Financial Management Unit 14

Unit 14 Receivable Management

Structure:
14.1 Introduction
Objectives
14.2 Costs Associated with Maintaining Receivables
14.3 Credit Policy Variables
14.4 Evaluation of Credit Policy
14.5 Summary
14.6 Glossary
14.7 Terminal Questions
14.8 Answers
14.9 Case Study

14.1 Introduction
In the previous unit, we studied about inventory management, role of
inventory in working capital, costs associated with inventories. In this unit,
we will discuss about costs associated with maintaining receivables. Firms
sell goods on credit to increase the volume of sales. In the present era of
intense competition, to improve their sales, business firms offer relaxed
conditions of payment to their customers. When goods are sold on credit,
finished goods get converted into receivables.
Trade credit is a marketing tool that functions as a bridge for the movement
of goods from the firm’s warehouse to its customers. When a firm sells
goods on credit, receivables are created. The receivables arising out of
trade credit have three features:
 Receivables that arise out of trade credit involve an element of risk.
Therefore, before sanctioning credit, careful analysis of the risk involved
needs to be done.
 Receivables out of trade credit are based on economic value. Buyer
gets economic value in goods immediately on sale, while the seller
receives an equivalent value later on.
 Receivables out of trade credit have an element of futurity. The buyer
makes payment in future.

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Amounts due from customers, when goods are sold on credit are called
trade debits or receivables. Receivables form a part of the current assets.
These constitute a significant portion of the total current assets of the
buyers, after inventories.
Receivables are assets – accounts representing amount due to the firm
from sale of goods/services in the ordinary course of business.
The main objective of selling goods on credit is to promote sales, for
increasing the profits of the firms. Customers always prefer buying on credit
rather than buying on cash. They always go to a supplier who gives credit.
Therefore, all firms grant credit to their customers to increase sales, profit
and to sustain competition.
Objectives:
After studying this unit, you should be able to:
 explain the meaning of receivables management
 recognise the costs associated with maintaining receivable
 determine the credit policy variables
 define the process of evaluation of credit policy
Meaning of receivables management
Receivables are a direct result of credit. A firm resorts to credit sales to push
up its sales which in turn, push up the profits earned by the firm. At the
same time, by selling goods on credit the funds of the accounts receivables
are blocked.
Therefore, additional funds are required for the operating needs of the
business, which involve extra costs in terms of interest. Moreover, increase
in receivables also increases the chances of bad debts. Thus, creation of
accounts receivables is beneficial as well as dangerous to the firm.
The financial manager needs to follow a policy of using cash funds
economically to such an extent that it is possible to extend the receivables
to enhance the chances of increasing sales and making more profits.
Management of accounts receivables may, therefore, be defined as the
process of making decision related to the investment of funds in receivables
for maximising the overall return on the investment of the firm.

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Thus, the objective of receivables management is to promote sales and

projects, until the cost involved in further funding of receivables is less than
the cost involved in financing that additional cost. Therefore, the purpose of
receivables can be directly related to the company’s objectives of promoting
credit sales. Those objectives are as follows:
 To increase sales – when a company sells its goods on credit, it will be
able to sell more goods than if it insists on immediate cash payments.
 To increase profits – this is as a result of increase in sales, not just in
terms of volume, but also in terms of profit margins. Firms normally have
a higher profit margin set on credit sales than cash sales.
 To meet increasing competition – company may look at granting
better credit facilities in order to attract more customers.

14.2 Costs Associated with Maintaining Receivables

There are four different varieties of costs associated with maintaining
receivables: capital cost, administration cost, delinquency cost and bad-
debts or default cost. Figure 14.1 depicts the costs associated with
maintaining of receivables.

