Accounts Receivable Management

SO FAR in WC mgmt…• Working capital and net working capital?• Determinants of working capital?• Sources of liquidity• Sources and uses of cash• How stock holder value maximisation, value of a firm and WC

mgmt is related?• Operating cycle concept• Issues in WC financing• Issues in optimal working capital• Cash Budgeting• Cash management models

• Accounts receivable (also popularly known as receivables) constitute a significant portion of the total current assets of the business next after inventories. They are a direct consequence of ‘trade credit’ which has become an essential marketing tool in modern business.

• Granting credit is making an investment tied to a sale of product or service

• Receivables created in books when goods or services are sold on credit.

• Usually, the credit sales are made on open account which means that no formal acknowledgements of debt obligations are taken from the buyer except the PO, shipping documents, despatch statement etc.

• Meaning: Receivables are asset accounts representing amounts owned to the firm as a result of sale of goods/services in the ordinary course of business.

• The objective of such a facility is to allow the customer a reasonable period of time in which they can pay for the goods purchased by them.

• Terms of Sale• Credit period• Credit standards• Collection policy

What four variables make up a firm’s credit policy?

Terms of Sale• The conditions under which a firm sell its

products or services for cash or creditBasic form - • Net 30.• 2/10 net 30It means that

<Take this discount form invoice price> / <If you pay in as many days><else pay the full invoice amount in this many days>

Terms of Sale

•The Credit Period

The invoice date- ROG, EOM, seasonal

The Length of Credit PeriodOC of the buyer

Factors influencing Credit Period

Other factors influencing Credit Period

• Perishability• Consumer demand• Cost, profitability and standardisation• Credit risk• Size of the account• Competition• Customer type

Cash Discount

• Cost of discount and firm’s investment in receivables.

M atu rity P rice C u rren t P rice

C u rren t P rice

Problems1) 2/10 net 30. What is the cost to the buyer of not paying early?2) A firm has a terms of net 30 and ACP of 30 days. If it offers 2/10 net 30, 50% of customers will use the discount offer. The remaining customers will take an average of 30 days to pay.If firms annual credit sales are $15 million (before discount) , what will be the investment in receivables?

Credit policies:The credit policy is based on:• Credit standards and • Credit analysis

Optimal credit policy• Receivables as a result of - trade credit – push up

sales – to push up profit.• Credit sales leads to blocking of funds – therefore

additional funds are required for the operating needs resulting in additional costs in the form of interest

• Increase in trade credits results in bad debts.• Management of accounts receivables, therefore, is

defined as the process of making decisions relating to the investment of funds in this asset, which will result in maximising the overall return on the investment of the firm.

Therefore, the objective of receivable management is to promote sales and profits until that point is reached where the return on investment in further funding of receivables is less than the cost of the funds raised to finance that additional credit. i.e. the cost of capital.

Purpose of receivables:• Achieving growth in sales• Increasing profits• Meeting competition

Cost of maintaining receivables:• Capital costs – when funds blocked in receivables

means raising of additional funds to meet other cash out flows, resulting in additional capital costs

• Administrative costs• Collection costs – a. additional operating costs for

maintaining records etc and b. credit information about debtors

• Defaulting costs – bad debts• Delinquency costs – costs due to non-payment in

time – sending remainders, getting legal opinion etc

Credit Standards• Refers to the basic consideration for the extension of

credit facilities to the customers. If the standards are high, the sales and receivables are less and vice versa

• The credit standards are fixed by the factors such as:– Collection costs such as operating costs such as maintaining

records, staffing, bad debts, legal charges etc – are semi variable – a portion can be controlled.

– Average collection period – the time gap between the availing of credit and repayment – longer period means idle investment.

– Credit ratings – the integrity of the customers– Financial ratios such as debt collection period, liquid and current

asset ratios, CA to total assets etc

Credit analysis• It is the probability of ascertaining that a customer will

not pay

The credit analysis is usually done in two steps:• Obtaining credit information – from internal or external

sources. Usually the internal sources are supplemented by the external sources of information such as financial statements, bank references, trade references and specialist credit bureau reports.

• Analysis of credit information – by using quantitative and qualitative techniques and compare with the firm’s credit policies.

THE 5 C’S OF CREDIT ANALYSIS

Character of Owner/Manager

Capacity to Repay Financial Forecast Business Plan Income or Profits

Collateral Liquidation Value Enforceability Liquidity

Credit Conditions Ability to Access New

Financing Credit Checks Terms of Loan

Capital Adequate Amount of

Long-Term FundsEspecially Equity

Credit analysis

• One time sale vs repeat sale• New customer vs existing customer

Credit Terms• After establishing good credit policy the concern

should design its credit terms. Credit terms mean the principles listed for extending credit facilities to the customers. It contains three elements:

• Credit period• Cash discount• Cash discount period• The credit period is highly flexible and vary depending

upon the nature of business, nature of customers, competition, inventory policy etc. Further, an earlier period is fixed to avail some concessions by the customers in the form of cash discounts vary from 1 – 2.5 %. The cash discount is a loss, but ensures prompt payments and better turn over of cash.

