FAQ

Q.1. Why do firms provide credit?

The business organization is interested in providing credit as attractive credit terms
might enable the firm to increase sales turnover. Credit sales could attract more
customers for the firm, which could lead to higher sales, higher market share & growth
of the firm. Increased sales turnover, in turn, can bring in more profits, further, at times,
firms also charge higher price if the sales are on credit, rather than, credit terms.
Extending credit is now practically an industry norm, particularly after the markets have
moved from sellers’ market to buyers’ market and credit is now emerged as a
competitive tool.

Q.2. What are the costs & risks involved in granting credit?
However, granting credit also involves certain costs & risks.
firstly, the funds are tied up in receivables, resulting in higher cost of selling.
Secondly, credit sales can lead to increased administrative expenses for record
keeping, follow-up & recovery of the dues.
Thirdly, there could also be additional costs due to the likelihood of increased bad
debts.
Receivables management, therefore, becomes important, both from the business point
of view as well as from the liquidity, profitability & sustainability perspective.

Q.3. Discuss receivables management

Receivable management is concerned with the trade-off between the profits from
increased sales generated by credit policies and the costs of such policies.

Account receivables management refers to the set of policies, procedures, and

practices employed by a company with respect to managing sales offered on credit.
It encompasses the evaluation of client credit worthiness and risk, establishing sales
terms and credit policies, and designing an appropriate receivables collection process.
Accounts receivables are found on the balance sheet of a company, and are considered
a short-term or current asset.
They are one of the backbones of sales-generation, and thus must be managed to
ensure they are eventually translated into cash-flows.

Q.4. What are the main functions of accounts-receivable management?

The main functions of accounts-receivable management are:
(1) the establishment of an overall credit policy(ies);
(2) credit evaluation /the application of the policy to individual customers; and
(3) the administration and control of the credit policy.

Q.5. Explain credit policy:

When a firm extends credit, its resources are blocked. It is therefore imperative to have
a suitable & effective credit policy to control the total funds in the receivables.
The managerial decision involved is whether to extend credit or not, if yes, how much &
for how long. This is what credit policy would be about.
If a firm has to manage receivables, it must put in place credit policy which would
determine the conditions that the customer must meet (credit standards) & the terms &
conditions on which the credit would be extended.
The important aspect of credit policy decision would be to balance the benefits of
additional or higher sales against the cost of increasing bad debts.

Q.6. Explain credit evaluation:

Credit evaluation involves determining what type of customers should be extended
credit to.
Credit evaluation can be undertaken based on information like bank reference, credit
agency report, publications or published reports credit scores. This information should
not only be collected but analyzed to be able to arrive at meaningful decisions.
Q.7. Explain the control & monitoring aspects & methods of receivables
management.
While having credit policy & information about the customer is good, none of these
would serve much of a purpose by itself.
Effective implementation & monitoring is a must.
A suitable receivable supervision system should be put in place. It would stipulate
procedure and periodicity as regards reminders, follow-up and realization of the
receivables. It would be advisable to have an upper limit or cap on the credit limit,
customer-wise.
One of the traditional methods that can be used for monitoring receivables is the
“average collection period”.
Average collection period can be stated as acp = (debtors x 360) / credit sales
The average collection calculated, using the formula, is compared with the firm’s stated
credit period to assess the efficiency of collection of receivables. The average collection
period measures the quality of receivables since it indicates the speed of collectability or
realsation of receivables.
An extended collection period impacts cash flow adversely, delays it & impairs the firm’s
liquidity status. It also increases the probability of receivables turning bad.
Another technique is “aging schedule” or age-wise break-up of receivables. A detailed
age-wise break-up or aging schedule, giving bill-wise, date-wise, customer-wise details,
should be available on hand to track payments. It enables one to ascertain how many
bills are due for payment & how many bills receivables are overdue. Suitable recovery
could then be initiated to expedite recovery & ensure better cash flow.
Appropriate ratios like receivable turnover ratio, average collection period and exception
report should be put in place and made use of for effective realization of receivables.

One more technique that can be used is the “collection experience matrix”. This method
or technique enables us to see the credit sales, it also gives us input about the credit
sales or receivables outstanding vis-a-vis sales. It enables us to view and evaluate the
receivables in broader context.
Q.8. Explain in detail “factoring”
Now a days, apart from the techniques of average collection method, aging schedule 7
collection experience matrix, yet another method has started catching up, which is
known as “factoring”.
While credit sales are easy, recovery is not so easy. Delayed or derailed recovery of
receivables could lead to distorted financials and liquidity problems.
Factoring has therefore emerged as a popular mechanism for managing, financing &
collecting receivables.
Factoring provides both financial as well as management support to the client.
As stated by m. Westlake, it is a method of converting a non-productive, non-
performing, inactive- at times defunct- asset (overdue receivables) into productive,
performing asset (cash) by selling receivables to an agency or company that has
specialized knowledge in receivable collection & administration.
Factoring provides short-term financial accommodation the its clients. Factoring can be
classified into four broad categories viz.
1. Full service non-recourse.
2. Full service recourse factoring.
3. Bulk / agency factoring, &,
4. Non-notification factoring.
Factoring being a receivable collection service, is not free and has two costs viz.
Factoring commission or service fees & interest on advance granted by the factor to
the client firm.
Notwithstanding these costs, factoring is getting popular as factoring provides
specialised service in managing credit sales and helps the firm focus upon its
manufacturing and / or marketing functions.
Factoring also helps the firm save costs of credit administration due to economies of
scale and specialisation.

