Receivables Management

Unit 5

INTRODUCTION
Trade credit happens when a firm sells its
products or services on credit and does not
receive cash immediately.
A credit sale has three characteristics:
First, it involves an element of risk that should be
carefully analyzed.
Second, it is based on economic value.
Third, it implies futurity.

Goals of Credit Policy

Marketing tool
Maximisation of sales Vs.
incremental profit
production and selling costs
administration costs
bad-debt losses

Credit Policy Variables

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 or loose credit
standards.
Credit analysis
Average collection period (ACP)
Default rate
5

Cont

Customer categories

Numerical credit scoring

good accounts
bad accounts
marginal accounts
ad hoc approach
simple discriminant approach
multiple discriminant approach

Credit-granting
Decision

Credit terms
Credit period
Cash discount

Collection policy and

procedures

regularity of collections
clarity of collection procedures
responsibility for collection and follow-up
case-by-case approach
cash discount for prompt payment

Optimum Credit Policy

Estimation of
incremental profit
Estimation of
incremental
investment in
receivable
Estimation of
incremental rate of
return (IRR)
Comparison of incremental rate of return
with required rate of
return (RRR)
Optimum credit
policy: IRR = RRR

Costs of Credit Policy

10

CREDIT EVALUATION OF INDIVIDUAL

ACCOUNTS
Credit Information
Financial statement
Bank references
Trade references
Other sources

Credit Investigation and Analysis

Analysis of credit file
Analysis of financial ratios
Analysis of business and its management

Credit Limit
Collection Efforts
11

Steps in evaluation of investment in

receivables accounts
1.Estimation of incremental operating profit.
2.Estimation of incremental investment in
accounts receivables.
3.Estimation of the incremental rate of return
of investment.
4.Comparison of incremental rate of return
with the required rate of return

Estimation of the effect of relaxing the credit standards on profit

Change in profit
Incremental contribution
Less: bad-debts on new sales

Incremental EBT
Less: Income tax on Incremental EBT

Incremental EAT
Less: cost of incremental investment in receivables
(incremental investment x cost of capital)

Increase in profit
Incremental investment in receivables

Increase in Sales
Average Collection period Variable cos t to Sales ratio
No. of days in the year

Problem

The details shown in table are regarding the statistics of the

company X Ltd.
Current sales

Rs.100 million

Increase in sales

Rs.15 million

Bad-debt losses

10%

Contribution margin ratio

20%

Average collection period

40 days

Post-tax cost of funds

10%

Tax-rate

30%

Examine the effect of relaxing the credit policy on the

profitability of the organisation.

Solution

Incremental contribution =
Bad debts on new sales =
Incremental investment in receivables
Increase in Sales
Average Collection period Variable cos t to Sales ratio
No. of days in the year

Cost of incremental investment =

Solution

Incremental contribution = 15 x 0.20 = Rs 3 million

Bad debts on new sales = 15 x 0.10 = Rs 1.5 million
Incremental investment in receivables
Increase in Sales
Average Collection period Variable cos t to Sales ratio
No. of days in the year

[15 / 360] 40 0.8 Rs.1.33million

Cost of incremental investment

10
1.33
100

= 0.133

Change in profit
Incremental contribution
Less: bad-debts on new sales

Incremental EBT
Less: Income tax on Incremental EBT

Incremental EAT
Less: cost of incremental investment in receivables
(incremental investment x cost of capital)

Increase in profit

Credit Period
Effect of changing the credit period on profits of the firm

Change in profit
= (Incremental contribution Bad debts on new sales)
(1 tax rate) cost of incremental investment in receivables.
P = [S (1-V) - bn S ] (1-t) - k I
I = increase in investment
I = (ACPn ACPo) (So/360) + V (ACPn) (S/360)
Where, ACPn = new average credit period (after increasing credit
period)
ACPo = old average credit period
V = variable cost to sales ratio
S = increase in sales
So = Sales before liberalising

Problem
RD company is currently allowing its customers, 30 days
of credit. Its present sales are Rs. 50 million. The firms
cost of capital is 10% and the ratio of variables cost to
sales is 0.85. RD is considering extending its credit
period to 60 days. Such an extension will increase the
sales of the firm by Rs. 5 million. Bad debts on
additional sales would be 8%. Tax rate is 40%. Assume
360 days in a year. Examine the effect of relaxing the
credit policy on the profitability of the company.

