ACCOUNTS RECEIVABLE
Trade credits creates accounts receivable or
trade debtors that the firm is expected to
collect in future.
The customers from whom receivable or book
debts have to be collected in the future are
CHARACTERISTICS OF CREDIT
SALES
• It involves an element of risk that should
be carefully analyzed.
• It is based on economic value.
CREDIT POLICY
A Firms investment in accounts receivable
depends on:
a. The volume of credit sales
b. The collection period
Firms average investment =
Daily credit sales X Average collection
period
Credit policy is evaluated in terms of return and
costs of additional sales.
CREDIT POLICY
• Credit policy refers to
1. Credit standards :
Criteria to decide the types of customers
to whom goods could be sold on credit.
Slow paying customers will increase
investment in receivable and is exposed to
high default risk
CREDIT POLICY
2. Credit terms :
The duration of credit and terms of payment by customers. Extended time period for making payments will increase investment in receivables.
3. Collection efforts:
Determine the actual collection period. The lower the collection period, the lower the investment in accounts receivables and vice versa.
GOALS OF CREDIT POLICY
• A firm following a lenient credit policy will
grant credit in liberal terms and standards
and grant credit to longer period and also
to customers whose creditworthiness is
not fully known.
• A firm following a stringent credit policy
sells on credit on a highly selective basis
only to customers with proven
CREDIT POLICY AS MARKETING
TOOL
Firms use credit policy as a marketing tool during expansion sales.
In a declining market, it is used to maintain market share. It helps to retain old customers and to create new customers.
In a growing market, it is used to increase firm’s market share.
Under a highly competitive situation or recessionary economic conditions, firm loosen its credit policy to maintain sales or to
NECESSITY OF GRANTING
CERDIT
•
Companies in India grant credit for
1. Competition: Higher the degree of
competition, the more the credit grant
2. Bargaining power: Higher bargaining power
leads to less credit or no credit
3. Buyer’s status and requirement: Large
buyers demand easy credit terms.
NECESSITY OF GRANTING
CERDIT
4. Dealer relationship
5. Marketing tool
6. Industry practice & past practice
7. Transit delays: Forced reason for granting
credit.
TYPES OF COST INVOLVED
1. Production and selling cost:
If sales expand with in the existing production capacity there will be increase only in variable production and selling cost.
If capacity is added, then the incremental production and selling costs will include both variable and fixed costs.
Incremental contribution of the change in credit policy is the difference between incremental sales revenue and the incremental production and selling costs.
TYPES OF COST INVOLVED
2. Administration costs:
when the firm loosens its credit policy, two types
of administration costs are involved.
1.
Credit investigation cost
2.
Collection costs
CHANGE IN CREDIT POLICY
The evaluation of change in credit policy
involves analysis of
Opportunity cost of lost contribution
Administration costs and bad-debt losses.
Credit policy will be determined by the trade-off
between opportunity cost and credit
OPTIMUM CREDIT POLICY
Optimum credit policy is one which
maximizes the firm’s value.
Value of firm is maximized when the
incremental or marginal rate of return of
an investment is equal to the incremental
or marginal cost of funds used to finance
the investment
MARGINAL COST- BENEFIT
ANALYSIS
To achieve the goal of maximization of firm’s value, the evaluation of investment in accounts receivable should involve
1. Estimation of incremental operating profit (change in contribution – additional costs)
2. Estimation of incremental investment in accounts receivable ( Investment in accounts receivable = credit sales per day X Average
collection period)
3. Estimation of the incremental rate of return of investment (Operating profit after tax / Investment in accounts receivable)
4. Comparison of the incremental rate of return with the required rate of return.
CREDIT POLICY VARIABLES
1. CREDIT STANDARDS
The two aspects of quality of customers are
Time taken by customers to repay credit obligation.
The average collection period (ACP) determines the speed of payment by customers.
The default rate: It can be measured in terms of bad-debt losses ratio.
The customers are categorized as good, bad and marginal accounts.
DEFAULT RISK
To estimate the probability of default the following three C’s are considered.
1. Character: It refers to the customer’s willingness to pay. The manager should judge whether the customers will make honest efforts to honour their credit obligations.
2. Capacity: It refers to the customer’s ability to pay. It is judged by assessing the customer’s capital and assets offered as security. This is done by analysis of ratios and trends in firm’s cash and
working capital.
