIBERAL ACCOUNT RECEIVABLES POLICY

1. Increase in sales:
Most of the firms sell goods on credit, either because of trade customs or other
conditions. The sales can be further increased by liberalizing the credit terms. This
will attract more customers to the firm resulting in higher sales & growth of the
firm.

2. Increase in profits:
Increase in sales help the firm in
a) to easily recover the fixed expenses & attaining the break-even level.
b) Increase the operating profit of the firm.

3. Extra profit:
Sometimes, the firm makes the credit sales higher than the usual cash selling price.
This brings an opportunity to the firm to make extra profit over & above the
normal profit.

4. Customer Loyualty:

A liberal credit policy has the advantage of building customer loyalty, since the
firm believes that they trust their customers to make their payments. A further
factor in creating loyal customers is the convenience of ordering without having to
make the payment first. Thus, Credit sales helps to retain the existing customers
and alongside to attract the new customers.

Factors Affecting the size of receivables:

The role which receivables play in the total financial picture directly or indirectly
affected by the following important factors:

1. Size of credit sales - Size of credit sale is the prime factor that affects the
level of investment in receivables. Investment in receivables increases when
 the firm sells a major portion of goods on credit base and vice versa. In other
words, increase in credit sales increases the level of receivables and vice
versa.

2. Credit policies - There are two types of credit policies such as lenient and
stringent credit policy. A firm that is following a lenient credit policy tends
to sell on credit to customers very liberally, which will increase the size of
receivables, on the other hand, a firm that follows a stringent credit policy
will have a low size of receivables, because, the firm is very selective in
providing stringent credit. A firm that provides stringent credit may be able
to collect debts promptly, this will keep the level of receivables under
control.

3. Terms of trade - It is the most important factor (variable) in determining the

level of investment in receivables. The important credit terms are credit
period and cash discount. If credit period is more when compared to other
companies/industry, then the investment in receivables will be more. Cash
discount reduces the investment in receivables because it encourages early
payments.

4. Credit collection policies - Collection policy is needed because all

customers do not pay the firm’s bills on time. A firm’s liberal collection
policy will not be able to reduce investment in receivables, but in future
sales may be increased. On the other hand, a firm that follows a stringent
collection policy will definitely reduce its receivables, thus reducing future
sales. Therefore, the collection policy should aim at accelerating collections
from slow payers and reducing bad debt losses.

5. Expansion plans – Expansion of credit plan usually stimulate the volume

of credit sales and attracting more customers. Expansion of credit facilities
likely to increase the working capital investment in receivables.

6. Habits of customer – Paying habits of customers is one of the factors also

influence the size of receivables. There are certain type of customers who
consistently pay their debt promptly, some other customers may be delaying
payment though they are financially sound. In such a situation the firm
 should maintain cordial relations with the customers and encourage them to
timely discharge their obligations.

7. Operating efficiency – Establishment of credit department and its function

of operating efficiency in billing , record keeping, inspecting the
creditworthiness of customers, reminder or follow up letter etc are the
important aspect of determination of size of receivables

8. Size of Market - size of receivables are closely associated with the firm to
explore a new market for its product or services. More liberal extension of
credit, a firm can easily enter into a new market by attracting new customers.
This factor will make the firms to arrange additional size of receivables.

Different Dimensions of Receivables Management :

I. Formulation of credit policies:

The discharge of the credit function in a company embraces a number of activities

for which the policies have to be clearly laid down. Such a step will ensure
consistency in credit decisions and actions. A credit policy thus, establishes
guidelines that govern grant or reject credit to a customer, what should be the level
of credit granted to a customer etc. A credit policy can be said to have a direct
effect on the volume of investment a company desires to make in receivables.

A company falls prey of many factors pertaining to its credit policy. In addition to
specific industrial attributes like the trend of industry, pattern of demand, pace of
technology changes, factors like financial strength of a company, marketing
organization, growth of its product etc. also influence the credit policy of an
enterprise. Certain considerations demand greater attention while formulating the
credit policy like a product of lower price should be sold to customer bearing
greater credit risk. Credit of smaller amounts results, in greater turnover of credit
collection. New customers should be least favored for large credit sales. The profit
margin of a company has direct relationship with the degree or risk. They are said
to be inter-woven. Since, every increase in profit margin would be counterbalanced
by increase in the element of risk.
Credit policy of every company is at large influenced by two conflicting objectives
irrespective of the native and type of company. They are liquidity and profitability.
Liquidity can be directly linked to book debts. Liquidity position of a firm can be
easily improved without affecting profitability by reducing the duration of the
period for which the credit is granted and further by collecting the realized value of
receivables as soon as they falls due. To improve profitability one can resort to
lenient credit policy as a booster of sales, but the implications are:

• Changes of extending credit to those with weak credit rating.