Figure 14.1: Costs Associated with Maintaining Receivables

Capital cost
When firm sells goods on credit, the good achieves higher sales. Selling
goods on credit has consequences of blocking the firm’s resources in
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receivables, as there is a time lag between a credit sale and cash receipt
from customers.
To the extent the funds are held up in receivables, the firm has to arrange
for additional funds to meet its own obligation of monthly as well as daily
recurring expenditure. Additional funds may have to be raised either out of
profits or from outside.
In both the cases, the firm incurs a cost. In the former case, there is the
opportunity cost of the income the firm could have earned had the same
amount been invested in some other profitable avenue. In the latter case of
obtaining funds from outside, the firm has to pay interest on the loan taken.
Therefore, sanctioning credit to customers for the sale of goods has a
capital cost.
Administration cost
When a firm sells goods on credit it has to incur two types of administration
costs:
 Credit investigation and supervision costs
 Collection costs
Before sanctioning credit to a customer, the firm has to investigate the credit
rating of the customer to ensure that credit given will be recovered on time.
Therefore, administration costs are incurred in this process.
Costs incurred in collecting receivables are administrative in nature. These
include additional expenses on staff for administering the process of
collection of receivables from customers.
Delinquency cost
The firm incurs this cost when the customer fails to pay back the amount on
the expiry of credit period. These costs take the form of sending reminders
and legal charges.
Bad-debts or Default costs
When the firm is unable to recover the due amount from its customers, it
results in bad debts. Defaults occur when a firm relaxes its credit policy, for
customers with relatively low credit rating. In this process, a firm may make
credit sales to customers who do not pay at all.

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Therefore, assessing the effect of a change in credit policy of a firm involves

examination of:
 Opportunity cost of lost contribution
 Credit administration cost
 Collection costs
 Delinquency cost
 Bad-debt losses

Self Assessment Questions

1. Costs of maintaining receivables are _____________, _________ cost
and _______.
2. A period of “Net 30” means that it allows its customers, 30 days of
credit with ____ for ___________.
3. Selling goods on credit has consequences of blocking the firm’s
resources in receivables as there is a time lag between
_____________ and ____________.
4. When a firm sells goods on credit it has to incur two types of
administration cost: _____ and _________________.
5. The four different varieties of costs associated with maintaining
receivables are _________, ________, _____ and ____.
6. Define receivable management.
7. Define receivables.

14.3 Credit Policy Variables

The credit policy of a firm can be termed as a trade-off between increased
credit sales leading to increase in profit and the cost of having larger amount
of cash locked up in the form of receivables along with the loss due to the
incidence of bad debts.
The term ‘credit policy’ comprises the policy of a company with respect to
the credit standards adopted; the period over which the credit is extended to
customers; any incentive in the form of cash discount offered; as also the
period over which the discount can be used by the customers; and the
collection effort made by the company.
Thus, the four aspects of credit policy are as follows (see figure 14.2):
 Credit standards

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 Credit period
 Cash discounts and
 Collection programme
These variables are related and have a bearing on the level of sales, bad
debt loss, discounts taken by customers, and collection expenses. Figure
14.2 depicts the credit policy variables.

Figure 14.2: Credit Policy Variables

Credit standards
The term credit standards refer to the criteria for extending credit to
customers. The basis for setting credit standards are:
o Credit ratings
o References
o Average payment period
o Ratio analysis
There is always a benefit to the company with the extension of credit to its
customers, but with the associated risks of delayed payments or non-
payment and of getting funds blocked in receivables.
The firm may have light credit standards. The firm may sell goods on cash
basis and extend credit only to financially strong customers.
Such strict credit standards will bring down bad-debt losses and reduce the
cost of credit administration.
However, the firm will not be able to increase its sales. The profit on lost
sales may be more than the costs saved by the firm. The firm should
evaluate the trade-off between cost and benefit of any credit standards.
Credit period
Credit period refers to the length of time allowed by a firm, for its customers
to make payment, for their purchases. Credit period is generally expressed
in days like 15 days or 20 days. Generally, firms give cash discount if
payments are made within the specified period.
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If a firm follows a credit period of ‘net 20’ it means that it allows its
customers 20 days of credit with no inducement for early payments.
Increasing the credit period will bring in additional sales from existing
customers and new sales from new customers.
Reducing the credit period lowers sales, decreases investments in
receivables and reduces the bad-debt loss. Increasing the credit period
increases sales, increases investment in receivables and increases the
incidence of bad debt loss.
The effects of increasing the credit period on the profits of the firms are
similar to that of relaxing the credit standards.
Cash discount
Firms offer cash discounts to induce their customers to make prompt
payments. Cash discounts have implications on sales volume, average
collection period, investment in receivables, incidence of bad debts and
profits.
A cash discount of 2/10 net 20 means that a cash discount of 2% is offered
if the payment is made by the tenth day; otherwise full payment will have to
be made by 20th day.
Collection programme
The success of a collection programme depends on the collection policy
pursued by the firm. The objective of a collection policy is to achieve a
timely collection of receivables. Releasing funds locked in receivables and
minimising the incidence of bad debts are the other objectives of the
collection policy. The collection programmes consists of the following:
o Monitoring the receivables
o Reminding customers about due date of payment
o Interacting on-line through electronic media with customers about the
payments due, around the due date
o Initiating legal action to recover the amount from overdue customers as
the last resort to recover the dues from defaulted customers
o Formulating collection policy such that, it should not lead to bad
relationship with the customers

