5 receivables management
TRANSCRIPT
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Management ofReceivables
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Introduction
Liquid asset after Cash
Credit sales
Sundry Debtors
Why to manage?
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Size and Trends in Receivables
Engineering Industry
Year End
TotalCurrentAssets
SundryDebtors % of CA
Y2010 61857.07 14990.62 24.23
Y2009 145500.08 42801.28 29.42
Y2008 126300.37 38503.85 30.49
Y2007 96936.66 31153.93 32.14
Y2006 77363.00 29279.25 37.85
Y2005 61206.62 24104.23 39.38
Y2004 51113.34 18811.56 36.80
Y2003 47550.10 16326.07 34.33
Y2002 36172.95 12615.32 34.88
Textile Industry
Year End
TotalCurrentAssets
SundryDebtors % of CA
Y2010 16994.55 4675.38 27.51
Y2009 332138.52 96054.26 28.92
Y2008 309076.82 83128.70 26.90
Y2007 273062.19 69223.58 25.35
Y2006 299699.17 61274.61 20.45
Y2005 181011.66 53982.78 29.82
Y2004 156072.06 51531.12 33.02
Y2003 136201.81 47845.64 35.13
Y2002 129824.57 44721.95 34.45
Rs. In million
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Factors Affecting Credit Terms
Competition Operating cycle
Type of good (raw materials vs finished
goods, perishables, etc.) Seasonality of demand
Consumer acceptance
Cost and pricing
Customer type
Product profit margin
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Trade Credit:
Marketing and Finance Trade off Goals of Mktg.:
Meeting Demands
Choice of Distribution system
Long term impact
Goals of Fin.: Optimum Investment
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Distribution Channel
Direct Impact of Receivables and Inventory
Direct Marketing Vs Traditional Chain
Direct Marketing: Best from Receivables Management point of view
Mfg. has direct control over distribution system
Close monitoring
Less distortion in credit information
Better understanding of creditworthiness of customers
Example Go to page No. 46
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Competitive Market From Sellers Market to Buyers Market
There is an inherent conflict between a
manufacturer who typically produce a large
quantity of a limited variety of goods and the
customer who usually desire to buy only a
limited quantity of a wide variety of goods
Requires Dedicated Marketing and
Distribution System
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Motive for Extending Trade Credit
Operating Motive Allow receivables to absorb shocks of demand fluctuations Meet deficit in demand by relaxing credit terms or standards
Respond to variable and uncertain demand Change credit terms rather than:
install extra capacity, building or depleting inventories,
or forcing customers to wait.
Marketing Motive Attract Customers, New Market, Increase in Market share,
occupy display space of distribution outlet etc. Financial Motive
Exploitation of opportunities thrown up by marketimperfections is the source of financial motive for extendingtrade credit
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Financial Motive Trade credit: Lending through receivables
This is an alternative lending opportunity
beyond the money market
Recovering Financial Market Tariff
Difference in lending and borrowing rates
Go to Page No. 52 Example
Price Discrimination
Pushing the Product
Motivating Distribution Channel Member
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Limitations The time period at which marginal cost of fund of a
seller equals the market borrowing rate of the
customer, is the maximum period for which trade
credit can be extended. Tax Consideration: Full profit is booked at the time of
sales under accrual system and quarterly advance tax is
paid on that. Go to Page No. 57 for example
The constraints discussed above limit the Maximum
Length of Trade Credit that a firm can allow on its
receivables.
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A/R Management andShareholder Value
Marketing Strategy
Market Share Obj.
Aggregate Inv. in A/R Credit Terms Credit Standards
Total Dollar Investment Length of Time to Pay Acceptance of Marg Cust.