• Unduly long credit terms.
• Tendency to expand credit to suit customer’s needs; and
• Lack of attention to over dues accounts.

Setting a Credit Policy

To establish a credit policy, a company must establish credit terms, credit

standards and a collection policy.

1. Credit Terms

Credit terms refer to the stipulations recognized by the firms for making credit sale
of the goods to its buyers. In other words, credit terms literally mean the terms of
payments of the receivables. A firm is required to consider various aspects of
credit customers, approval of credit period, acceptance of sales discounts,
provisions regarding the instruments of security for credit to be accepted are
a few considerations which need due care and attention like the selection of
credit customers can be made on the basis of firms, capacity to absorb the bad
debt losses during a given period of time. However, a firm may opt for
determining the credit terms in accordance with the established practices in the
light of its needs. The amount of funds tied up in the receivables is directly related
to the limits of credit granted to customers. These limits should never be
ascertained on the basis of the subjects own requirements, they should be based
upon the debt paying power of customers and his ledger record of the orders and
payments. There are two important components of credit terms which are detailed
below:

1. Credit period: The credit period lays its multi-faced effect on many aspects
the volume of investment in receivables; its indirect influence can be seen on
the net worth of the company. A long period credit term may boost sales but
it‘s also increase investment in receivables and lowers the quality of trade
 credit. While determining a credit period a company is bound to take into
consideration various factors like buyer’s rate of stock turnover, competitors
approach, the nature of commodity, margin of profit and availability of
funds etc. The period of credit diners form industry to industry. In practice,
the firms of same industry grant varied credit period to different individuals.
as most of such firms decide upon the period of credit to be allowed to a
customer on the basis of his financial position in addition to the nature of
commodity, quality involved in transaction, the difference in the economic
status of customer that may considerably influence the credit period. The
general way of expressing credit period of a firm is to coin it in terms of net
date that is, if a firm’s credit terms are “Net 30”, it means that the customer
is expected to repay his credit obligation within 30 days. Generally, a free
credit period granted, to pay for the goods purchased on accounts tends to be
tailored in relation to the period required for the business and in turn, to
resale the goods and to collect payments for them. A firm may tighten its
credit period if it confronts fault cases too often and fears occurrence of bad
debt losses. On the other side, it may lengthen the credit period for
enhancing operating profit through sales expansion. Anyhow, the net
operating profit would increase only if the cost of extending credit period
will be less than the incremental operating profit. But the increase in sales
alone with extended credit period would increase the investment in
receivables too because of the following two reasons: (i) Incremental sales
result into incremental receivables, and (ii) The average collection period
will get extended, as the customers will be granted more time to repay credit
obligation.
2. Cash Discount Terms: The cash discount is granted by the firm to its
debtors, in order to induce them to make the payment earlier than the expiry
of credit period allowed to them. Granting discount means reduction in
prices entitled to the debtors so as to encourage them for early payment
before the time stipulated to the i.e. the credit period. Grant of cash discount
beneficial to the debtor is profitable to the creditor as well. A customer of
the firm i.e. debtor would be realized from his obligation to pay Soon that
too at discounted prices. On the other hand, it increases the turnover rate of
working capital and enables the creditor firm to operate a greater volume of
working capital. It also prevents debtors from using trade credit as a source
of working capital. Cash discount is expressed as a percentage of sales. A
cash discount term is accompanied by (a) the rate of cash discount, (b)
the cash discount period, and (c) the net credit period. For instance, a
credit term may be given as “1/10 Net 30” that mean a debtor is granted 1
percent discount if settles his accounts with the creditor before the tenth day
 starting from a day after the date of invoice. But in case the debtor does not
opt for discount he is bound to terminate his obligation within the credit
period of thirty days.

Change in cash discount can either have positive or negative implication and
at times both. Any increase in cash discount would directly increase the
volume of credits sale. As the cash discount reduces the price of commodity
for sale. So, the demand for the product ultimately increase leading to more
sales. On the other hand, cash discount lures the debtors for prompt payment
so that they can relish the discount facility available to them. This in turn
reduces the average collection period and bad debt expenses thereby,
bringing about a decline in the level of investment in receivables. Ultimately
the profits would increase. Increase in discount rate can negatively affect the
profit margin per unit of sale due to reduction of prices. A situation exactly
reverse of the one stated above will occur in case of decline in cash discount.

