Chapter 5

Receivables management
Receivables management refers to the decision a business makes regarding to the overall credit,
collection policies and the evaluation of individual credit applicants. Receivables Management is
also called trade credit management.
When a firm makes an ordinary sale of goods or services and does not receive payment, the firm
grants trade credit and creates accounts receivable which could be collected in the future.
Receivables management is also called trade credit management.
The term receivables refer to the debt amount payable to firm by the customers resulting from
the sale of goods and services in the ordinary course of business. These are the funds blocked
due to credit sales. Receivables are also called as trade receivables, account receivables, sundry
debtors and bills receivables etc.
Significance And Purpose Of Receivable Management
1. To evaluate the creditworthiness of customers before granting or extending the credit.
2. To minimize the cost of investment in receivables.
3. To minimize the possible bad debt losses.
4. To formulate the credit terms in such a way that results into maximization of sales revenue and
still maintaining minimum investment in receivables.
5. To minimize the cost of running credit and collection department.
6. To maintain a trade off between costs and benefits associated to credit policy.

Motives for maintaining receivables

a. Sales growth motives: to increase the total sales of the business by providing the credit
facility to the customers who have shortage of fund at the time of purchase of goods
b. Increased profit motive: due to credit sales, the total sales of the business increases which
in turn results in increase of profits
c. Meeting competition motive: in business goods are sold on credit to protect the current
sales against emerging competition.
Cost of investment in receivables
a. Administrative cost: to record the credit sale and collection form the customers, a separate
credit department is needed with additional staff, accounting records, stationary etc.
Expenses have also to be incurred on acquiring information about the creditworthiness about
the customers.
b. Capital cost: there is time gap between sales of good and its collection from customers. In
that time the firm has to pay for purchases, wages salary and other expenses. Therefore the
firm needs additional funds which may be arranged form external sources or from retained
earnings. Both of these sources involve cost.
c. Collection cost: these are the expenses incurred by the firm on collection from customers
after expiry of the credit period
d. Default cost or Delinquent cost: despite all efforts by the management the firm may not be
able to recover full amount due from the customers. Such dues are known as the bad debt
Receivables size of the business concern depends upon various factors. Some of the important
factors are as follows: delinquent
1. Sales Level: Sales level is one of the important factors which determine the size of receivable
of the firm. If the firm wants to increase the sales level, they have to liberalize their credit policy
and Credit terms. When the firms maintain more sales, there will be a possibility of large size of
receivable.
2. Credit Policy: Credit policy is the determination of credit standards and analysis. It may vary
from firm to firm or even some times product to product in the same industry. Liberal credit
policy leads to increase the sales volume and also increases the size of receivable. Stringent
credit policy reduces the size of the receivable.

3. Credit Terms: Credit terms specify the repayment terms required of credit receivables.
Depend upon the credit terms, size of the receivables may increase or decrease. Hence, credit
term is one of the factors which affect the size of receivable.
4. Credit Period: It is the time for which trade credit is extended to customer in the case of
credit sales. Normally it is expressed in terms of Net days.
5. Cash Discount: Cash discount is the incentive to the customers to make early payment of the
due date. A special discount will be provided to the customer for his payment before the due
date.
6. Management of Receivable: It is also one of the factors which affects the size of receivable
in the firm. When the management involves systematic approaches to the receivable, the firm can
reduce the size of receivable.

A. Credit Policies
The credit policy of a firm provides the framework to determine
1) whether or not to extend credit to a customer and
2) how much credit to extend.
The credit policy decision of a firm has two broad aspects:
1) Credit standards and
Credit analysis
Credit Standards: The term credit standards represent the basic criteria for the extension of
credit to customers. The following factors relevant to the decision to relax credit standards are as
follows
1) Collection cost: if the credit standards are liberal, then there will be high sales volume,
large size of receivables, a large credit department to handle the accounts receivables and
as a result increase in the collection cost and vice versa.

2) Cost of investment in accounts receivable: Investment in accounts receivables involves

the capital cost. If the credit standards are liberal, then there will be high sales volume,
large size of receivables, and the cost of investment in accounts receivable will be high.
3)

Level of bad debt losses: it is also called as delinquent cost that refers to loss from
debtors to whom goods were sold on credit. If the credit standards are liberal, then there
will be high sales volume, large size of receivables and as a result the level of bad debt
losses will be high.

