FinancialManagement

Unit14

Unit14
Structure 14.1 Introduction

ReceivablesManagement

14.2 Costsassociatedwithmaintainingreceivables 14.3 Creditpolicyvariables 14.4 Evaluationofcreditpolicy 14.5 Summary TerminalQuestions 14.6 AnswertoSAQsandTQs 14.1Introduction: Firmssellgoodsoncredittoincreasethevolumeofsales.Inthepresenteraofintense competition, business firms, to improve their sales, offer to their customers relaxed conditionsofpayment.Whengoodsaresoldoncredit,finishedgoodsgetconvertedinto receivables.Tradecreditisamarketingtoolthatfunctionsasabridgeforthemovement ofgoodsfromthefirmswearhousetoitscustomers.Whenafirmsellsgoodsoncredit receivablesarecreated.Thereceivablesarisingoutoftradecredithavethreefeatures. 1. Itinvolvesanelementofrisk.Therefore,beforesanctioningcredit,carefulanalysisof theriskinvolvedneedstobedone 2. It isbasedon economicvalue.Buyer gets economicvaluein goods immediately on sale,whilethesellerwillreceiveanequivalentvaluelateronand 3. Ithasanelementoffuturity.Thebuyermakespaymentinafutureperiod. Amountsduefromcustomers,whengoodsaresoldoncredit,arecalledtradedebitsor receivables. Receivables form part of current assets. They constitute a significant portionofthetotalcurrentassetsofthebuyersnexttoinventories. Receivablesareassetaccountsrepresentingamountsowingtothefirmasaresultof saleofgoods/servicesintheordinarycourseofbusiness. Objectives: The main objective of selling goods on credit is to promote sales for increasingtheprofitsofthefirm.Customerswillalwaysprefertobuyoncredittobuying
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oncashbasis.Theyalwaysgotoasupplierwhogivescredit.Allfirmsthereforegrant credittotheircustomerstoincreasesales,profitsandtomeetcompetition. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1.Understandthemeaningofreceivablesmanagement. 2.Whatarethecostsassociatedwithmaintainingreceivable? 3.Understandthecreditpolicyvariables. 4.Understandtheprocessofevaluationofcreditpolicy. MeaningofReceivablesManagement: Receivables are a direct result of credit sales are resorted to, by a firm to push up its sales which ultimately result in pushing up the profits earned by the firm. At thesame time, selling goods on credit results in blocking of funds in accounts receivables. Additional funds are, therefore, required for the operating needs of the business which involveextracostsintermsofinterest.Moreover,increaseinreceivablesalsoincreases thechancesofbaddebts.Thus,creationofaccountsreceivablesisbeneficialaswellas dangeroustothefirm. The financial manager needs to follow a policy of usingcash fundseconomically to the extent possible in extending receivables without adversely affecting the chances of increasing sales and making more profits. Management of accounts receivables may, therefore, be defined as, the process of making decision relating to the investment of fundsinreceivableswhichwillresultinmaximisingtheoverallreturnontheinvestmentof thefirm. Thus,theobjectiveofreceivablesmanagementistopromotesalesandprojectsuntilthe levelwherethereturnoninvestmentinfurtherfindingofreceivablesislessthenthecost offundsraisedtofinancethatadditionalcredit. 14.2Costsassociatedwithmaintainingreceivables: Costsofmaintainingreceivablesare: 1) Capitalcosts: Afirm whensells goodscredit achieveshigher sales. Sellinggoods oncredithasconsequencesofblockingthefirmsresourcesinreceivablesasthereis
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atimelagbetweenacreditsaleandcashreceiptfromcustomers.Totheextentthe fundsareheldupinreceivables,thefirmhastoarrangeforadditionalfundstomeet itsownobligationofmonthlyaswellasdailyrecurringexpenditure.Additionalfunds mayhavetoberaisedeitheroutofprofitsorfromoutside.Inboththecases,thefirm incursacost.Intheformercasethereistheopportunitycostoftheincomethefirm couldhaveearnedhadthesamebeeninvestedinsameotherprofitableavenue.In thelattercaseofobtainingfundsfromoutside,thefirmhastopayinterestontheloan taken. Therefore, sanctioning credit to customers on sale of goods oncredit has a capitalcost. 2) AdministrationCost: Whenafirmsellsgoodsoncreditithastoincurtwotypesof administrationcostviz a. Creditinvestigationandsupervisioncostsand b. CollectionCosts. Beforesanctioningcredit to anycustomerthe firm has toinvestigate thecreditratingof thecustomertoensurethatcreditgivenwillrecoveredontime.Therefore,administration costshavetobeincurredinthisprocess. Costs incurred in collecting receivables are administrative in nature. These include additional expenses on staff for administering the process of collection of receivables fromcustomers. 3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the amount to it on the expiry of credit period. These costs take the form of sending remaindersandlegalcharges. BadDebtsorDefaultcost: Whenthefirmisunabletorecovertheamountduefromitscustomers,itresultsinbad debts.Whenafirmrelaxesitscreditpolicy,sellingtocustomerswithrelativelylowcredit ratingoccurs.Inthisprocessafirmmaymakecreditsalestoitscustomerswhodonot payatall. Therefore, the assessing the effect of a change in credit policy of a firm involves examinationof a. OpportunityCostoflostcontribution b. CreditadministrationCost
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c. CollectionCosts d. DelinquencyCost e. Baddebtloses SelfAssessmentQuestions1 1. Costs of maintaining receivables are ________________, _________ cost and _______. 2.AperiodofNet30meansthatitallowstoitscustomers30daysofcreditwith____ for___________. 3. Selling goods on credit has consequences of blocking the firms resources in receivablesasthereisatimelagbetween___________________and____________. 4.Whena firmsells goods oncredit it has to incur two types of administrationcostviz _____and_________________. 14.3CreditpolicyVariables 1. Creditstandards. 2. Creditperiod. 3. Cashdiscountsand 4. Collectionprogramme. 1.Creditstandards: Thetermcreditstandardsrefertothecriteriaforextendingcreditto customers.Thebasesforsettingcreditstandardsare. a. Creditrating. b. References c. Averagepaymentperiod d. Ratioanalysis Thereisalwaysabenefittothecompanywiththeextensionofcredittoitscustomersbut with the associated risks of delayed payments or non payment, funds blocked in receivablesetc.Thefirmmayhavelightcreditstandards.Itmayselloncashbasisand extend credit only to financial strong customers. Such strict credit standards will bring down bad debt lossesand reduce thecost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more than the costs

