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Lec 4

accounts receivable

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7 views

Lec 4

accounts receivable

Uploaded by

pal 8311
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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-Credit Management

Lecture 04
Accounts Receivable

• Credit and Collection Policies


• Analyzing the Credit Applicant
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
Credit Standards
Credit Standards – The minimum quality of credit
worthiness of a credit applicant that is acceptable to the
firm.
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.
Credit Standards
Costs arising from relaxing credit standards
• A larger credit department
• Additional clerical work
• Servicing additional accounts
• Bad-debt losses
• Opportunity costs
Credit Management: Key Issues
• Granting credit increases sales
• Costs of granting credit
• Chance that customers won’t pay
• Financing receivables
• Credit management examines the trade-off between
increased sales and the costs of granting credit

21-6
Credit and Collection Policies of the
Firm
Quality of Length of
Trade Account Credit Period

Lec 05:SM
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program 7
Components of Credit Policy
• Terms of sale
• Credit period
• Cash discount and discount period
• Type of credit instrument
• Credit analysis – distinguishing between “good” customers
that will pay and “bad” customers that will default
• Collection policy – effort expended on collecting
receivables 21-8
The Cash Flows from Granting Credit

Credit Sale Check Mailed Check Deposited Cash Available

Cash Collection

Accounts Receivable

21-9
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.
Terms of Sale
• Basic Form: 2/10 net 45
• 2% discount if paid in 10 days
• Total amount due in 45 days if discount not taken
• Buy $500 worth of merchandise with the credit terms
given above
• Pay $500(1 - .02) = $490 if you pay in 10 days
• Pay $500 if you pay in 45 days
21-11
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.
• Additional annual credit sales of $250,000 from new customers
are forecasted, in addition to the current $2 million in annual
credit sales.
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-debt losses that may arise,


should Basket Wonders relax their credit period?
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
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

Yes! Profits > Required pre-tax return


Credit Policy Effects
• Revenue Effects
• Delay in receiving cash from sales
• May be able to increase price
• May increase total sales
• Cost Effects
• Cost of the sale is still incurred even though the cash from the sale has
not been received
• Cost of debt – must finance receivables
• Probability of nonpayment – some percentage of customers will not pay
for products purchased
• Cash discount – some customers will pay early and pay less than the full 21-16
sales price
Collection Policy and Procedures
The firm should increase collection
A firm has to incur some routine expenditures until the marginal
costs like sending reminders, reduction in bad-debt losses equals the
telephone expenses, expenses marginal outlay to collect.
incurred for personal visits to
customers’ places, commission and

Bad-Debt Losses
fees payable to collection agencies,
legal expenses etc.
If the firm goes on increasing the Saturation
Point
cost of collection of debts, after-
some point, there would not be
further decrease of bad debts. The
point is called ‘saturation point’ Collection Expenditures
Analyzing the Credit Applicant

• Obtaining information on the credit


applicant
• Analyzing this information to determine the
applicant’s creditworthiness
• Making the credit decision
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
Five Cs of Credit
• Character – willingness to meet financial obligations
• Capacity – ability to meet financial obligations out of
operating cash flows
• Capital – financial reserves
• Collateral – assets pledged as security
• Conditions – general economic conditions related to
customer’s business
21-20
Credit Analysis
A credit analyst is likely to utilize
information 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
Other Credit Decision Issues
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.
Total Cost of Granting Credit
• Carrying costs
• Required return on receivables
• Losses from bad debts
• Costs of managing credit and collections
• Shortage costs
• Lost sales due to a restrictive credit policy
• Total cost curve
• Sum of carrying costs and shortage costs
• Optimal credit policy is where the total cost curve is minimized
21-23
21-24

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