P = [S (1-V) - bn S ] (1-t) - k I
P=[S(1-V)-bn S](1-t)-k[(ACPnACPo)(So/360)+V (ACPn)(S/360)]
=[(5 x.15 5 x .08)0.6] - .10[(60-30) x (50/360 )+.85x60x5/360]
=(0.75-0.4) 0.6 - .10[ 4.875]
=0.21- 0.4875
= -0.2775

Cash Discount
Effect of changing the cash discount on profits of the firm

Change in profit
= (Incremental contribution Increase in discount cost)
(1 tax rate) Opportunity cost of savings in receivables investment
P = [S (1-V) - DIS ] (1-t) - k I
DIS = Increase in discount cost = pn(So + S)dn poSodo
Where, pn = proportion of discount sales after liberalising
So = sales before liberalising
S = increase in sales
dn = new discount percentage
po = proportion of discount sales before liberalising
do = old discount percentage

Collection policy

The collection programme ideally comprises the following:

Monitoring the state of receivables
Despatching letters to customers whose due date is
approaching
Sending telegraphic/telephonic/SMS/email advice to
customers around due date
Demonstrating threat of legal action to overdue accounts
Taking legal action against overdue accounts

Computation of the effect of

new collection programme
Change in profit
= (Incremental contribution Increase in bad debts) (1
tax rate) cost of increase in investment in receivables.
P = [S (1 V) BD] (1-t) k I
Where,
P = change in profits
S = increase in sales
V = variable costs to sales ratio
k = cost of capital
BD = increase in bad debts cost = bn(So + S) - boSo

I = increase in investment in receivables

=(So/360)(ACPn ACPo) + (S/360)(ACPn) V
Where, ACPn = new average credit period (after
increasing credit period)
ACPo = old average credit period
V = variable cost to sales ratio
S = increase in sales
So = Sales before liberalising
bn = bad debts loss ratio on new sales
bo = bad debts before changes

Problem
A company is considering relaxing its collection effort.
Its present sales are Rs 50 million, ACP = 20 days,
variable cost to sales ratio = 0.8, cost of capital 10%.
The companys bad debt ratio is 0.05. The relaxation in
collection programme is expected to increase sales by
Rs 5 million, increase ACP to 40 days and bad debts
ratio to 0.06. Tax rate is 30%.
Examine the effect of change in collection programme
on firms profits. Assume 360 days in a year.

Solution
Increase in Contribution
= 5, 000, 000 x 0.2
= Rs.1, 000, 000

Increase in bad debts

Bad debts on existing sales

= 25,00,000

(50, 000, 000 x 0.05)

Bad debts on total sales after increase in sales

= 33,00,000

(55, 000, 000 x 0.06 )

Increase in bad debts

= Rs.8,00,000

Incremental investment in receivables

50,000,000( 40 20 ) 5,000,000 40 0.8

360
360

= 2777778 + 444444 = Rs.3222222

Opportunity cost of incremental investment in
receivables
= 0.1x 3222222 = Rs.322222

Impact of New Collection policy

Incremental contribution

1,00,000

Less: increase in bad debts

8,00,000
2,00,000

Less: Income tax at 30%

60,000
1,40,000

Less: opportunity cost of increase in investment in

receivables
Profit/loss

3,22,222
(1,82,222)
negative

Since the change will lead to decrease in profit (a loss of

Rs.182222) it is not desirable to relax the collection programme
of the firm.