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savedbythefirm.Thefirmshouldevaluatethetradeoffbetweencostandbenefitof anycreditstandards. 2.Creditperiod: creditperiodreferstothelengthoftimeallowedtoitscustomersbya firm to make payment for the purchases made bycustomersof thefirm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if paymentsaremadewithinthespecifiedperiod. Ifafirmfollowsacreditperiodofnet20itmeansthatitallowstoitscustomers20days ofcreditwithnoinducementforearlypayments.Increasingthecreditperiodwillbringin additionalsalesfromexistingcustomersandnewsalesfromnewcustomers.Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales increases investment in receivablesandincreasestheincidenceofbaddebtloss. The effects of increasing the credit period on profits of the firm are similar to that of relaxingthecreditstandards. 3.CashdiscountFirmsoffercashdiscountstoinducetheircustomerstomakeprompt payments.Cashdiscountshaveimplicationsonsalesvolume,averagecollectionperiod, investmentinreceivables,incidenceofbaddebtsandprofits.Acashdiscountof2/10net 20meansthatacashdiscountof2%isofferedifthepaymentismadebythetenthday
th otherwisefullpaymentwillhavetomadeby20 day.

4Collectionprogramme Thesuccessofacollectionprogrammedependsonthecollectionpolicypursuedbythe firm. The objective of acollection policy isto achieve.Timely collection of receivables, therebyreleasingfundslockedinreceivablesandminimizestheincidenceofbaddebts. Thecollectionprogrammesconsistsofthefollowing. 1. Monitoringthereceivables 2. Remindingcustomersaboutduedateofpayment 3. On line interaction through electronic media to customers about the payments due aroundtheduedate. 4. Initiatinglegalactiontorecovertheamountfromoverduecustomersasthelastresort torecovertheduesfromdefaultedcustomers.

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Collectionpolicyformulatedshallnotleadtobadrelationshipwithcustomers

SelfAssessmentQuestion2 1.Creditperiodisa______________. 2._______refertothecriteriaforextendingcredittocustomers. 3. _________ refers to the length of time allowed to its customers by a firm to make paymentforpurchasemadebycustomersofthefirm. 4.Acashdiscountof2/10net20meansthata____________isofferedifthepayment ismade__________________ 14.4EvaluationofCreditPolicy: Optimumcreditpolicyisonewhichwouldmaximize thevalueofthefirm.Valueofafirmismaximizedwhentheincrementalrateofreturnon an investment is equal to the incremental cost of fundsusedtofinance theinvestment. Therefore,creditpolicyofafirmcanberegardedasatradeoffbetweenhigherprofits fromincreasedsalesandtheincrementalcostofhavinglargeinvestmentinreceivables. The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors.Ifcompetitorsaregranting15dayscreditandifthefirmdecidestoextend the credit period to 30 days, the firm will be flooded with customers demand for companysproducts. Creditpolicyvariablesofafirmare 1. CreditStandard Theeffectofrelaxingthecreditstandardsonprofitcanbeestimatedasunder: Changeinprofit=P Increaseinsales=S Contribution=c=1V WhereV=Variablecosttosales BadDebtsonnewsales=Sxbn K=posttaxcostofcapital Increaseinreceivablesinvestment=I Therefore

