Accounts Receivable

ACCOUNTS RECEIVABLE Trade credits creates accounts receivable or trade debtors that the firm is expected to collect in future. The customers from whom receivable or book debts have to be collected in the future are called trade debtors or debtors

CHARACTERISTICS OF CREDIT SALES • It involves an element of risk that should be carefully analyzed. • It is based on economic value. • It implies futurity.

CREDIT POLICY A Firms investment in accounts receivable depends on: a. The volume of credit sales b. The collection period Firms average investment = Daily credit sales X Average collection period Credit policy is evaluated in terms of return and costs of additional sales.

CREDIT POLICY • Credit policy refers to 1. Credit standards : Criteria to decide the types of customers to whom goods could be sold on credit. Slow paying customers will increase investment in receivable and is exposed to high default risk

CREDIT POLICY 2. Credit terms : The duration of credit and terms of payment by customers. Extended time period for making payments will increase investment in receivables. 3. Collection efforts: Determine the actual collection period. The lower the collection period, the lower the investment in accounts receivables and vice versa.

GOALS OF CREDIT POLICY • A firm following a lenient credit policy will grant credit in liberal terms and standards and grant credit to longer period and also to customers whose creditworthiness is not fully known. • A firm following a stringent credit policy sells on credit on a highly selective basis only to customers with proven creditworthiness.

CREDIT POLICY AS MARKETING TOOL Firms use credit policy as a marketing tool during expansion sales. In a declining market, it is used to maintain market share. It helps to retain old customers and to create new customers. In a growing market, it is used to increase firm’s market share. Under a highly competitive situation or recessionary economic conditions, firm loosen its credit policy to maintain sales or to minimize erosion of sales.

NECESSITY OF GRANTING CERDIT •

Companies in India grant credit for 1. Competition: Higher the degree of competition, the more the credit grant 2. Bargaining power: Higher bargaining power leads to less credit or no credit 3. Buyer’s status and requirement: Large buyers demand easy credit terms.

NECESSITY OF GRANTING CERDIT 4. Dealer relationship 5. Marketing tool 6. Industry practice & past practice 7. Transit delays: Forced reason for granting credit.

TYPES OF COST INVOLVED 1. Production and selling cost: If sales expand with in the existing production capacity there will be increase only in variable production and selling cost. If capacity is added, then the incremental production and selling costs will include both variable and fixed costs. Incremental contribution of the change in credit policy is the difference between incremental sales revenue and the incremental production and selling costs.

TYPES OF COST INVOLVED 2. Administration costs: when the firm loosens its credit policy, two types of administration costs are involved. 1. 2.

Credit investigation cost Collection costs

3. Bad debt losses.

CHANGE IN CREDIT POLICY The evaluation of change in credit policy involves analysis of Opportunity cost of lost contribution Administration costs and bad-debt losses. Credit policy will be determined by the trade-off between opportunity cost and credit administration and bad debts looses.

OPTIMUM CREDIT POLICY Optimum credit policy is one which maximizes the firm’s value. Value of firm is maximized when the incremental or marginal rate of return of an investment is equal to the incremental or marginal cost of funds used to finance the investment

MARGINAL COST- BENEFIT ANALYSIS To achieve the goal of maximization of firm’s value, the evaluation of investment in accounts receivable should involve 1. Estimation of incremental operating profit (change in contribution – additional costs) 2.

Estimation of incremental investment in accounts receivable

( Investment in accounts receivable = credit sales per day X Average collection period) 3. Estimation of the incremental rate of return of investment (Operating profit after tax / Investment in accounts receivable) 4. Comparison of the incremental rate of return with the required rate of return.

CREDIT POLICY VARIABLES 1. CREDIT STANDARDS The two aspects of quality of customers are Time taken by customers to repay credit obligation. The average collection period (ACP) determines the speed of payment by customers. The default rate: It can be measured in terms of baddebt losses ratio. The customers are categorized as good, bad and marginal accounts.

DEFAULT RISK To estimate the probability of default the following three C’s are considered. 1. Character: It refers to the customer’s willingness to pay. The manager should judge whether the customers will make honest efforts to honour their credit obligations. 2. Capacity: It refers to the customer’s ability to pay. It is judged by assessing the customer’s capital and assets offered as security. This is done by analysis of ratios and trends in firm’s cash and working capital. 3. Condition: It refers to the prevailing economic and other conditions that affect the customers’ ability to pay.

CREDIT ANALYSIS A firm can do credit analysis using 2. Numerical credit scoring models: It includes a. Adhoc approach: The attributes identified by the firm may be assigned weights depending on their importance and combined to create an overall score or index. d. Simple discriminant analysis: A firm use more objective methods of differentiating between good and bad customers.(Eg:- ratio of EBDIT to sales) e. Multiple discriminant analysis: It combines many factors according to the importance (weight) given to each factor and determine a score to differentiate customers as good and bad

CREDIT SCORING MODELS • Credit scoring models such as MDA are based on objective factors and help a firm to quickly distinguish between good and bad customers. • These models can mislead since they are based on past data.

