Receivables Management Final (2)

8/2/2019 Receivables Management Final (2)

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10-1

Accounts ReceivableAnd Factoring


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10-2

Accounts Receivable

Credit and Collection

Policies Analyzing the Credit

Applicant

Factoring


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10-3

Reasons to Offer Credit

Competition

Market Share

PromotionCredit Availability to Customers

Customer Convenience

Profit


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10-4

Goals of Credit Policy

Marketing tool

Maximisation of sales Vs.incremental profit

production and selling costs

administration costs

bad-debt losses

Opportunitycost

Cost of administrationAnd bad debt losses

Tight credit policy loose

Cost and Benefit

## Firm moves from tight to looseCredit policy ,the opportunity cost

Declines and bad debt losses increaseIn loose credit policy


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10-5

Optimum Credit Policy

Estimation of incremental profit ( change in contribution = change in sales x contributionratio)

Estimation of incremental investment in receivable (investment in accountsrecievable = Credit sales per day Average collection period

Estimation of incremental rate of return (IRR) (Rate of Return = operating profit/investment in accounts recievable

Comparison of incre-mental rate of return with required rate of return(RRR)

Optimum credit policy: IRR = RRR

Cost andReturn %

Optimum investment in

recievable

Marginal rateof return (r)

Marginal costOf capital (k)

Stringent credit policy liberal


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10-6

Credit and CollectionPolicies of the Firm

(1) AverageCollection Period

(2) Bad-debt

Losses

Quality ofTrade Account

Length ofCredit Period

Possible CashDiscount

FirmCollectionProgram


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10-7

Credit Standards

The financial manager should continually

lower the firms credit standards as long asprofitability from the change exceeds theextra costs generated by the additional

receivables.

Credit Standards -- The minimum qualityof credit worthiness of a credit applicant

that is acceptable to the firm.Why lower the firms credit standards?


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10-8

Credit Standards

A larger credit department

Additional clerical work

Servicing additional accounts

Bad-debt losses

Opportunity costs

Costs arising from relaxingcredit standards


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10-9

Example of RelaxingCredit Standards

Basket Wonders is not operating at full capacityand wants to determine if a relaxation of their

credit standards will enhance profitability. The firm is currently producing a single

product with variable costs of Rs 20 andselling price of Rs25.

Relaxing credit standards is not expected toaffect current customer payment habits.

Production is 48000 units


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10-10


Additional annual credit sales of Rs120,000 and anaverage collection period for new accounts of 3months is expected.

The before-tax opportunity cost for each Rupee offunds tied-up in additional receivables is 20%.

Ignoring any additional bad-debt lossesthat may arise, should Basket Wondersrelax their credit standards?


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10-11


Profitability of (Rs 5 contribution) x (4,800 units) =additional sales $24,000

Additional ($120,000 sales) / (4 Turns) =receivables $30,000

Investment in ($20/$25) x ($30,000) =add. receivables $24,000

Req. pre-tax return (20% opp. cost) x $24,000 =on add. investment $4,800

Yes! Profits > Required pre-tax return


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10-12



(2) Bad-debt

Losses






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10-13

Credit Terms

A) Credit Period -- The total length of time

over which credit is extended to a customerto pay a bill. For example, net 30requiresfull payment to the firm within 30 days from

the invoice date.

Credit Terms -- Specify the length of timeover which credit is extended to a customer

and the discount, if any, given for earlypayment. These Includes


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10-14

Example of Relaxingthe Credit Period

Basket Wondersis considering changing itscredit period from net 30(which has resultedin 12 A/R Turns per year) to net 60(which is

expected to result in 6 A/R Turns per year).

The firm is currently producing a single productwith variable costs of $20 and a selling price of

$25.

Additional annual credit sales of $250,000 fromnew customers are forecasted, in addition to the

current $2 million in annual credit sales.


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10-15


The before-tax opportunity cost for each dollarof funds tied-up in additional receivables is20%.

Ignoring any additional bad-debt lossesthat may arise, should Basket Wonders

relax their credit period?


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10-16


Profitability of ($5 contribution)x(10,000 units) =additional sales $50,000

Additional ($250,000 sales) / (6 Turns) =receivables $41,667

Investment in add. ($20/$25) x ($41,667) =receivables (new sales) $33,334

Previous ($2,000,000 sales) / (12 Turns) =receivable level $166,667


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10-17


New ($2,000,000 sales) / (6 Turns) =receivable level $333,333

Investment in $333,333 - $166,667 =add. receivables $166,666(original sales)

Total investment in $33,334 + $166,666 =

add. receivables $200,000

Req. pre-tax return (20% opp. cost) x $200,000 =on add. investment $40,000

Yes! Profits > Required pre-tax return


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10-18



(2) Bad-debt

Losses






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10-19

Credit Terms

Cash Discount -- A percent (%) reduction in

sales or purchase price allowed for earlypayment of invoices. For example, 2/10

allows the customer to take a 2% cash discountduring the cash discount period.