3. Condition: It refers to the prevailing economic and other conditions that affect the customers’ ability to pay.
CREDIT ANALYSIS
A firm can do credit analysis using
2. Numerical credit scoring models: It includes
a. Adhoc approach: The attributes identified by the firm may be assigned weights depending on their
importance and combined to create an overall score or index.
d. Simple discriminant analysis: A firm use more
objective methods of differentiating between good and bad customers.(Eg:- ratio of EBDIT to sales)
e. Multiple discriminant analysis: It combines many
factors according to the importance (weight) given to each factor and determine a score to differentiate
CREDIT SCORING MODELS
• Credit scoring models such as MDA are
based on objective factors and help a firm
to quickly distinguish between good and
bad customers.
• These models can mislead since they are
based on past data.
CREDIT GRANTING DECISION
Credit granting decision
Grant Credit
Payment
received Payment Not received Benefit PV of Future Net Cash Flow Cost PV of Lost Investment Net Payoff No Credit No Pay-off
CREDIT TERMS
The stipulations under which the firm sells on credit to customers are called credit terms.
These include
1. Credit period: The length of time for which credit is extended to customers is called the credit period.
2. Cash discount: It is a reduction in payment
offered to customers to include them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is expressed as a percentage of sales. It is a cost to the firm for faster recovery of cash.
COLLECTION POLICY
Collection policy is needed to accelerate
collections from slow payers and reduce bad
debt losses.
2. It should ensure prompt and regular collection.
3. It should lay down clear cut collection
procedures.
4. The responsibility for collection and follow up
should be explicitly fixed.( Accounts or sales)
5. The firm should decide on cash discounts to
be allowed for prompt payment
6. It should be flexible
CREDIT EVALUATION
For effective management of credit, clear cut
guidelines and procedures for granting credit to
individual customers and collecting individual
accounts should be laid down.
The credit evaluation procedure includes:
1. Credit information
2. Credit investigation
3. Credit limits
CREDIT INFORMATION
To ensure full and prompt collection of receivables,
credit should be allowed only to customers who have the ability to pay in time. For this the firm should have credit information of customers.
Collecting credit information involves cost. The cost should be less than the potential profitability.
Depending on cost and time, the following sources can be employed to collect credit information
SOURCES OF CREDIT
INFORMATION
1. Financial statement: One of the easiest ways to obtain information on the financial condition of the customer is to scrutinise his financial statements. (Balance sheet & P&L a/c)
2. Bank references: Bank where the customer
maintains his account is another source of collecting credit information
3. Trade references: Contacting the persons or firms with whom the customer has current dealings is an
useful source to obtain credit information at no cost.
4. Other sources: Credit rating organisations such as CRISIL, CARE etc
CREDIT INVESTINGATION AND
ANALYSIS
The factors that affect the nature and extent of
credit investigation of an individual customer
are:
2. Type of customer, whether new or existing
3. The customer’s business line, background and
the related trade risks.
4. The nature of the product- perishable or
seasonal
5. Size of the customer’s order and expected
further volumes of business with him
CREDIT INVESTINGATION AND
ANALYSIS
Steps involved in credit analysis are
2. Analysis of the credit file: A credit file updated regularly is maintained for each customer, which gives information on his trade experiences, performance report based on financial statements, credit amount etc.
3. Analysis of financial ratios: The evaluation of the customer’s financial conditions should be done very carefully. Ratios should be calculated to determine the customer’s liquidity position, ability to repay debts etc., 4. Analysis of business and its management: The firm
should also consider the quality of management and the nature of the customer’s business. For this a management audit.
CREDIT LIMIT
A credit limit is a maximum amount of credit
which the firm will extend at a point of time.
It indicates the extent of risk taken by the firm by
supplying goods on credit to a customer.
The decision on the magnitude of credit, the
time limit etc depends on the amount of sales,
industry norms and customer’s financial
CREDIT EFFORTS
The firm should follow a well defined credit
policy and procedure to collect dues from
customers.
MONITORING RECEIVABLE
For the success of collection efforts, the
firm needs to monitor and control its
receivables.
The methods used for evaluation are
1. Average collection period
Average Collection period
To judge the collection efficiency, the average collection period (ACP) is compared with the firm’s stated credit period.
ACP = Debtor X360 Credit sales It measures the quality of receivables Limitations:
6. It provides an average picture of collection experience and is based on aggregate data.
7. It is susceptible to sales variations and the period over which sales and receivables have been aggregated.
Thus ACP cannot provide a very meaningful information about the quality of outstanding receivable
AGING SCHEDULE
It breaks down receivables according to
the length of time for which they have
been outstanding.
It overcomes one of the limitations of
aging schedule
COLLECTION EXPERIENCE
MATRIX
Using disaggregated data for analysing
collection experience, the problem of relating
outstanding receivables of a period with the
credit sales of the same period is eliminated.
The receivables is related to sales of the same
period.