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Change in profit = (Additional contribution on increase in sales Bad Debts on new sales) (1 tax rate) cost of incremental investment. (1 tax rate) cost of capital x Incrementalinvestmentinreceivables. Increase in profit i.e change in profit = [Incremental contribution Bad debts on new sales] Example: Followingdetailsareavailableinrespectofxltd: Currentsales=Rs100million The company is considering relaxation of its credit policy. Such relaxation would increase the sales by Rs 15 million on which bad debt losses would be 10%. The contributionmarginratioforthefirmis20%.Averagecollectionperiodis40days.Post taxcostoffundsis10%.Taxrateapplicabletothefirmis30%.Assume360daysina year. Examine the effect of relaxing the credit policy on the profitability of the organization. (MBA)adopted. Solution: Incrementalcontribution=1,50,00,000x0.20=Rs30,00,000 Baddebtsonnewsales=1,50,00,000x0.10=Rs15,00,000 Costofcapitalis10% Incrementalinvestmentinreceivables= Investmentinsales = No.ofdaysintheyear XAverageCollectionPeriodXVariableCosttoSalesratio

15000000 X40X0.8=Rs.13,33,333 360

CostofIncrementalInvestment 10 = 100 x 13,33,333

Thereforechangeinprofitiscalculatedasunder

IncrementalContribution=

3000000

Less:Baddebtsonnewsales= 1500000
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Less:Incometaxat30%=

450000 1050000

Less:Opportunitycostof Incrementalinvestmentin Receivables Increaseinprofit 13,33,333 916667

Sincetheimpact ofchangeincredit standards onprofit is positive thechange incredit standardsmaybeconsidered. 2.Creditperiod Theeffectofchangingthecreditperiodonprofitsofthefirmcanbecomputedasunder: Changein profit = (Incrementalcontribution Bad debts on new sales) (1 taxrate) costofincrementalinvestmentinreceivables. Example: Acompanyiscurrentlyallowingitscustomers,30daysofcredit.ItspresentsalesareRs 100 million. The firms cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extensionwillincreasethesalesofthefirm byRs100 million. Baddebtsonadditional saleswouldbe8%.Taxrateis30%.Assume360daysinayear. (MBA)adopted. Solution: Incrementalcontribution=10,000,000x0.2=Rs2,000,000 Baddebtsonnewsales=10,000,000x0.8=Rs8,000,000 Existinginvestmentinreceivables= 30 100000000x 360 Rs.8333333

Expectedinvestmentinreceivablesafterincreasingthecreditperiodto60days: Expectedinvestmentinreceivablesoncurrentsales= = 100000000 360 X60=Rs.16666667

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Additionalinvestmentinreceivableonnewsales 100000000x 60 360 X0.80=Rs.1333333

Expectedtotalinvestmentinreceivablesonincreasingtheperiodofcredit=18000000 Incrementalinvestmentinreceivables=180000008333333=Rs.9666667 OpportunitycostofIncrementalinvestmentinreceivables= 0.10x9666667=Rs.966667

Statementshowingtheeffectofincreasingthecreditperiodfrom30daysto60daysas firmsproject IncrementalContribution Less:Baddebtsonnewsales 200000 800000 1200000 Less:Incometaxat30% 360000 840000 Less:Opportunitycostofincremental Investmentinreceivables Changeinprofit 966667 (126667)negative

Since the impact of increasing the credit period on profits of the firm is negative, the proposedchangeincreditperiodisnotdesirable. 2. CashDiscount

Forassessingtheeffectofcashdiscountthefollowingformulacanbeused. Change in profit = (Incremental contribution increase in discount cost) (1 t) + opportunitycostofsavingsinreceivablesinvestment. Example Presentcredittermsofacompanyare1/10net30.ItssalesareRs100million,average collectionperiodis20days,variablecosttosalesratiois0.8,andcostofcapitalis10%. Theproportionofsalesonwhichcustomerscurrentlytakediscountis0.5.

