Module III

Module IIIReceivables ManagementThe term receivables refers to the debt owed to the firm by the customers resulting from sale of goods or services in the ordinary course of business.These are the funds blocked due to credit sales.Receivables are also called as trade receivables, accounts receivables, book debts, sundry debtors and bills receivables etc.Management of receivables is also known as Management of trade credit.

Motives of Maintaining Receivables:-

(i) Sales Growth Motives:-The main objectives of credit sales is to increase the total sales of the business. On being given the facility of credit, customers have shortage of cash may also purchase the goods. Therefore, the prime motive for investment in receivables is sales growth.(ii) Increased profit Motive:-Due to credit sales, the total sales of business increases. Thus, in turn, results in increase in profits of the business.(iii) Meeting Competition Motive:-In business, goods are sold on credit to protect the current sales against emerging competition. If goods are not sold on credit, the customers may shift to the competitors who allow credit facility to them.

Costs of Investment in Receivables:-

When a firm sells goods or services on credit, it has to bear several types of costs. These costs are as follows:-(i) Administrative Cost:-To record the credit sale and collections from customers, a separate credit department with additional staff, accounting records, stationery etc is needed. Expenses have also to be incurred on acquiring information about the credit worthiness of the customers.(ii) Capital Cost:-There is a time lag between sale of goods and its collection from customers. In that time period, the firm has to make payment for purchases, wages, salary and other expenses. Therefore, the firm needs additional funds which may arrange either from external sources or from retained earnings. Both of these sources involve cost. If funds are arranged from external sources, interest has to be paid. On the other hand, if retained earnings are used for this purpose, the firm has to bear opportunity cost. Opportunity cost means the income which could have been earned by investing this amount elsewhere.

(iii) Collection Cost:-These are the expenses incurred by the firm on collection from the customers after expiry of the credit period.(iv) Default Cost or bad debts:-Despite all efforts by the management, the firm may not be able to recover full amount due from the customers. Such dues are known as bad debts or default cost.

Objectives of Receivable Management:-

(i) To obtain optimum (not maximum) volume of sales.(ii) To minimize cost of credit sales.(iii) To optimize investment in receivablesFactors affecting the Size of ReceivablesSize of credit salesBasis of volume of sales2. Credit policesLiberal or not3. Terms of tradeThe period of credit allowed and rates of discount given are linked with receivablesIf more credit allowed, the receivables will be more4. Expansion plansWhen a concern wants to expand its activities, it will have to enter new markets.To attract new customer, it will give incentives in the form of credit facilities.In the early stages of expansion, more credit becomes essential and size of receivables or vice versa.5. Credit collection effortsCustomers should be sent periodical reminders, if they fail to pay in time. Otherwise get bad debts.6. Habits of customersPaying habits of customers also have a bearing on the size of receivables.Habit of delaying payment.Forecasting the receivablesIt is not possible of exact forecastSome estimation is possible on the basis of past experience, present credit policies and policies pursued by other concerns.Credit period allowedThe longer the amounts remain due, the higher will be the size of receivables. the increase in receivables will result in more profits as well as higher cost too.If credit period is less, then the size of receivables will also be less.2. Effect of cost of goods soldSome times an increase in sales results in decrease in cost of goods sold. If this is so then sales should be increased to that extent where costs are low. The increase in sales will also increase the amount of receivables.3. Forecasting expensesThe receivables are associated with a number of expenses. These expenses are administrative expenses on collection of amounts, cost of funds tied in receivables, bad debts etc.4. Forecasting average collection period and discountsTime allowed for making payments and time allowed for availing discountsAverage collection period = trade Drs * No.of working days/net salesOr365/Drs turn over ratio5. Average size of receivablesThe determination of average size of receivables will also be helpful in forecastAverage size of receivables = Estimated annual sales* Average collection Period

Scope or Aspects of Receivables Management:-

Scope of receivables management is quite wide. It includes the following aspects:(1) Formulation of Optimum Credit Policy.(2) Determination of Credit Terms.(3) Formulation of Collection Policy.(4) Evaluation of Credit Policy.

(1) Formulation of Optimum Credit Policy:-

A firm needs a clear policy regarding as to whether the credit should be allowed to a customer and if yes, to what extent.Credit standards are set for making such decisions. credit policy is a set of parameters and principles that govern the extension of credit to the customersIn order to write a credit policy, following are the questions that a firm must answer;What is its mission and its goal?Who has specific credit facilities?How is credit evaluated?How is collection handles?What are the terms of sale?

Credit policy should be;Written in simple language, so it is understandable by staff and customersAccessible to all staff who are required to administer itMade available to customers in summary formKeep up-to-date

Therefore, a credit policy has two dimensions:I.Credit StandardsII.Credit Analysis

I. Credit Standards:-Credit standards are the basic criteria set for extension of credit to customers. These are the conditions that the customer must meet before being granted credit.Decision of credit to customers are taken on the basis of their credit rating, security provided by them, average collection period of the firm and financial ratios. Standards are set for all these factors. A firm can control its credits by setting the credit standards accordingly. If credit standards are liberal, more credit will be extended. On the other hand, if standards are tight, less credit will be extendedFactors for which standards are set can be classified into two broad categories namely:a) Qualitative Factors:-Qualitative factors such as willingness and ability of the customers to pay for purchase, public image of the customer and other social factor are included.b) Quantitative Factors:-Quantitative factors such as average collection period and financial ratiosII. Credit Analysis:-Credit Analysis is made to evaluate the credit worthiness of the customers before making credit sales. Decision of sale of credit is taken only on the basis of credit analysis. The firm need not follow the policy of treating all the customers equal for allowing credit.Each customer may be fully examined or evaluated before offering credit terms to time. Credit worthiness factors are ;CharactersCapacityCollateral ie, security offered by the customer against the creditFactors considering credit analysis;Companies name, address, phone number, fax number.etcName of chief executiveType of organization (sole, partnership, jont stock)Type of business (distributor, retailer wholesaler)Bank referenceYear of business startedAgency ratingBanking informationFinancial statementTax payment proofCredit Analysis involves two steps:A) Obtaining Credit Information:-Credit Information concerning each customer is gathered from different sources. Gathering credit information involves cost. Cost of collecting information should be less than the expected profit accruing from it.