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Self Assessment Questions

8. Credit period is a ______________.
9. _______ refer to the criteria for extending credit to customers.
10. _________ refers to the length of time allowed by a firm for its
customers to make payment for their purchase.
11. A cash discount of 2/10 net 20 means that a ____________ is offered
if the payment is made __________________.
12. The four varieties of credit policy variables are ____, ______, _____
and _____.

14.4 Evaluation of Credit Policy

Credit policy of every company is largely influenced by two conflicting
objectives, irrespective of the native and type of company. They are liquidity
and profitability. Liquidity can be directly linked to book debts. Liquidity
position of a firm can be easily improved without affecting profitability by
reducing the duration of the period for which the credit is granted and further
by collecting the realised value of receivables as soon as they fail due. To
improve profitability one can resort to lenient credit policy as a booster of
sales, but the implications are:
 Chances of extending credit to those with week credit rating.
 Unduly lenient credit terms.
 Tendency to expand credit to suit customer's needs.
 Lack of attention to over dues accounts.
Optimum credit policy is one which would maximise the value of the firm.
Value of a firm is maximised when the incremental rate of return on an
investment is equal to the incremental cost of funds used to finance the
investment.
Therefore, credit policy of a firm can be regarded as:
 Trade-off between higher profits from increased sales and
 The incremental cost of having large investment in receivables
The credit policy to be adopted by a firm is influenced by the strategies
pursued by its competitors. If competitors are granting 15 days credit and if
the firm decides to extend the credit period to 30 days, the firm will be
flooded with customers’ demand for company’s products.

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To summarise, in order to achieve the goal of maximising the value of the

firm the evaluation of investment in receivables accounts should involve the
following four steps:
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
In reality, it is rather a different task to establish an optimum credit policy as
the best combination of variables of credit policy is quite difficult to obtain.
The important variables of credit policy should be identified before
establishing an optimum credit policy and then they should be evaluated.
We have learnt about the important credit policy variables in the earlier
pages.
Individual evaluation of all the four credit policy variables of a firm is as
shown:
Credit standard
The effect of relaxing the credit standards on profit can be estimated as
under:
P = S (1-V) - k I - bn S
P = Change in profit
S = Increase in sales
Contribution to sales ratio = c = 1 – V
Where V = Variable cost to sales ratio
bn = bad debts loss ratio on new sales
k = post tax cost of capital
I = Increase in receivables investment= S/360 X Average collection period
(ACP) X V
Therefore,

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 Incremental investment in receivables.
= Increase in profit i.e. change in profit = [Incremental contribution – Bad

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Solved Problem – 1
The details shown in table 14.1 are regarding the statistics of the
company X Ltd.
Table 14.1: Statistics of 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. (MBA) adopted.
Solution
Incremental contribution = 15 x 0.20 = Rs 3 million
Bad debts on new sales = 15 x 0.10 = Rs 1.5 million
Cost of capital is 10%
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
10
Cost of incremental investment   1.33 = 0.133
100
Therefore, change in profit is calculated using the information in table
14.2
Table 14.2: Change in Profit ( in millions)
Incremental contribution 3.00
Less: bad-debts on new sales 1.50
Less: Income tax at 30% .45
1.05
Less: Opportunity cost of incremental 0.13
investment in receivables
Increase in profit 0.92

Because the impact of change in credit standards on profit is positive, the

change in credit standards may be considered.
debts on new sales]

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Credit period
Credit period refers to the length of time allowed to customers to pay for
their purchases. It generally varies from 15 to 60 days. If a firm allows, 45
days of credit with no discount to induce early payment, its credit terms are
stated as ‘net 45’.
Lengthening the credit period pushes sales up by inducing existing
customers to purchase more and attracting additional customers, at the
same time increasing receivables investment and incidence of bad debts.
The effect of changing the credit period on profits of the firm can be
computed as shown:

Change in profit = (Incremental contribution – Bad debts on new sales) Formatted: Font color: Auto

(1 – tax rate) – cost of incremental investment in receivables. Formatted: Font color: Auto
Formatted: Font color: Auto
The components of the formula are the same as discussed in the earlier
section, i.e.
P = S (1-V) - k I - bn S
Except for one thing that here I = increase in investment is defined as
below:
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

Solved Problem – 2
A company is currently allowing its customers, 30 days of credit. Its
present sales are Rs 100 million. The firm’s 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 extension will increase the
sales of the firm by Rs 100 million. Bad debts on additional sales would be
8%. Tax rate is 30%. Assume 360 days in a year. Examine the effect of
relaxing the credit policy on the profitability of the organisation
(MBA) adopted.

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Solution
Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000
Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000
Existing investment in receivables =
30
1,00,000,000   Rs.8,333,333
360
Expected investment in receivables after increasing the credit period to
60 days:
Expected investment in receivables on current sales =
1,00,000,000
  60  Rs.16,666,667
360
60
1,00,000,000   0.80  Rs.13,33,333
360
Additional investment in receivable on new sales = Rs. 13,33,333
Expected total investment in receivables on increasing the period of
credit = 1,80,00,000
Incremental investment in receivables = 18000000 – 8333333 =
Rs. 9666667
Opportunity cost of incremental investment in receivables =
0.10 x 9666667 = Rs.966667
Table 14.3 depicts the statement showing the effect of increasing the
credit period from 30 days to 60 days as firm’s project.
Table 14.3: Effect of Increase in Credit Period
Incremental contribution 20,00,000
Less: Bad debts on new sales 8,00,000
12,00,000
Less: Income tax at 30% 3,60,000
8,40,000
Less: Opportunity cost of incremental in
receivables 9,66,667
Change in profit (1,26,667)

Because the impact of increasing the credit period on profits of the firm is
negative, the proposed change in credit period is not desirable.

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Cash discount
Firms usually offer cash discounts to induce prompt payments. Credit terms
reflect the percentage of discount and the period during which it is available.
For instance, credit terms of 1/20, net 30 mean discount of 1 percent is
offered if the payment is made by the 20th day, otherwise the full payment is
due by the 30th day.
For assessing the effect of cash discount the following formula can be used.

Change in profit = (Incremental contribution – Increase in discount cost)

(1 - t) + Opportunity cost of savings in receivables investment
P = S (1 – V) + kI – DIS
Where P = change in profit
S = increase in sales
V = variable cost to sales ratio
k = cost of capital
I = savings in receivables management =
(ACPo – ACPn) (So/360) - V (ACPn) (S/360)

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

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Computation of the effect of new collection programme can be evaluated

with the help of the following formula.
Change in profit = (Incremental contribution – Increase in bad debts) (1 –
tax rate) – cost of increase in investment in receivables.

Formatted: Font color: Auto

P = S (1 – V) – k I – BD – C
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 = b n(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

Solved Problem – 3
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 company’s 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 0.56. Tax rate is 30%.
Examine the effect of change in collection programme on firm’s profits.
Assume 360 days in a year. (MBA adopted and also ACS
Solution
Increase in Contribution = 5, 000, 000 x 0.2 = Rs.1, 000, 000
Increase in bad debts
Bad debts on existing sales = 50, 000, 000 x 0.05 = 25, 00, 000
Bad debts on total sales after increase in sales =

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55, 000, 000 x 0.56 = 33, 00, 000

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

Table 14.4 depicts the statement showing the impact of new collection
programme on profits of the organisation.
Table 14.4: Impact of New Collection
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 3,22,222
receivables
Profit/loss (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.

Activity:
Indicate by a (+), (-) or (0) whether each of the following events would
probably cause A/R, Sales, and profits to increase, decrease or no
change.
A/R Sales Profits
1. The firm tightens credit
standards
2. The credit manager gets
tough with past due
accounts
Hint: Decrease, decrease, decrease
Decrease, decrease, increase
Reference: Fundamentals of Financial Management, Brigham and Houston

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Self Assessment Questions

13. Credit policy of a firm can be regarded as a trade-off between
___________ and _______.
14. Optimum credit policy maximises the __________.
15. 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.
16. Credit policy to be adopted by a firm is influenced by strategies
pursued by its competitors. (True/False)

14.5 Summary
 Receivables are a direct result of credit sales.
 Management of accounts receivables is the process of making decision
related to investment of funds in receivable which will result in
maximising the overall return on the investment of the firm.
 Cost of maintaining receivables are of three types - capital costs,
administration costs and delinquency costs.
 Credit policy variables are credit standards, credit period, cash discounts
and collection programme. Optimum credit policy is that which
maximises the value of the firm.