Q.9. What other factors need to be considered in receivables management?

(i) the need to create demand for stock that may otherwise become obsolete, e.g.
Fashion goods.
(2) if the customers are in abnormal cyclical industrial downswing but the long-term
potential appears good, then the firm may allow extended credit periods in order to help
out valuable customers over short-term liquidity crises.
(3) generous credit terms may be given as part of a promotional campaign relating to
new or existing products.
(4) more generous credit terms may be given during off-season times so as to generate
more consistent sales. This will allow more continuous production runs and/or reduce
the level of finished inventories.
(5) competitive pressures may force a firm to revise its policies.

Q. 10. Discuss creditworthiness of the customer

Investigations of the creditworthiness of a customer can be made by obtaining
references and reports from various institutions (with the agreement ofthe debtor) and
from independent agencies (without the consent ofthe debtor) such as trade references,
bank references, credit agencies and human judgement.
A major method of assessing a customer's creditworthiness is to examine the financial
statements of that customer - for corporate and business organisations; private
customers cannot, of course, be appraised in this way. This largely involves the use of
solvency and performance ratios, trends of ratios and forecasting of future profitability.

Q. 11. Why do companies offer sales on credit?

The majority of enterprises offer their clients the opportunity to purchases their goods
and services on credit. When designed appropriately, such an arrangement can be
mutually beneficial for both the firm and their clients.
Companies can ramp up their sales in a given quarter, move inventories, and ensure
stable operating cycles. On the other hand, clients can access company inventories
while deferring payments, allowing them to manage their cash flows as they deem is
best for their own operational cycle.
Q.12. How could the credit-worthiness and risk be assessed?
Prior to engaging in a sales credit agreement with a client, a company typically conducts
an analysis of client creditworthiness and short-term liquidity.
Payment history, financial statements, and general economic conditions are all
scrutinized.
Particular attention is paid to the customer’s liabilities (short and long-term) which
impacts ability to meet obligations.
Furthermore, third-parties that furnish credit-risk analysis and reports such (such as dun
and Bradstreet) are typically consulted, and in some cases completely outsourced.

Q.13. Dow to design the sales and credit terms?

Depending on the assessment of the client’s creditworthiness and credit risk profile, the
ensuing step entails extending the actual terms of sales on credit. For example, the
term 5/10 net 30 is a sale on credit policy allowing the client to pay the net purchase
amount 30 days after the billing invoice date.
The client is also offered a 5% discount on the net purchase amount should the
payment obligation be satisfied within 10 days of the invoice date.
Companies must critically balance the benefits of extending favorable terms to clients
(e.g. Offering lengthy terms) with their cash flow needs and working capital
requirements.
While enticing clients with a lengthy term increases revenues, this also means that
receivables will be tied up longer, and cash receipts delayed.
Moreover, the risk of receivables becoming uncollectable increases the longer they are
outstanding.

Q.14. Illustrate the collections process

In most cases, the payment collections process is rather simple.
Using their respective banks, customers will send payments to meet their obligations
and the sales terms.
The a/r department is responsible for keeping abreast of all communication,
documentations, bookkeeping, and pertinent matters concerning collecting payments.
Upon receiving payments, companies perform an accounting journal entry, whereby the
account receivables account is credited (reduced) and cash is debited (increased).

Q.15. Explain the “delinquent accounts”

In the event of non-payment, the use of collections agencies (or the company’s own
department) can be effective in recuperating all or a portion of the bad debts.
Most companies create a specific account to deal with delinquent accounts, commonly
referred to in the industry as allowances for doubtful accounts or bad debt accounts (a
contra-account to accounts receivables).
By examining historical delinquent accounts and their patterns, management usually
forecasts bad debt (typically as a percentage of sales), and take that into consideration
when managing their sales and receivables.

Q.16. How to undertake performance evaluation of accounts receivables

management?
Employing best-practices in receivables management can yield good results with
respect to revenue and cash-flow generation, working capital, liquidity, and stable
operating cycles.
Using certain financial ratios can help in evaluating a company’s receivables policies
and practices.
1. Aging receivables analysis
This report tabulates the total amount of receivables outstanding for each client, as well
as their duration. When aggregated, it is a useful assessment of receivables’ credit risk
and collectability, and pinpoints financially problematic clients.
2. Receivables turnover ratio
Measures the average number of times receivables are collected during a period. A
high ratio is congruent with efficient receivables management, and could indicate that
the company’s credit and collection policies are sound.
3. Days in sales outstanding
A ratio that measures the average length of time required to convert receivables into
cash receipts. Low ratios can indicate good receivables management and collection
policies since the company is translating its receivables into cash efficiently.
4. Cash conversion cycle
Measuring the average amount of time (days) to transform inventory purchases into
cash receipts. Specifically, it measures the average time inventory is stored, receivables
collected, and suppliers paid all in one cycle. Low cccs are supportive of healthy cash
flows and liquidity. Management can use it to assess how efficient their receivables
management is in supporting a low ccc
5. Net working capital (nwc)
Receivables can comprise a major part of working capital levels. Assessing how
receivables management affects nwc levels can help in good liquidity management,
6. Current and quick ratio
Two other liquidity measures, the current and quick ratio is an excellent trend-analysis
tool that can serve to raise warning or red flags with respect to receivables
management.