Credit information can be obtained from internal as well as external sources;Internal Sources:-As internal sources of credit information, firm can require its customers to fill up forms giving details about their financial activities. They may also be asked to furnish trade references with whom the firm can have contact to obtain the required information.

External Sources:-Credit information can also be obtained externally from:(i) Financial Statements:Financial statements, that is , Balance Sheet and profit & loss a/c are major source of credit information.(ii) Bank References:-Bank of the customer is also a useful source of credit information about the customer. Firms obtain credit information from customer's bank with the help of its own bank. Information such as normal balance of customer, loan taken by him, any default in repaying such loan etc. can obtain from the bank of the customer.

(iii) Bazaar Reports:-Credit information about the customer can also be maintained from the business concerns in the same trade or industry.(v) Other Sources:-Other sources from where credit information can be obtained are trade directories, journals, government revenue records such as income tax returns, sales tax returns etc

B) Analysis of Credit Information:-After obtaining the desired information from various source, the information is analyzed to determine the credit worthiness of the customer. Analysis of credit information should cover two aspects:(i) Quantitative Aspects:-Analysis from quantitative aspects is on the basis of information available from the financial statements, past records of the customers, and so on.

(ii) Qualitative Statements:-Analysis from qualitative includes judgment regarding quality of management, willingness to pay the debts, public image of the customer etc.

(2) Determination of Credit Terms:-

The second aspect of receivable management, after setting the credit standards and assessment of credit worthiness of the customers, is the determination of the terms on which credit will be given. Credit terms are the terms which relate to the repayment of the amount of credit sale. There are three components of credit terms namely:-

(i) Credit Period:-Credit period is the time period for which credit is extended to the customers and after which they have to make the payment. For example, credit period of 30 days indicates that customers are required to pay before then end of 30 days from the date of sale. It will be written as 'Net 30'

(ii) Cash Discount:-To encourage the customers for prompt payment, cash discount may be offered by the firm. Customers can take advantage of cash discount by paying amount within the period of cash discount.(iii) Cash Discount Period:-It is the duration within which cash discount is available. It is written in form of an abbreviation Example, '2/10 net 30 indicates that if payment is made within 10 days, 2% cash discount will be paid. If cash discount is availed, customer has to make the payment before the end of 30 days from the date of sale.

(3) Formulation of Collection Policy:-

The third aspect of the receivable management is to formulate a collection policy. Collection policy is required because all the customers do not pay in time. Some customers pay after the due date and some do not pay at all. If collection is delayed, additional funds are needed during the meantime to pay for purchase, wages etc. Delay in collection also increases risk of bad-debts. Collection policy pays down the collection procedure followed to collect the amounts from the customers who do not pay within credit period allowed to them.It includes ;The collection ProcedureDevelop a policy for dealing with slow pay customers.After the expiry of credit period, the firm should initiate collection procedures to make collection from debtors. The efforts should be polite in the beginning but, with the passage of time, they should be made strict.

Collection process are;Timely billing collection process starts with the customer invoice. Invoice should be prepared as soon as it is determined the receivable due.2. Prompt collectionIt is the responsibility of credit department to monitor their accounts receivable to assure that timely and appropriate collection policies are in place.3. Standards for collection effortIt should be regular and co-ordinated with atlest one attempt to collect in each third day periodThe efforts usually made by the firm include:(i) Reminder Letters(ii) Telephone Calls(iii) Personal Visits(iv) Engaging collection agencies.(v) Settlement at extended payment period.(vi) Legal Action.4. External help and Litigation (legal)Depend collection agencies and pay a collection fee for them for their serviceIf agency failed , final recourse is through the courtsPrinciples of collection;Prompt initiativeFeed back (to customer after delivery of pdt)Planning collection procedureMaintaining good will (while pressing of collection)Deciding collection strategiesReviewing periodically

(ii) Monitoring of receivablesTo control the receivables, the firm should apply regular checks and there should be a continuous monitoring system.(iii) Line of creditIt refers to the maximum amount a particular customer may have as due to the firm at any time.Different line of credit to different customersAs long as the customers unpaid balance remain within this maximum limit.

(iv) Accounting ratiosCalculate to find out the changing pattern of receivables. These are; -Receivables Turn over ratio-Average collection period

(4) Evaluation of Credit Policy:-

A credit policy is formulated to maintain the investment in receivables at optimum level. The ratio analysis used for evaluating credit policy are;a) Receivable Turnover Ratiob) Average Collection PeriodManagement of PayablesThe objective of receivables management is to maximize the acceleration of the collection process , the objective in case of accounts payable is to slow down the payments process as much as possible. But it should be noted that the delay in payment of accounts payable may result in saving of some interest costs but it can prove very costly to the firm in the form of loss of credit in the market.The finance manager has therefore to ensure that the payments to the creditors are made at the stipulated time periods after obtaining the best credit terms possible.Crs turnover ratio = Credit purchase/average a/c payableDebt payment period = 12/creditors turn over ratioMaturity matching (matching or hedging approach)Known as self liquidity approachThe organization finances long term assets through long term source of fund and short term assets finances through short term sources of fund.