3rdCHAP_5

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Copyright 2005 by Thomson Learning, Inc.

Chapter 5

Accounts Receivable Management

A / R

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The Cash F low Timeline

Order Order Sale Payment Sent Cash

Placed Received Received

Accounts Collection

< Inventory > < Receivable > < Float >

Time ==>

Accounts Disbursement

< Payable > < Float >

Invoice Received Payment Sent Cash Disbursed

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Learning Objectives

Define credit policy and indicate its components.

Describe the typical credit-granting sequence.

Apply net present value analysis to credit extensiondecisions.

Define credit scoring and explain limitations.

List the elements in a credit rating report.

Describe how receivables management can benefitfrom EDI (Electronic Data Interchange).

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Trade Credit and Shareholder Value

Trade credit arises when goods are sold underdelayed payment terms

Traced to Romans due to obstacles faced intransferring money through various trading areas

Credit terms are taken for granted today

Value can be added by managing three areas:

– aggregate investment in receivables

– credit terms

– credit standards

Over-investing in receivables can be costly

...but, if credit terms are not competitive, then lost

sales can be costly

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Conclusion

Minimize bad debts and outstanding receivables

Maintain financial flexibility

Optimize mix of company assets Convert receivables to cash in a timely manner

Analyze customer risk

Respond to customer needs

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A/R Management and Shareholder

Value

Marketing Strategy

Market Share Obj.

Aggregate Inv. in A/R Credit Terms Credit Standards

Total Dollar Investment Length of Time to Pay Acceptance of Marg Cust.

Max Shareholder Value

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Trade vs. Bank Credit

Length of terms

– TC: Short, Usually < 90 days

– BC: Longer and may be repaid on a seasonal basis

Security

– TC: Unsecured

– BC: Usually secured, relatively high standards if not

Amounts involved

– TC: Small

– BC: Larger

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Trade vs. Bank Credit – cont.

Resource transferred (goods vs. money)

– TC: Goods and services

– BC: Money

Extent of analysis

– TC: Varies with exposure

– BC: Usually more in-depth

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Why Extend Credit?

Financial Motive

Operating Motive

Contracting Motive Pricing Motive

All reasons are related to market imperfections

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F inancial Motive

Potential of getting a higher price

Sellers raise capital at lower rates than customersand have cost advantages vis-a-vis banks due to:

– similarity of customers

– the information gathered in the selling process

– lower probability of default (the goods purchased are anessential element of the buyer’s business)

– seller can more easily resell product if payment is not made.

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Operating Motive

Respond to variable and uncertain demand

Change credit terms rather than:

– install extra capacity,

– building or depleting inventories,

– or forcing customers to wait.

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Contracting Cost Motive

Buyer gets to inspect goods prior to payment

Seller has less theft with separation of collectionand product delivery

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Pricing Motive

Change price by changing credit terms

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The Credit Decision Process

Marketing contact

Credit investigation

Customer contact for information

Finalize written documents, e.g.. security agreements

Establish customer credit file

Financial analysis

T i m e

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Basic Credit Granting Model

S - EXP(S)

NPV = ----------------- - VCR(S)

1 + iCP

Where:

NPV = net present value of the credit sale

VCR = variable cost ratio (per $ of sale)

S = dollar amount of credit sale

EXP = credit administration and collection expense ratio (per $ of sale)

i = daily interest rate

CP = collection period for sale (days)

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Managing the Credit Policy

Should we extend credit?

Credit policy components

Credit-granting decision

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Should We Extend Credit?

Follow industry practice

Extent and form of credit offer

– in-house credit card

– sell receivables to a factor

– captive finance company?

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Components of Credit Policy

Development of credit standards

– profile of minimally acceptable credit worthy customer

Credit terms

– credit period

– cash discount

Credit limit

– maximum dollar level of credit balances

Collection procedures – how long to wait past due date to initiate collection efforts

– methods of contact

– whether and at what point to refer account to collection agency

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Credit-Granting Decision

Development of credit standards

Gathering necessary information

Credit analysis: applying credit standards Risk analysis

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Grant-Granting Sequence

No

Order and credit

request received

New/increased

credit limit

Material

change incustomer status

Redo credit

investigation

Size of proposed

credit limit

Medium SmallLarge

Indepth

credit invest.

Moderate

credit invest.

Minimal

credit invest.

Check new A/R

total vs credit lmt

No Yes

Yes

Extend CreditNo

Yes

Record

disposition

Set up,post

A/R, ship

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Credit Standards

Based on five C's of Credit

– Character – willingness to pay

– Capital – net worth

– Capacity – ability to generate cash flows

– Collateral – pledged assets

– Conditions - general economic and industry conditions

Determine risk classification system

Link customer evaluations to credit standards

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Gather ing Information

credit reporting agencies, e.g.. Dun & Bradstreet

credit interchange bureaus, NACM (NationalAssociation of Credit Management)

bank letters

references from other suppliers

financial statements

field data gathered by sales reps

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Emergence of Expert Systems

Example of decision rule:

“If gross income is equal to or grater than $20,000

and the applicant has not been delinquent andgross income per household member is equal to orgreater than $12,000 and debt/equity ratio is equalto or greater than 30% but less than 50% andpersonal property is equal to or greater than

$50,000, then grant credit.”

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Factors Affecting Credit Terms

Competition

Operating cycle

Type of good (raw materials vs finished goods,perishables, etc.)

Seasonality of demand

Consumer acceptance

Cost and pricing Customer type

Product profit margin

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Cash Discounts

The lower the VC, the higher the feasible discount

Based on company’s cost of funds

Consider timing effect when changing discounts Should be based on product’s price elasticity

Higher the bad debt experience, higher the optimaldiscount

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Practice of Taking Cash Discounts

51% of firms always took cash discount

40% sometimes

9% take discount and pay late Study found that 4 or 5 companies would be more

profitable if cash discount was eliminated

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A/R Management in Practice

Discounts appear to be changed to matchcompetitors, not inflation or interest rates

The higher a firm’s contribution margin, the morelikely the firm should be to offer discounts.

A price cut is thought to have more impact thaninstituting a cash discount

The more receivables a firm has, does not

necessarily relate to use of penalty fees

The greater amount of receivables does not relateto a more active credit evaluation.

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Receivables, Collections, and EDI

If credit approval is delayed...

– buyers using EDI purchase orders and JIT manufacturing canencounter serious problems.

– sellers can now ship within hours of receiving orders...thus sellermust be able to handle electronically transmitted orders.

Seller may also issues electronic invoices and bepaid electronically using an EDI-capable bank sothat remittance data can be automatically read by

seller’s A/R system Trend is for use of data transmission to automate

the cash application process

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Summary

Investment in A/R represents a significantinvestment.

Key aspects outlined

– credit policy

– credit standards

– credit granting sequence

– credit limits

– credit terms

Management of A/R is influenced by whatcompetitors are doing not by shareholder wealthconsiderations.

Proper use of NPV techniques can ensure thatcredit decisions enhance shareholder value.

3rdCHAP_5

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