CREDIT GRANTING DECISION Credit granting decision

No Credit

Grant Credit

Payment received

No Pay-off

Benefit PV of Future Net Cash Flow Net Payoff PV of Benefit-cost

Payment Not received Cost PV of Lost Investment

CREDIT TERMS The stipulations under which the firm sells on credit to customers are called credit terms. These include 1. Credit period: The length of time for which credit is extended to customers is called the credit period. 2. Cash discount: It is a reduction in payment offered to customers to include them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is expressed as a percentage of sales. It is a cost to the firm for faster recovery of cash.

COLLECTION POLICY

2. 3. 4. 5. 6.

Collection policy is needed to accelerate collections from slow payers and reduce bad debt losses. It should ensure prompt and regular collection. It should lay down clear cut collection procedures. The responsibility for collection and follow up should be explicitly fixed.( Accounts or sales) The firm should decide on cash discounts to be allowed for prompt payment It should be flexible

CREDIT EVALUATION For effective management of credit, clear cut guidelines and procedures for granting credit to individual customers and collecting individual accounts should be laid down. The credit evaluation procedure includes: 1. Credit information 2. Credit investigation 3. Credit limits 4. Collection procedures

CREDIT INFORMATION To ensure full and prompt collection of receivables, credit should be allowed only to customers who have the ability to pay in time. For this the firm should have credit information of customers. Collecting credit information involves cost. The cost should be less than the potential profitability. Depending on cost and time, the following sources can be employed to collect credit information

SOURCES OF CREDIT INFORMATION 1. Financial statement: One of the easiest ways to obtain information on the financial condition of the customer is to scrutinise his financial statements. (Balance sheet & P&L a/c) 2. Bank references: Bank where the customer maintains his account is another source of collecting credit information 3. Trade references: Contacting the persons or firms with whom the customer has current dealings is an useful source to obtain credit information at no cost. 4. Other sources: Credit rating organisations such as CRISIL, CARE etc

CREDIT INVESTINGATION AND ANALYSIS 2. 3. 4. 5. 6.

The factors that affect the nature and extent of credit investigation of an individual customer are: Type of customer, whether new or existing The customer’s business line, background and the related trade risks. The nature of the product- perishable or seasonal Size of the customer’s order and expected further volumes of business with him Company’s credit policies and practices.

CREDIT INVESTINGATION AND ANALYSIS 2.

3.

4.

Steps involved in credit analysis are Analysis of the credit file: A credit file updated regularly is maintained for each customer, which gives information on his trade experiences, performance report based on financial statements, credit amount etc. Analysis of financial ratios: The evaluation of the customer’s financial conditions should be done very carefully. Ratios should be calculated to determine the customer’s liquidity position, ability to repay debts etc., Analysis of business and its management: The firm should also consider the quality of management and the nature of the customer’s business. For this a management audit.

CREDIT LIMIT A credit limit is a maximum amount of credit which the firm will extend at a point of time. It indicates the extent of risk taken by the firm by supplying goods on credit to a customer. The decision on the magnitude of credit, the time limit etc depends on the amount of sales, industry norms and customer’s financial strength.

CREDIT EFFORTS The firm should follow a well defined credit policy and procedure to collect dues from customers.

MONITORING RECEIVABLE For the success of collection efforts, the firm needs to monitor and control its receivables. The methods used for evaluation are 1. Average collection period 2. Aging schedule 3. Collection Experience Matrix

Average Collection period

6. 7.

To judge the collection efficiency, the average collection period (ACP) is compared with the firm’s stated credit period. ACP = Debtor X360 Credit sales It measures the quality of receivables Limitations: It provides an average picture of collection experience and is based on aggregate data. It is susceptible to sales variations and the period over which sales and receivables have been aggregated. Thus ACP cannot provide a very meaningful information about the quality of outstanding receivable

AGING SCHEDULE It breaks down receivables according to the length of time for which they have been outstanding. It overcomes one of the limitations of aging schedule

COLLECTION EXPERIENCE MATRIX Using disaggregated data for analysing collection experience, the problem of relating outstanding receivables of a period with the credit sales of the same period is eliminated. The receivables is related to sales of the same period. Sales over a period of time are shown horizontally and associated receivables vertically, and a matrix is constructed

Sales and Receivables from July to December (Rs. In lakhs) Month July Sales Receivable July Aug Sept Oct. Nov. Dec.

Aug.

Sept. Oct.

Nov.

Dec.

400

410

370

220

205

350

330 242 80 0 0 0

320 245 76 0 0

320 210 72 0

162 120 40

160 130

285

Sales and Receivables from July to December (Rs. In lakhs) Month July Sales Receivable July Aug Sept Oct. Nov. Dec.

Aug.

Sept. Oct.

Nov.

Dec.