Collection Policies• The collection policies are the procedure to be

followed in collecting the receivable after the expiry of collection period.

• The collection policy can be liberal or strict based on the cost-benefit analysis.

• The collection procedure should be fixed, for an efficient receivable management.

• The receivable can be collected through,• Sending reminders• Personal contacts• Collection agencies• Legal action as last resort

Monitoring ReceivablesAge Days

Amount (000) Percent of Total

0 – 30 $200 46.51%

31 – 60 150 34.88%

61 – 90 50 11.63%

Over 90 30 6.98%

Total $430 100%

Trade-off Between Non-Collection and Stringent and Expensive Collection Methods as well as Loss

of Customer Goodwill

Inventory Management

• Inventories are goods held for eventual sale by a firm. Inventories are thus one of the major elements, which help the firm in obtaining the desired level of sales.

Kinds of Inventories• Raw materials: goods not yet been committed to

production in a manufacturing firm consists of basic raw materials or finished components.

• Work-in-progress: This includes those materials which have been committed to production process but not yet been completed

• Finished goods: These are completely produced products awaiting for sale. They are the final output of the production process after inspection in a manufacturing firm and in retail and wholesale merchandise, it is referred to as merchandise inventory.

• The level of inventory differ depending upon the nature of business, time, type of inventory, availability of facilities etc.

Benefits of holding inventories:• Avoiding losses of sales• Availing quantity discounts• Reducing ordering cost• Achieving efficient production runs, thereby

reducing the set up costs• Risks and costs associated with inventories

such as – Price decline– Product deterioration– Obsolescence

However, management of inventories from the finance manager point of view involves two basic problems:

1.Maintaining a sufficient large size of inventory for efficient and smooth production and sales operation

2.Maintaining a minimum investment in inventories to minimise the direct/indirect costs associated with holding inventories to maximise profitability

• High inventory means high interest cost and high storage costs

• Low inventory means interruption in production schedule resulting in underutilization of capacity and lower sales

Management of inventory• Good inventory management is good financial

management• Inventories constitute a major element of total WC

hence inventory involve costsInventory management covers:-• Fixation of minimum and maximum levels• Determining the size of inventory to be carried• Deciding about the issue price policy• Setting up receipt and inspection procedure• Determining the EOQ• Providing proper storage facilities• Keeping check on obsolescence and setting up

effective information system with regard to inventories

So, the objective is to hold optimum inventory to ensure:-

• Continuous sufficient stock of raw materials in periods of short supply

• Sufficient stock of raw materials in periods of short supply

• Sufficient stock of finished goods for smooth sales

• Minimum carrying costs• Investment in inventories at the optimum

level

Techniques of inventory managementEconomic Order quantity• EOQ refers to the size of the order which gives

maximum economy in purchasing any item of raw material or finished product after taking into consideration of the following costs

• Ordering cost – It is the cost of placing an order and securing supplies. It varies from time to time depending upon the orders placed and the number of items ordered. The more frequent the placing of orders and few the quantity in each order, greater the ordering cost and v.v.

• Inventory carrying cost – It is the cost of keeping items in stock, includes interest on investment, obsolescence losses, store-keeping cost, insurance premium etc. The larger the volume of inventory, higher the ICC

• As the ordering cost or the cost of acquiring decreases while the cost of holding increases with every increase in the quantity of purchase lot. A balance is therefore stuck between the two opposing factors and the economic ordering quantity is determined at a level for which the aggregate of two cost is the minimum

EOQ = 2UP CS Where, U = Quantity(units) purchased in a year or

month• P = Cost of placing an order• S = Percentage of storage cost and carrying

cost • C = Cost per unit of material

• Assumptions:• The firm knows with certainty the annual usage or

demand of the particular item of inventories• The rate at which the firm uses the inventories or

makes sales is constant throughout the year• The orders for replenishment of inventory are placed

exactly when inventories reach at zero level• The above assumptions may also be called as

limitations of EOQ model.– There is every likelihood of a discrepancy between actual

and estimated demand for a particular item of inventory– The assumptions as to constant usage or sale of

inventories are also of doubtful validity.

2. Determination of reorder level• Reorder level is that level of inventory at which the firm

should place an order to replenish the inventory. In case, the order is placed at this level, the new goods will arrive before the firm runs out of goods to sell.

• In order to determine reorder level, information is required about two things – a. the lead time and

• b. the usage time• Lead time: It is the normal time taken in receiving the

delivery of inventory after the order has been placed • Usage time: It is the rate at which the consumption

took place, either daily or weekly etc.• Reorder level = Average usage x Lead time

• 3. Safety stock• The reorder level is computed presuming that there is

no uncertainty regarding the usage as well as the lead time. However in actual practice, it is almost impossible to correctly predict both of them. The actual usage and the lead time may be different from the normal usage and/or normal lead time. In order to guard against such a contingency, the firm maintains a safety stock – the minimum of buffer stock as a cushion against possible increase in usage or delay in delivery time.

• The level of safety stock can be worked out with the following formula:

• Safety stock = Average usage x period of Safety stock• If the firm maintains safety stock, then the • ROL = Lead time x Average usage + Safety stock