14.6 Glossary
Credit period: Refers to the length of time allowed to customers to pay for
their purchases.

14.7 Terminal Questions

1. Examine the meaning of receivable management.
2. Examine the costs of maintaining receivables.
3. Examine the variables of credit policy.
4. What are the features of optimum credit policy?

14.8 Answers
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Self Assessment Questions

1. Capital costs, administration, delinquency costs
2. No inducement for early payments
3. Credit sale, cash receipt from customers
4. Credit investigation and supervision cost, collection costs
5. Capital cost, administration cost, delinquency cost and bad-debts or
default cost
6. Management of accounts receivables may be defined as the process
of making decision relating to the investment of funds in receivables
that will result in maximising the overall return on the firm’s investment
7. Receivables are asset-accounts representing amounts owing to the
firm as a result of sale of goods/services
8. Credit policy variable
9. Credit standards
10. Credit period
11. Cash discount of 2%, on the tenth day
12. Credit standards, credit periods, cash discounts and collection
programme.
13. Higher profits from increased sales, incremental cost of having large
investment in receivable.
14. Value of the firm.
15. Equal
16. True

Terminal Questions
1. Receivables are a direct result of credit. Refer to 14.1.
2. There are four different varieties of costs associated with maintaining
receivables. Refer to 14.2.
3. The term ‘credit policy’ comprises the policy of a company with respect
to the credit standards adopted; the period over which the credit is
extended to customers; any incentive in the form of cash discount
offered; as also the period over which the discount can be used by the
customers; and the collection effort made by the company. Refer to
14.3.

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4. Optimum credit policy is one which would maximise the value of the firm.
Refer to 14.4.

14.9 Case Study: Credit Policy

Jubilee Chemicals Ltd. are manufacturer and exporter of industrial
chemicals and fine chemicals such as chlorinated paraffin oil,
monochlorobenzene, paradichlorobenzene, orthodichlorobenzene,
orthonitrochlorobenzene, orthonitroaniline, paranitrochlorobenzene and
ortho nitrotolune.
They are among the leading International Marketing companies in India.
They market chemicals, petrochemicals and commodities to their principals
abroad. They further provide a unique platform to their overseas principals
for developing market of their products in India. The company facilitates
export of the above mentioned products and guaranties international quality,
timely delivery and competitive prices.
The company currently provides a credit period of 30 days to its clients. 25%
of the clients pay on the 15 th day while 50% of the clients pay on the 30 th
day and the rest of the clients pay on the 85 th day.
For the year that ended on March 31, 2011, the company recorded sales of
Rs.10 crores, out of which the credit sales are 80%. Its variable cost to sales
ratio is 80%. The company financed its receivables using bank finance at an
interest rate of 18% p.a. and with a margin requirement of 40%.
Mr. Jadhav, the marketing manager of the company, proposed to change
the credit terms from net 30 to 1/10 net 45. He expects that this change
would improve the credit sales by Rs. 2 crores and also change the
payment pattern of the customers.
If the credit policy is introduced, as per his market survey, 75% of clients
pay on the 10th day, 10% of the clients will pay on the 45 th day and the rest
15% of the clients will pay on the 120th day. He believes that these 15%
clients are also long standing customers and hence need not be
discouraged. The bank will provide finance as per the existing terms for the
additional credit sales, also.
Out of the additional sales of Rs. 2 crores, however there is a risk of bad
debts to the extent of 5%.
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The cost of capital of the company is 16% and the tax rate applicable to it is
35%.

Discussion Questions:
1. Analyse the details and suggest whether the change in credit terms is
advisable.
(Hint: Refer credit variables)
2. Explain how a credit policy affects the sales and reputation of a firm.
(Hint: Refer credit policy)

References:

 Prasanna, Chandra (2007), Financial Management: Theory and Practice,

7th Edition, Tata McGraw Hill.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition

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