4) Differential Cost: This cost can be computed by finding the difference between the cost
of carrying receivables before and after the proposed relaxation in credit standards.
5) Average collection period: if the credit standards are liberal then the size of the
receivables is large, then the average collection period will be high.
6) Level of sales. If the credit standards are liberal, then there will be high sales volume,
large size of receivables and vice versa.
Credit Analysis
The second aspect of credit policies of a firm is credit analysis and investigation. Two basic steps
are involved in the credit analysis process:
(a) Obtaining credit information, and
(b) Analysis of credit information.
Obtaining Credit Information: the first step in the credit analysis is to obtain the credit
information on which the creditworthiness of the customer can be evaluated. There are
two sources of credit information
(1) Internal: Usually, firms require their customers to fill various forms and documents giving
details about financial operations. They are also required to furnish trade references with
whom the firms can have contacts to judge the suitability of the customer for credit.
Another internal source of credit information is derived from the records of the firms
contemplate an extension of credit. It is possible that a particular customer may have enjoyed
credit facility in the past
(2) External: The following external sources may be employed to collect information.
Contemplate

Financial Statements like balance sheet, fund flow statement, profit and loss account.
Bank References: Another useful source of credit information is the bank of the firm
which is contemplating the extension of credit.

Trade References: These refer to the collection of information from firms with whom the
applicant has dealings and who on the basis of their experience would guarantee for the
applicant.
Credit Bureau Reports: credit bureau reports of specialized credit rating agencies can
supply credit information which can be utilized

Analysis of Credit Information

Once the credit information has been collected from different sources, it should be analysed to
determine the credit worthiness of the applicant. The analysis should cover two aspects:

(1) Quantitative
The quantitative assessment is based on the factual information available from the financial
statements, the past records of the firm, and so on. The first step involved in this type of
assessment is to calculate the average payment period. Another step in analyzing the credit
information is through a ratio analysis of the liquidity, profitability and debt capacity of the
applicant. These ratios should be compared with the industry average.
(2) Qualitative
The quantitative assessment should be supplemented by a qualitative/subjective interpretation of
the applicants creditworthiness. The subjective judgment would cover aspects relating to the
quality of management. Here, the references from other suppliers, bank references and specialist
bureau reports would form the basis for the conclusions to be drawn.
B. Credit Terms
The second decision area in accounts receivable management is the credit terms. After the credit
standards have been established and the creditworthiness of the customers has been assessed, the
management of a firm must determine the terms and conditions on which trade credit will be
made available. Thus, credit terms specify the repayment terms of receivables.

Credit period, in terms of the duration of time for which trade credit is extendedduring
this period the overdue amount must be paid by the customer;
Cash discount, if any, which the customer can take advantage of, that is, the overdue
amount will be reduced by this amount; and
Cash discount period, which refers to the duration during which the discount can be
availed of. These terms are usually written in abbreviations, for instance, 2/10 net 30.
The three numerals are explained below:

 2 signifies the rate of cash discount (2 per cent), which will be available to the customers
if they pay the overdue within the stipulated time;
10 represents the time duration (10 days) within which a customer must pay to be entitled
to the discount;
30 means the maximum period for which credit is available and the amount must be paid
in any case before the expiry of 30 days.

C. Cash Discount
The cash discount has implications for the sales volume, average collection period/average
investment in receivables, bad debt expenses and profit per unit. The implications of increasing
or initiating cash discount are as follows:
The sales volume will increase. The grant of discount implies reduced prices. If the
demand for the products is elastic, reduction in prices will result in higher sales volume.
Since the customers, to take advantage of the discount, would like to pay within the
discount period, the average collection period would be reduced. The reduction in the
collection period would lead to a reduction in the investment in receivables as also the
cost. The decrease in the average collection period would also cause a fall in bad debt
expenses. As a result, profits would increase.
The discount would have a negative effect on the profits. This is because the decrease in
prices would affect the profit margin per unit of sale.
D. Collection Policies
The fourth area involved in the accounts receivable management is collection policies. They
refer to the procedures followed to collect accounts receivable when, after the expiry of the credit
period, they become due. These policies cover two aspects:
1) degree of effort to collect the overdues, and
2) type of collection efforts.

Degree of Collection Effort

In order to show the degree of collection effort, the credit policy is divided into two categories.
(i) strict/light, and (ii) lenient. The collection policy would be tight if credit policy is strict. A

tight collection policy has implications which involve benefits as well costs. Likewise, a lenient
collection effort also affects the cost-benefit trade-off.

Type of Collection Efforts

The second aspect of collection policies relates to the steps that should be taken to collect
overdues from the customers. After the credit period is over and payment remains due, the firm
should initiate measures to collect them. The effort should in the beginning be polite, but, with
the passage of time, it should gradually become strict. The steps usually taken are
1) letters, including reminders, to expedite payment;
2) telephone calls for personal contact;
3) personal visits;
4) help of collection agencies; and finally,
5) legal action.