2. Credit Standards

Credit standards refers to the minimum criteria adopted by a firm for the purpose
of short listing its customers for extension of credit during a period of time. The
nature of credit standard followed by a firm can be directly linked to changes in
sales and receivables. A liberal credit standard always tends to push up the sales by
luring customers into dealings. The firm, as a consequence would have to expand
receivables investment along with sustaining costs of administering credit and bad-
debt losses. As a more liberal extension of credit may cause certain customers
to the less consciousnes in paying their bills on time. Contrary, to these strict
credit standards would mean extending credit to financially sound customers
only. This saves the firm from bad debt losses and the firm has to spend lesser
by a way of administrative credit cost. But, this reduces investment in
receivables besides depressing sales. In this way profit sacrificed by the firm on
account of losing sales amounts more than the cost saved by the firm. Prudently, a
firm should opt for lowering its credit standard only up to that level where
profitability arising through expansion in sales exceeds the various costs associated
with it. That way, optimum credit standards can be determined and maintained by
inducing trade-off between incremental returns and incremental costs.

3. Collection Policy

Collection policy refers to the procedures adopted by a firm (creditor) collect the
amount of from its debtors when such amount becomes due after the expiry of
credit period. The requirements of collection policy arises on account of the
defaulters i.e. the customers not making the payments of receivables in time. As a
few turnouts to be slow payers and some other non-payers. A collection policy
shall be formulated with a whole and sole aim of accelerating collection from bad-
debt losses by ensuring prompt and regular collections. Regular collection on one
hand indicates collection efficiency through control of bad debts and collection
costs as well as by inducing velocity to working capital turnover. On the other
hand it keeps debtors alert in respect of prompt payments of their dues. A credit
policy is needed to be framed in context of various considerations like short-term
operations, determinations of level of authority, control procedures etc. Credit
policy of an enterprise shall be reviewed and evaluated periodically and if
necessary amendments shall be made to suit the changing requirements of the
business. It should be designed in such a way that it co-ordinates activities of
concerns departments to achieve the overall objective of the business enterprises.
Finally, poor implementation of good credit policy will not produce optimal
results.

To conclude, the credit policy of a company should be developed in accord with

the strategic, marketing, financial and organisational context of the business and be
designed to contribute to the achievement of corporate objectives. The corporate
strategy can include trade credit management not just in terms of its contribution to
collection and cash flow but as a means of generating sales and profits, and of
investing in customers by building relationships. The management of trade credit
can help build stable and long term relationships with customers, generate
information about the customer and their requirements and facilitate different
customer strategies in terms of credit granting, credit terms and customer service.
The objective is to generate growing but profitable sales

II . Execution of credit policy:

Once credit policies have been formulated, the finance manager should execute
these policies properly. Execution of credit policies calls for evaluation of credit
applicants and financing of investment in receivables.

Evaluation of credit applicants - Mere determination of appropriate credit policy

for the firm will not help accomplish the overall objective of minimizing
investment in receivables and reducing bad debt losses unless creditworthiness of
applicants is evaluated to ensure that they conform to the credit standards
prescribed by the firm. Credit evaluation process involves three steps, viz.,
gathering credit information about the credit applicants, determining the
credit-worthiness of the applicants on the basis of information so collected and
finally, taking decision to grant credit facilities.

Gathering credit information:

Before granting credit facilities to a customer, a firm must identify the sources of
information about the customer to assess clients credit worthiness. The amount of
information collected Needs to be considered in relation to the time and expenses
required.

The sources of such information are-

• Financial statements – Financial statement is one of the most desirable

sources of information for credit analysis. Audited profit and loss account
and balance sheet shows the operational efficiency of the business of the
customer.
• Bazar reports – Information about the customers can be obtained from
various market particularly from businessman carrying on the same trade.
Such bazaar reports are closely related and highly useful to assess the credit
worthiness of the customer.
• Reports of credit rating agencies: In addition to financial statements and
bazar reports, credit ratings are available from various credit reporting
agencies. These organisations provide useful and necessary authentic
information about the credit worthiness of customers.
• Reports from Banks: The banker of the customer may be requested to
highlight the credit worthiness. The analyst can obtain information such as
average cash balance carried, loan availed, Financial solvency position and
operational efficiency of a customer, etc.
• Firm’s own records: Firm’s own records highlight the accurate and specific
information about the credit standing of the customers. It indicates
promptness of past payments, reports from salesman, seasonal pattern and
past experiences with customers while provide useful information about
credit worthiness of the customer.
• Trade references : This is one of the useful sources of information
available without cost. Credit information is frequently exchanged among
companies selling to the same customer.
 • Other sources: Other sources of credit information on business firms,
especially the large ones, might be trade journals, periodicals, newspapers,
trade directories, public records such as income tax statements, wealth tax
returns, sales tax returns, reports about actions and decrees in Government
gazette, registration, revenue and municipal records.