Max Shareholder Value
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TERMS OF PAYMENT
Cash Terms
Open Account
Consignment
Bill of Exchange
Letter of Credit
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Nature of Credit Policy
Investment in receivable
volume of credit sales
collection period
Credit policy
credit standards
credit terms collection efforts
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Goals of Credit Policy
Marketing tool
Maximisation of
sales Vs.
incremental profit
production and selling
costs administration costs
bad-debt losses
Profitability
Liquidity
Tight Credit
policy
Loose
Costs & Benefits
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Optimum Credit Policy
Estimation of incremental
profit
Estimation of incremental
investment in receivable
Estimation of incremental
rate of return (IRR)
Comparison of incre-mental
rate of return with required
rate of return (RRR)
Optimum credit policy:
IRR = RRR
Marginal cost of capital
Marginal rate of return
Tight Creditpolicy
Loose
Costs & Return (%)
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CREDIT POLICY VARIABLES
The important dimensions of a firms credit policy are:
Credit standards
Credit period
Cash discount
Collection effort
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CREDIT STANDARDS
Liberal Stiff
Sales Higher Lower
Bad debt loss Higher Lower
Investment Larger Smaller
in receivables
Collection costs Higher Lower
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IMPACT ON RESIDUAL INCOME
OF RELAXATION
RI= [S(1V) - Sbn] (1t )k Iwhere RI = change in residual income
S = increase in sales
V = ratio if variable costs to sales
bn = bad debt loss ratio on new sales
t = corporate tax rate
I = increase in receivables investment
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EXAMPLE
The current sales of pioneer are 100 ml. The companyclassifies its customers into four categories. Companypresently extends unlimited credit to customers incategory 1 and 2, limited credit to 3 and no credit to 4.As a result it forgoing sales of Rs. 10 ml in category
3&4 each. Company is planning to adopt more liberal standards
and to give unlimited credit to 3rd and limited to 4thcategory
Such relaxation would increase sales by 15 ml on which10% would be bad debt. The contribution margin is20%. The Average collection period is 40 days. The costof fund is 10% and tax rate is 40%
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EXAMPLE
Pioneer Limited is considering relaxing its credit
standards.S = Rs.15 million,bn = 0.10, V= 0.80,ACP = 40 days,k = 0.10,t = 0.4
RI= [15,000,000 (10.80)15,000,000 x 0.10] (10.4)15,000,000
0.10 x x 40 x 0.80
360
= Rs.766,667
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CREDIT PERIOD
Longer Shorter
Sales Higher Lower
Investment in Larger Smaller
receivables
Bad debts Higher Lower
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IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD
RI= [S(1V) - Sbn
] (1t )k I
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INCREASE IN RECEIVABLES
INVESTMENT
S0 SI= (ACPnACP0) + V(ACPn)
360 360
where: I = increase in receivables investmentACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection periodV = ratio of variable cost to sales
S = increase in sales
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EXAMPLE
Zenith Limited is considering extending its credit period
from 30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V= 0.85,bn = 0.08, k = 0.10,t = 0.40
RI= [5,000,000 x 0.155,000,000 x 0.08] (0.6)
0.10 (6030) x + 0.85 x 60 x
= [750,000400,000] (0.6)0.10 [4,166,667 + 708,333]
=277,500
50,000,000
360
5,000,000
360
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Rakesh Enterprises currently provides 30 dayscredit to its customers. Its present sales are Rs.
200 million .Its cost of capital is 12 percent and
the ratio of variable costs to sales is 0.80Rakesh Enterprises are considering extending
the credit period to 45 days which is likely to
push sales up by Rs.60 million. The bad debt
proportion on additional sales would be 15
percent. The tax rate is 33 percent. What will be
the effect of lengthening the credit period on the
residual income of the firm?
Quiz Time
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Solution
RI = [ S(1-V)Sbn](1-t)kI
I = (ACPNACP0){ S0/360} + V(ACPN) S/360
= (45-30) x (200,000,000/360) + 0.80 x 45 x ( 60,000,000/360)
= 14,333,333
RI = (60,000,000 x 0.20 - 60,000,000 x 0.15)(0.67) -0.12 x 14,333,333
= 290,000
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LIBERALISING THE CASH
DISCOUNT POLICY
RI= [S(1V) - DIS] (1t ) +k I
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Example
The present credit terms of Indus Industries are 3/15,net 30. Its sales are Rs.470 million, its averagecollection period is 45 days, its variable costs to salesratio, V, is 0.85, and its cost of capital is 12 percent.
