Working Capital Management - Receivables Management

RECEIVABLES management

          Accounts 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 worthiness and risk, establishing sales terms and credit policies, and designing an appropriate receivables collection process. When a firm sells goods to another, it does not usually expect to be paid immediately. These unpaid bills, or trade credit, composed the bulk of accounts receivables. The balance is made of consumer credit, that is, bills that are awaiting payment by the final customer. A company that fails to efficiently convert its receivables into cash can find itself in a poor liquidity position, crippling its working capital and facing unpleasant operational difficulties. A firm’s investment in accounts receivable depends on: volume of credit sale and the collection period. By changing the terms of credit policy, the financial manager can consequently change investment in accounts receivable which affects the volume of sales and collection period.

The costs associated with the extension of credit and accounts receivables are identified as:

«Collection cost: The cost incurred in collecting the receivables from the customers to whom credit sales have been made.

« Capital cost: The cost incurred on the use of additional capital to support credit sales which could have been employed elsewhere

«Administrative cost: The additional administrative cost for maintaining account receivable in the form of salaries to the staff kept for maintaining records relating to customers, cost of investigation, etc.

«Default cost: The over dues that cannot be recovered due to the inability of customers

Credit Policy:

The credit policy is used to refer to the combination of three decision variables: credit standards and analysis, credit terms, and collection policy and procedures.

I. Credit standards:

          Credit standards are the criteria which a firm follows in selecting customers for the purpose of credit extension. The firm may have tight credit standards like only cash sales, credit sales only to the reliable and financially strong customers, which results in no bad-debt losses and less administration cost but with the loss of sales. If the firm has liberal credit policy, the firm may have larger sales but with bad debt losses and administration cost. Thus, the optimum choice of credit standards lies in the optimum tradeoff between incremental costs and incremental sales.

Credit Analysis: Credit analysis is done to assess the credit worthiness of firm’s customers. On the basis of the past practice and experience, the financial credit manager should be able to form a reasonable judgment regarding the chances of default. On assessing the character – the customer’s willingness to pay; capacity – the customer’s ability to pay; and condition – the prevailing economic situation that affect the customer’s ability to pay, decision can be taken regarding setting of credit terms to the customers.

Credit Evaluation: The credit evaluation procedure of the individual accounts should involve the following steps:

    Credit information: Credit information of a customer can be obtained through financial statements – financial condition and performance of the firm can be evaluated; bank references – the bank where the customer maintains his trading account; trade references – the reference given by the prospective customers of the firm; credit agencies – based on the credit and risk rating  done by the credit agencies.

   Credit investigation: The factors that affect the extent and nature of credit investigation of an individual customer are:    

• The type of customer
• The customer’s business line, background and the related trade risks
• The nature of the product – perishable, durable or seasonal
• Size of customer’s order and expected further volumes of business
• Company’s credit policies and practices

         Credit investigation can be done by analyzing the credit file of the customer; financial rations of the firm; and the analysis of business and management through conducting audit.

II. Credit Terms: 

        The stipulation under which the firm sells on credit to customers is called credit terms, which include: the credit period and the cash discount.

Credit period: The length of time for which credit is extended to customers is called the credit period, which is generally stated in terms of a net date.

Cash discount: A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. A firm uses cash discount to increase sales and accelerate collections from customers.
            Credit terms may be expressed as 2/10 net 30, which means 2% discount will be granted if the customer pays within 10 days, if he does not avail the offer, he must make payment within 30 days.

Credit limit: The maximum amount of credit which the firm will extend at a point of time- i.e., the extent of risk taken by the firm by supplying goods on credit to a customer.

III. Collection Policy and Procedures:

        A collection policy is needed because all the customers do not pay the firm’s bills in time. Prompt collection is needed for fast turnover of working capital, keeping collection costs and bad debts within limits and maintaining collection efficiency. The collection policy should lay down clear cut collection procedures for prompt payment.

Performance Evaluation of Accounts Receivables Management:

1. Aging Receivables analysis: This report tabulated the total amount of receivables outstanding and their duration. It is useful in the assessment of receivables’ credit risk and collectability.

2. Receivables Turnover Ratio: This ratio measures the average number of times receivables are collected during a period. Higher the ratio, better the credit and collection policies.

3.  Day in Sales Outstanding: A ratio that measures the average length of time required to convert receivables into cash receipt.

The Credit Decision:

          After fixing terms of sales and knowing the probability that a customer a will pay, it is to be decided which customers credit should be offered. If there is no possibility of repeat orders, the decision is relatively simple. Suppose that the probability the customer will pay up is (p) and the probability of default is (1-p). If the customer does pay, the additional revenue received is (R) and the additional costs incurred are (C). The net gain is the present value of R-C. If the customer does not pay, there incurs additional cost(C).

The expected profit from each course of action is as follows:

Decision	Expected Profit
Refuse Credit	0
Grant Credit	(p* PV(R-C) )-((1-p)*PV(C)