Sales over a period of time are shown
horizontally
and
associated
receivables
vertically, and a matrix is constructed
Sales and Receivables from July to December
(Rs. In lakhs)
Month July Aug. Sept. Oct. Nov. Dec. Sales 400 410 370 220 205 350 Receivable July 330 Aug 242 320 Sept 80 245 320 Oct. 0 76 210 162 Nov. 0 0 72 120 160 Dec. 0 0 0 40 130 285
Sales and Receivables from July to December
(Rs. In lakhs)
Month July Aug. Sept. Oct. Nov. Dec. Sales 400 410 370 220 205 350 Receivable July 82.5 Aug 60.5 78.0 Sept 20.0 59.8 86.5 Oct. 0 18.5 56.8 73.6 Nov. 0 0 19.5 54.5 78.0 Dec. 0 0 0 18.2 63.0 81.4
FACTORING
Factoring is a popular mechanism of managing,
financing and collecting receivables.
It is assigning the credit management and
collection, to specialist organisations.
It is an unique financial innovation
It is a method of converting non-productive
inactive asset, receivables into productive asset,
cash by selling receivables to a company that
specialises in their collection and administration.
It is a means of short-term financing
FACTORING
It is a business involving a continuing legal
relationship between a financial institution
(the factor) a business concern (the client)
selling goods or providing services to
trade customers whereby the factor
purchases the client’s accounts receivable
and in relation thereto, controls the credit,
extended to customers and administers
the sales ledger.
FACTORING SERVICES
The factor provides the following services.
3. Sales ledger administration and credit
management
4. Credit collection and protection against
default and bad-debt losses
5. Financial accommodation against the
assigned book debts (receivables).
CREDIT ADMINISTRATION
A factor
2. Helps and advises the firm from the stage of deciding credit extension to customers to the final stage of book debt collection
3. Maintains an account for all customers of all items owing to the firm
4. Provides information about market trends, competition and customers.
5. Makes a systematic analysis of the information regarding credit for its proper monitoring and management.
CREDIT COLLECTION AND
PROCTECTION
The factor undertakes all collection
activity.
Provides full or partial protection against
bed-debts.
Develops appropriate strategy to guard
against possible defaults
FINANCIAL ASSISTANCE
The factor provides financial assistance to
the client by extending advance cash
against book debts.
The advance amount will be equal to
amount of factored receivables minus
1. factoring commission
2. interest on advance
Types of factoring
Factoring facilities can be divided into
3. Full service non-recourse(Old line
factoring)
4. Full service recourse
5. Bulk/agency factoring
FULL SERVICE NON-RECOURSE
In this method,
The book debts are purchased by the factor,
assuming 100% credit risk
Advances upto 80-90% of book debts to client
immediately
The customer pays directly to the factor
This is best suited where
6. Amount involved per customer is substantial
7. There are large number of customers of whom
the client cannot have personal knowledge
FULL SERVICE RECOURSE
In this method
2. The client is not protected against eh risk of bad debts. 3. It is often used as a short term financing rather than
pure credit management and protection service. 4. Less risky from factor’s point of view and less
expensive for the firm.
5. This method is preferred when the customers are
largely spread with low amount involved or if the firm is selling to high risk customers.
BULK/AGENCY FACTORING
It is basically used as a method of
financing book debts.
The client continues to administer credit
and operate sales ledger.
It is used when there is a good system of
credit administration but the client need
finances.
NON-NOTIFICATION FACTORING
Customers are not informed about the
factoring agreement.
The factor keeps the accounts ledger in
the name of a sales company to which the
client sells his book debts.
COST AND BENEFIT OF
FACTORING
Costs involved are
2. The factoring commission or service fee
3. The interest on advance granted by the factor to the firm.
Benefits are:
6. It provides specialised service in credit management and helps the firm’s management to concentrate on manufacturing and marketing
7. Helps the firm to save cost of credit administration due to the scale of economics and specialisation.
A company is currently selling 1,00,000
units of its product at Rs.50 each unit. At
the current level of production, the cost
per unit is Rs. 45, variable cost per unit
being Rs. 40. The company is current
extending one month’s credit to its
customers. It is thinking of extending
credit period to two months in the
expectation that sales will increase by
25%. If the required rate of return(Before
tax) on the fim’s investment is 30%, is the
Incremental sales unit = 25000
Contribution per unit = Rs. 50-40 = Rs.10 Incremental contribution= Rs.2,50,000
New level of receivables= 125000 X 50 X 60 360 = Rs. 1041667
Old level of receivables = 100000 X 50 X 30 360 = Rs. 416667 Incremental investment in receivables =
416667 = Rs. 625000