The proportion of sales on which customers currentlytake discount, is 0.4. Indus is considering relaxing itscredit terms to 5/15, net 30. Such a relaxation isexpected to increase sales by Rs.20 million, increasethe proportion of discount sales to 0.6, and reduce theACP to 40 days. Induss tax rate is 30 percent.
What will be the effect of liberalising the cash discounton residual income?
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Solution
pn (S0 + S) dn - p0S0do
RI = [ S ( IV ) - DIS ] (1 - t ) + R I
DIS =
=
=
0.6 [470,000,000 + 20,000,000 ] x 0.05 - 0.4 x
470,000,000 x 0.03
9,060,000
I
=
=470,000,000 20,000,000
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (4540) - 0.85 x -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- x 40
360 360360
= 4,638,889
RI =
=[ 20,000,000 x 0.15 - 9,060,000] 0.70 + 0.12 x 4,638,889
- 3,685,333
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Quiz Time
The present credit terms of Globus Corporation are 2/10, net 40.It sales are Rs.650 million, its average collection period is 30days, its variable costs to sales ratio, V, is 0.75, and its cost ofcapital is 10 percent. The proportion of sales on which
customers currently take discount, is 0.3. Globus is consideringrelaxing its credit terms to 3/10, net 40. Such a relaxation isexpected to increase sales by Rs.30 million, increase theproportion of discount sales to 0.5, and reduce the ACP to 20days. Globuss tax rate is 35 percent.
What will be the effect of liberalising the cash discount onresidual income?
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Solution
RI = [S (1 V) DIS] (1 t) + R I
DIS = pn (So + S)dnposo do
= 0.5 [650,000,000 + 30,000,000] .030.30 [650,000,000] .02
= 10,200,0003,900,000 = 6,300,000
650,000,000 30,000,000
I = ------------- (3020)0.75 x ------------- x 20
360 360
= 18,055,5561,250,000 = 16,805,556
R I = [30,000,000 (0.25) 6,300,000] (0.65) + 0.10 x 16,805,556
= 780,000 + 1,680,556
= 2,460,556
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DECREASING THE RIGOUR
OF COLLECTION PROGRAMME
RI= [S(1V) - BD] (1t )k I
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The Credit Decision Process
Marketing contact
Credit investigation
Customer contact for information
Finalize written documents, e.g.. security agreements
Establish customer credit file
Financial analysis
Time
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Components of Credit Policy
Development of credit standards
profile of minimally acceptable credit worthy customer
Credit terms
credit period
cash discount
Credit limit
maximum dollar level of credit balances
Collection procedures
how long to wait past due date to initiate collection efforts
methods of contact
whether and at what point to refer account to collection agency
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Credit Evaluation of Customers
Credit information financial statements
bank references
trade references
Credit investigation and analysis analysis of credit file
financial analysis
analysis of business and management
Credit limit
Collection efforts
ERRORS IN CREDIT EVALUATION
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ERRORS IN CREDIT EVALUATION
In assessing credit risks, two types of errors occur :
Type I error A good customer is misclassified as a
poor credit risk
Type II error A bad customer is misclassified as a good
credit risk
TRADITIONAL CREDIT ANALYSIS
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TRADITIONAL CREDIT ANALYSIS
Five Cs of Credit
Character : The willingness of the customer to honour
his obligations
Capacity : The operating cash flows of the customer
Capital : The financial reserves of the customer
Collateral : The security offered by the customer
Conditions : The general economic conditions that
affect the customer
SEQUENTIAL CREDIT ANALYSIS
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Should
credit be
granted?