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Thecompanyisconsideringrelaxingitsdiscounttermsto2/10,net30 Such a relaxation is expected to increase sales by Rs 10 million, reduce Average collectionperiodto14days,increasediscountsalesto0.8.Taxrateis0.30. Examinetheeffectofrelaxingthediscountpolicyonprofitsoftheorganisation Assume360daysinayear(MBAadopted). Solution IncrementalContribution=10000000x0.2=Rs.2000000 Increaseindiscount Discountcostbeforeliberalisingdiscountterms= 0.5x100000000x0.01=Rs.500000 Discountcostafterliberalisationofdiscountterms= 0.8x110000000x0.002=Rs.1760000 Increaseindiscountcost=Rs.1260000 Computationofsavingsinreceivablesinvestment = 10000000010000000 20 14 0.8x X14 360 360 100000000 60

311111

=1666667311111=Rs.1355556 Opportunitycost(savingsofreductionininvestmentinreceivables =0.1x135556=Rs.135556 Statementshowingtheeffectofchangeindiscountpolicyasprofitofthecompany IncreaseinContribution Less:increaseindiscountcost 2000000 1260000 740000 Less:Taxat30% 222000 518000 Add:Benefitofsavingsdueto Reductionininvestmentin
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Receivablesprofit

135556 653556

Itisdesirabletochangethediscountpolicyasitwillimprovetheprofitabilityofthefirm. 4.Collectionpolicy

Forcomputationoftheeffectofnewcollectionprogrammecanbeevaluatedwiththehelp offollowingformula . Changeinprofit=(IncrementalcontributionIncreaseinbaddebts)(1taxrate)cost ofincreaseininvestmentinreceivables. Example Acompanyisconsideringrelaxingitscollectioneffort.ItspresentsalesareRs50million, ACP=20days,variablecosttosalesratio=0.8,costofcapital10%.Itsbaddebtratiois 0.05. The relaxation in collection programme is expected to increase sales by Rs 5 million, increaseACPto40daysandbaddebtsratioto0.56.Taxrateis30%. Examine the effect of change in collection programme on firms profits. Assume 360 daysinayear.(MBAadoptedandalsoACS) Solution IncreaseinContribution=5000000x0.2=Rs.1000000 Increaseinbaddebts Baddebtsonexistingsales=50000000x0.05=2500000 Baddebtsontotalsalesafterincreaseinsales= 55000000x0.56=3300000 Increaseinbaddebts=Rs.800000 Incrementalinvestmentinreceivables = 50000000(4020) 5000000x40x0.8 + 360360

=2777778+444444=Rs.3222222 Opportunitycostofincrementalinvestmentinreceivables= 0.1 x3222222=Rs.322222

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Statementshowingtheimpactofnewcollectionprogrammeonprofitsoftheorganisation IncrementalContribution Less:Increaseinbaddebts Less:Incometaxat30% 1000000 800000 200000 60000 1,40,000 Less:Opportunitycostofincrease Ininvestmentinreceivables Profit 3,22,222 (182222)loss

Sincethechangewillleadtodecreaseinprofit(i,ealossofRs.182222)itisnotdesirable torelaxthecollectionprogrammeofthefirm SelfAssessmentQuestions3 1. Credit policy of a firm can be regarded as a tradeoff between ___________ and _______. 2.Optimumcreditpolicymaximisesthe__________. 3. Value of a firm is maximised when the incremental rate of return on investment in receivable is ________________ to the incremental cost of funds used to finance that investment. 4. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitions. 14.5Summary Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will resultinmaximisingtheoverallreturnontheinvestmentofthefirm.Costofmaintaining receivables are capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and collection programme. OptimumcreditpolicyisthatwhichMaximisesthevalueofthefirm.

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TerminalQuestions 1. Examinethemeaningofreceivablemanagement. 2. Examinethecostsofmaintainingreceivables. 3. Examinethevariablesofcreditpolicy. 4. Whatarethefeaturesofoptimumcreditpolicy AnswerforselfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalcosts,administration,Delinquencycosts. 2. Noinducementforearlypayments 3. Creditsale,Cashreceiptfromcustomers. 4. Creditinvestigationandsupervisioncost,collectioncosts SelfAssessmentQuestions2 1. Creditpolicyvariable. 2. Creditstandards 3. Creditperiod 4. Cashdiscountof2%,onthetenthday. SelfAssessmentQuestions3 1. Higher profits from increased sales, incremental cost of having large investment in receivable. 2. Valueofthefirm. 3. Equal AnswerforTerminalQuestions 1. Refertounit14.1 2. Refertounit14.2 3. Refertounit14.3 4. Refertounit14.4

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