Cash Discount Period -- The period of timeduring which a cash discount can be taken forearly payment. For example, 2/10allows a

cash discount in the first 10 days from theinvoice date.


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10-20

Example of Introducinga Cash Discount

A competing firm of Basket Wonders isconsidering changing the credit period from

net 60(which has resulted in 6 A/R Turnsper year) to 2/10, net 60.

Current annual credit sales of $5 million areexpected to be maintained.

The firm expects 30% of its credit customers (indollar volume) to take the cash discount andthus increase A/R Turns to 9


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10-21

The before-tax opportunity cost for each dollarof funds tied-up in additional receivables is20%.

Ignoring any additional bad-debt lossesthat may arise, should the competing firm

introduce a cash discount?

Example of Introducinga Cash Discount


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10-22

Example of Usingthe Cash Discount

Receivable level ($5,000,000 sales) / (6 Turns) =(Original) $833,333

Receivable level ($5,000,000 sales) / (9 Turns) =(New) $555,556

Reduction of $833,333 - $555,556 =investment in A/R $277,777


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10-23

Pre-tax cost of .02 x .3 x $5,000,000 =the cash discount $30,000.

Pre-tax opp. savings (20% opp. cost) x $277,777 =on reduction in A/R $55,555.

Yes! Savings > Costs

The benefits derived from released accountsreceivable exceed the costs of providing the

discount to the firms customers.

Example of Using theCash Discount


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10-24

Seasonal Dating

Avoids carrying excess inventory and the

associated carrying costs.

Accept dating if warehousing costs plus therequired return on investment in inventory exceedsthe required return on additional receivables.

Seasonal Dating -- Credit terms thatencourage the buyer of seasonal products

to take delivery before the peak sales periodand to defer payment until after the peak

sales period.


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10-25



(2) Bad-debt

Losses






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10-26

Default Risk andBad-Debt Losses

PresentPolicy Policy A Policy B

Demand $2,400,000 $3,000,000 $3,300,000Incremental sales $ 600,000 $ 300,000Default losses

Original sales 2%

Incremental Sales 10% 18%Avg. Collection Pd.

Original sales 1 monthIncremental Sales 2 months 3 months


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10-27

Default Risk andBad-Debt Losses

Policy A Policy B

1. Additional sales $600,000 $300,0002. Profitability: (20% contribution) x (1) 120,000 60,000

3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,0004. Add. receivables: (1) / (New Rec. Turns) 100,000 75,0005. Inv. in add. receivables: (.80) x (4) 80,000 60,0006. Required before-tax return on

additional investment: (5) x (20%) 16,000 12,0007. Additional bad-debt losses +

additional required return: (3) + (6) 76,000 66,000

8. Incremental profitability: (2) - (7) 44,000 (6,000)

Adopt Policy A but not Policy B.


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10-28

Collection Policyand Procedures

The firm should increase collectionexpenditures until the marginal

reduction in bad-debt losses equals

the marginal outlay to collect.

CollectionProcedures

Letters

Phone calls

Personal visits Legal action

SaturationPoint

Collection Expenditures

Bad-Debt

Losses


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10-29

Analyzing theCredit Applicant

Obtaining information on thecredit applicant

Analyzing this information todetermine the applicants

creditworthiness

Making the credit decision


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10-30

Sources of Information

Financial statements

Credit ratings and reports

Bank checking

Trade checking

Companys own experience

The company must weigh the amountof information needed versus the time

and expense required.


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10-31

Credit Analysis

the financial statements of the firm(ratio analysis)

the character of the company

the character of management the financial strength of the firm other individual issues specific to

the firm

A credit analyst is likely to utilizeinformation regarding:


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10-32

Other CreditDecision Issues

Line of Credit -- A limit to the amount of credit

extended to an account. Purchaser can buy oncredit up to that limit.

Streamlines the procedure for shippinggoods.

Credit-scoring System -- A system used todecide whether to grant credit by assigningnumerical scores to various characteristics

related to creditworthiness.


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10 33

Other CreditDecision Issues

Credit decisions are made Ledger accounts maintained

Payments processed Collections initiated

Decision based on the corecompetenciesof the firm.

Outsourcing Credit and Collections

The entire credit and/or collection function(s)

are outsourced to a third-party company.

Documents

Receivables Management Final (2)