Character
Capacity Capacity
Capital Capital CapitalCapital
Excellent risk Fair risk Doubtful risk Dangerousrisk
How much
credit
should be
granted ?
SEQUENTIAL CREDIT ANALYSIS
Strong Weak
StrongWeak Weak
Strong
StrongStrong
StrongWeakWeak Weak
WeakStrong
NUMERICAL CREDIT RATING INDEX
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NUMERICAL CREDIT RATING INDEX
Factor Factor Rating weight 5 4 3 2 1 score
Past payment 0.30 1.20
Net profit margin 0.20
0.80Current ratio 0.20 0.60Debt-equity ratio 0.10 0.40Return on equity 0.20 1.00
Rating index 4.00
DISCRIMINANT ANALYSIS
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DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity
+
+
+
+
++
+
+
+
+
+
+ +
++
+
Return on equity
Current
ratio
RISK CLASSIFICATION SCHEME
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isk Class Description
1 Customers withno risk of default
2 Customers with negligiblerisk of default (default rate less than 2
percent)3 Customers with littlerisk of default (default rate between 2 percent
and 5 percent)
4 Customers with some risk of default (default rate between 5 percent
and 10 percent)
5 Customers withsignificantrisk of default (default rate in excess of 10percent)
RISK CLASSIFICATION SCHEME
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Credit-Granting Sequence
No
Order and credit
request received
New/increased
credit limit
Material
change in
customer status
Redo credit
investigation
Size of proposed
credit limit
Medium SmallLarge
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Check new A/R
total vs credit lmt
No Yes
Yes
Extend CreditNo
Yes
Record
disposition
Set up,post
A/R, ship
CREDIT GRANTING DECISION
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p
RevCost
Cost
0
CREDIT GRANTING DECISION
Expected Pre-tax Profit
p (RevenueCost)(1p) Cost
EXAMPLE
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EXAMPLE
ABC Company is considering offering credit to a customer.
The probability that the customer would pay is 0.8 and theprobability that the customer would default is 0.2. The
revenues from the sale would be Rs.1,200 and the cost of
sale would be Rs.800.
The expected profit from offering credit, given the
above information, is:
0.8 (1,200800)0.2 (800) = Rs.160
REPEAT ORDER
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Expected profit on Probability of payment Expected profit on
initial order and repeat order repeat order
[p1(REV1COST1)(1-p1) COST1]
+p1 x [p2 (REV2COST2)(1-p2) COST2]
[0.9 (2000-1500)0.1(1500)]
+ 0.9 [0.95 (2000-1500)0.05 (1500)]
= 660
+ x
REPEAT ORDER
DECISION TREE FOR GRANTING CREDIT
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DECISION TREE FOR GRANTING CREDIT
CONTROL OF ACCOUNTS
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CONTROL OF ACCOUNTS
RECEIVABLES
Days Sales Outstanding
Ageing Schedule
Collection Matrix
COLLECTION MATRIX
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COLLECTION MATRIX
ercentage of Receivables January February March April May June
Collected During the Sales Sales Sales Sales Sales Sales
Month of sales 13 14 15 12 10 9
First following month 42 35 40 40 36 35
Second following month 33 40 21 24 26 26Third following month 12 11 24 19 24 25
Fourth following month - - - 5 4 5
SUMMING UP
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SUMMING UP
The important dimensions of a firms credit policy are : creditstandards, credit period, cash discount, and collection effort
In general, liberal credit standards tend to push sales up byattracting more customers. However, this is accompanied by ahigher incidence of bad debt loss, a larger investment inreceivables, and a higher cost of collection. Stiff credit standardshave opposite effects.
Three broad approaches are used for credit evaluation :traditional credit analysis, numerical credit scoring, anddiscriminant analysis.
The traditional approach to credit analysis calls for assessing a
prospective customer in terms of the five Cs of credit, viz.character, capacity, capital, collateral, and conditions.
Three methods are commonly employed for monitoring accountsreceivable : days sales outstanding, ageing schedule, and