receivables management final (2)
TRANSCRIPT
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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
Example of RelaxingCredit Standards
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
Example of RelaxingCredit Standards
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
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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10-13
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
Example of Relaxingthe Credit Period
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
Example of Relaxingthe Credit Period
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
Example of Relaxingthe Credit Period
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
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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10-19
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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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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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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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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10-26
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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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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Analyzing theCredit Applicant
Obtaining information on thecredit applicant
Analyzing this information todetermine the applicants
creditworthiness
Making the credit decision
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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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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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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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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.