400

410

370

220

205

350

82.5 60.5 20.0 0 0 0

78.0 59.8 18.5 0 0

86.5 56.8 19.5 0

73.6 54.5 18.2

78.0 63.0

81.4

FACTORING Factoring is a popular mechanism of managing, financing and collecting receivables. It is assigning the credit management and collection, to specialist organisations. It is an unique financial innovation It is a method of converting non-productive inactive asset, receivables into productive asset, cash by selling receivables to a company that specialises in their collection and administration. It is a means of short-term financing

FACTORING It is a business involving a continuing legal relationship between a financial institution (the factor) a business concern (the client) selling goods or providing services to trade customers whereby the factor purchases the client’s accounts receivable and in relation thereto, controls the credit, extended to customers and administers the sales ledger.

FACTORING SERVICES The factor provides the following services. 3. Sales ledger administration and credit management 4. Credit collection and protection against default and bad-debt losses 5. Financial accommodation against the assigned book debts (receivables).

CREDIT ADMINISTRATION 2. 3. 4. 5. 6.

A factor Helps and advises the firm from the stage of deciding credit extension to customers to the final stage of book debt collection Maintains an account for all customers of all items owing to the firm Provides information about market trends, competition and customers. Makes a systematic analysis of the information regarding credit for its proper monitoring and management. Prepares reports regarding credit and collection

CREDIT COLLECTION AND PROCTECTION The factor undertakes all collection activity. Provides full or partial protection against bed-debts. Develops appropriate strategy to guard against possible defaults

FINANCIAL ASSISTANCE The factor provides financial assistance to the client by extending advance cash against book debts. The advance amount will be equal to amount of factored receivables minus 1. factoring commission 2. interest on advance 3. reserve for bad debts losses.

Types of factoring Factoring facilities can be divided into 3. Full service non-recourse(Old line factoring) 4. Full service recourse 5. Bulk/agency factoring 6. Non-notification factoring

FULL SERVICE NON-RECOURSE In this method, The book debts are purchased by the factor, assuming 100% credit risk Advances upto 80-90% of book debts to client immediately The customer pays directly to the factor This is best suited where 6. Amount involved per customer is substantial 7. There are large number of customers of whom the client cannot have personal knowledge 8. The client prefers to obtain 100% cover

FULL SERVICE RECOURSE In this method 2. The client is not protected against eh risk of bad debts. 3. It is often used as a short term financing rather than pure credit management and protection service. 4. Less risky from factor’s point of view and less expensive for the firm. 5. This method is preferred when the customers are largely spread with low amount involved or if the firm is selling to high risk customers.

BULK/AGENCY FACTORING It is basically used as a method of financing book debts. The client continues to administer credit and operate sales ledger. It is used when there is a good system of credit administration but the client need finances.

NON-NOTIFICATION FACTORING Customers are not informed about the factoring agreement. The factor keeps the accounts ledger in the name of a sales company to which the client sells his book debts.

COST AND BENEFIT OF FACTORING 2. 3.

6. 7.

Costs involved are The factoring commission or service fee The interest on advance granted by the factor to the firm. Benefits are: It provides specialised service in credit management and helps the firm’s management to concentrate on manufacturing and marketing Helps the firm to save cost of credit administration due to the scale of economics and specialisation.

A company is currently selling 1,00,000 units of its product at Rs.50 each unit. At the current level of production, the cost per unit is Rs. 45, variable cost per unit being Rs. 40. The company is current extending one month’s credit to its customers. It is thinking of extending credit period to two months in the expectation that sales will increase by 25%. If the required rate of return(Before tax) on the fim’s investment is 30%, is the new credit policy desirable?

Incremental sales unit = 25000 Contribution per unit = Rs. 50-40 = Rs.10 Incremental contribution= Rs.2,50,000 New level of receivables= 125000 X 50 X 60 360 = Rs. 1041667 Old level of receivables = 100000 X 50 X 30 360 = Rs. 416667 Incremental investment in receivables = Rs.1041667416667 = Rs. 625000

Incremental rate of return = 250000 625500 = 0.40 or 40% Since incremental rate of return is more than required rate of return, new credit policy can be accepted. Net gain = Incremental profit – Incremental cost = 250000 – 0.30 X 625000 = 250000 - 187500 = Rs. 62500

Assumptions: 1.Credit period is increased to all 2.All sales are credit sales. 3.Fixed cost does not change with increase in level 4.Investment in receivables is represented by sales value If investment in receivable is represented at cost, then

variable cost per unit = Rs. 40 Fixed cost per unit (100000 units) = Rs. 5 Total fixed cost = Rs. 500000 Old sales at cost = 100000 X 40 + 500000 = Rs. 4500000 Old level of receivables = Rs. 4500000 X 30 360 =Rs. 375000 New sales at cost = 125000 X 40 + 500000 = Rs. 5500000 New level of receivables = Rs. 5500000 X 60 360 = Rs. 916667

Incremental level of receivables at cost = 916667 – 375000 = Rs. 541667 Incremental cost = Rs. 541667 X 0.30 = Rs. 162500 Net gain

= Rs. 250000 – 162500 = Rs. 87500