Credit Analysis: After assembling credit information about the potential

customer, the finance manager analyses these information’s to evaluate
creditworthiness of the customer and to determine whether he satisfies the standard
of acceptability or not. Such an analysis is known as credit analysis. Thus, credit
analysis involves the credit investigation of potential customer to determine the
degree of risk associated with the account.

For that matter, capacity of the applicant to borrow and his ability and willingness
to repay the debt in accordance with the terms of the agreement must be studied.
Analysis of credit-worthiness of the applicant, therefore, calls for detailed study of
five C’s, viz., credit character, capacity, capital, collateral and conditions.

‘Credit character’ refers to reputation of the applicant in meeting obligations of the

company upon maturity. Credit character is a relative matter. It is not difficult for a
person to be honest and have willingness to repay his obligations when income is
high, business is good and profits are plentiful. Hard times with their poor business
and low profits are the real test of credit character.

‘Capacity’ measures the ability of the ‘potential customer’ to utilise the loan
effectively and profitably. This is very important variable of credit analysis as the
customer’s ability to repay is essentially dependent upon his earning capacity.

‘Capital’ represents the general financial position of the customer’s firm with
special emphasis on tangible net worth and profitability (which indicates ability to
generate funds for debt repayment). The net worth figure in the business enterprise
is the key factor that governs the amount of credit that would be made available to
the customer.

“Collateral’ is represented by assets which may be offered as pledge against credit

extension. Collateral, thus, serves as a cushion or shock absorber if one or several
of the first three ‘Cs’ are insufficient to give reasonable assurance of repayment of
the loan on maturity. Collateral in the form of a pledged asset serves to compensate
for a deficiency in one or more of the first three ‘Cs.’

Finally, “condition” includes the present status of the business cycle and general
credit and business conditions throughout the country and also intensity of
competition. These together effect a potential customer’s ability to earn income
and repay the debt.

Credit decision: After determining creditworthiness of the applicant, finance

manager has to decide whether or not credit facilities should be provided to him.
For that matter, the creditworthiness of the applicant should be matched against
established credit standards. If the applicant is above or up to the standard,
naturally credit facilities would be provided otherwise not.

III Formulation of collection policy and its execution:

Collection policy:

After giving credit the next stage involved in planning of receivables is collection
policies. An efficient management of receivable calls for designing clear cut
collection policy of the firm and laid down collection procedure. These procedures
include things such as remaining of customers letter , phone calls , personal visits
and legal action. The purpose of every collection policy is to speed up the
collection of dues from slow payers after expiry of the credit period. A concern to
incur expenses on credit collection efforts. Efficient and timely collection of dues
ensures that the bad debt losses are reduced to the minimum and average collection
is short. Other things remaining the same, if the firm spends more amount on
collection efforts, the lower the proportion of bad debt losses and the shorter is the
average collection period. On the other hand, lenient collection policy would
increase in bad debt losses, increase in collection period and increase in collection
cost. Thus, a firm must workout the optimum amount that it should spend on
collection of debtors.

Steps in debt collection

The following effective steps are to be taken for ensuring minimum bad debts and
cost on collection efforts :
• Designing appropriate collection policy
• Ensuring proper system of collection of account receivables
• Organizing a collection cell to keep the amount of outstanding in check
• Send reminders including letters , phone calls , personal visits etc.
• Taking other necessary steps to collect the dues
• Fixing specific responsibility for collecting dues
• Take legal actions if necessary
• obtaining third party guarantee for settlement in case of dispute
• Organizing collection machinery to ensure the reduction of collection
expenditure.

Debtor’s Turnover Ratio:

Debtor’s turnover Ratio is also termed as Receivables turnover Ratio or Debtors

Velocity.

It indicates the number of time the receivables are turned over in business
during a particular period. In other words it indicates that how quickly the
debtors are converted into cash.

Debtor’s turnover Ratio = Net credit sales/ Average Receivables

Average collection period:

Average collection period is a technique which indicates the efficiency of the

debt collection period and the extent to which the debt have been converted into
cash.

Both the techniques are used to measure the quality of accounts receivable. It
points out the liquidity of trade debtors i.e, higher turnover Ratio and shorter
debt collection period indicate that prompt payments by debtors. Similarly, low
turnover ratio and higher collection period implies that payment by trade debtor
are delayed.

Debt collection period= Average accounts receivable × Month or days in a year

/ Net credit sales