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RECEIVABLES MANAGEMENT

Centre for Financial Management , Bangalore

2015 by McGraw Hill Education (India) Private Limited

CREDIT MANAGEMENT

OUTLINE
Terms of Payment
Credit Policy Variables
Credit Evaluation
Credit Granting Decision
Control of Accounts Receivable
Credit Management in India

Centre for Financial Management , Bangalore

Introduction
Firms

grant credit to facilitate sales.

Credit period 15 days to 60 days
On credit sales:
Finished Goods Sold -> Accounts receivable
Purchases -> Accounts payable

Accounts

Receivable = Sundry Debtors

Important Asset Categories:
Plant and Equipment,
Inventories and
Sundry Debtors

TERMS OF PAYMENT
Cash Terms
Open Account
Consignment
Bill of Exchange
Letter of Credit

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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
Sales

Stiff

Higher

Bad debt loss

Lower

Higher

Investment
in receivables

Larger

Collection costs

Lower
Smaller

Higher

Lower

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IMPACT ON RESIDUAL INCOME

OF RELAXATION
RI = [S(1 V) - Sbn] (1 t ) k I
where 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
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 (1 0.80) 15,000,000 x 0.10] (1 0.4)
15,000,000
0.10 x
360

x 40 x 0.80

= Rs.766,667

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CREDIT PERIOD
Longer
Sales

Shorter

Investment in

Higher

Lower

Larger

Smaller

Higher

Lower

receivables
Bad debts

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IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD

RI = [S(1 V) - Sbn] (1 t ) k I

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INCREASE IN RECEIVABLES
INVESTMENT
S
+ V (ACPn)
360

S0
I = (ACPn ACP0)
360
where:

= increase in receivables investment

ACPn = new average collection period (after lengthening

the credit period)
ACP0 = old average collection period
V
S

= ratio of variable cost to sales

= increase in sales

Centre for Financial Management , Bangalore

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 0.15 5,000,000 x 0.08] (0.6)
0.10 (60 30) x 50,000,000 + 0.85 x 60 x 5,000,000
360
360
= [750,000 400,000] (0.6) 0.10 [4,166,667 + 708,333]
= 277,500

Centre for Financial Management , Bangalore

LIBERALISING THE CASH

DISCOUNT POLICY

RI = [S(1 V) - DIS] (1 t ) + k I

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DECREASING THE RIGOUR

OF COLLECTION PROGRAMME

RI = [S(1 V) - BD] (1 t ) k I

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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

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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

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SEQUENTIAL CREDIT ANALYSIS

Should
credit be
granted?

Strong

Weak

Character

Capacity

Strong

Strong

Weak
Capital

Capital

Strong

Capacity

Strong Weak

Weak

Excellent risk

Fair risk

Weak
Capital

Capital

Strong

Weak

Strong

Doubtful risk

How much
credit
should be
granted ?

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Weak
Dangerous
risk

NUMERICAL CREDIT RATING INDEX

Factor

Past payment
Net profit margin
Current ratio
Debt-equity ratio
Return on equity

Factor
weight
0.30
0.20
0.20
0.10
0.20

Rating
3
2

Rating index

Centre for Financial Management , Bangalore

Factor
score
1.20
0.80
0.60
0.40
1.00
4.00

DISCRIMINANT ANALYSIS
Z = 1 Current ratio + 0.1 Return on equity
Current
+
ratio

+
+
+

+
+

+
+

Return on equity
Centre for Financial Management , Bangalore

RISK CLASSIFICATION SCHEME

Risk Class
1
2
3
4
5

Description
Customers with no risk of default
Customers with negligible risk of default (default rate less than 2
percent)
Customers with little risk of default (default rate between 2 percent
and 5 percent)
Customers with some risk of default (default rate between 5 percent
and 10 percent)
Customers with significant risk of default (default rate in excess of 10
percent)

Centre for Financial Management , Bangalore

CREDIT GRANTING DECISION

Expected Pre-tax Profit
p (Revenue Cost) (1 p) Cost

pa
r
e
m

to
Cus
p

it
d
e
cr

fer
f
O
Re f
use

Rev Cost

ys

Custome

r default

(1 p)

cred

it

0
Centre for Financial Management , Bangalore

Cost

EXAMPLE
ABC Company is considering offering credit to a customer.
The probability that the customer would pay is 0.8 and the
probability 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 (1,200 800) 0.2 (800) = Rs.160

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REPEAT ORDER

Centre for Financial Management , Bangalore

DECISION TREE FOR GRANTING CREDIT

s
5
Pay p = 0.9
1
dit
e
r
c
er
f
f
O

s
Pay
0.9
=
p1
e
Off

dit
e
r
rc

(1

De
fa
p1 )

ult
s

=0

.1

Centre for Financial Management , Bangalore

Def
ault
s
(1
p1 ) =
0.05

CONTROL OF ACCOUNTS
RECEIVABLES
Days Sales Outstanding
Ageing Schedule
Collection Matrix

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COLLECTION MATRIX

Percentage of Receivables
Collected During the
Month of sales
First following month
Second following month
Third following month
Fourth following month

January
Sales

13
42
33
12
-

February
Sales
14
35
40
11
-

March
Sales

April
Sales

May
Sales

June
Sales

15
40
21
24
-

12
40
24
19
5

10
36
26
24
4

9
35
26
25
5

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SOME GUIDELINES FOR MANAGING

RECEIVABLES

Here are some guidelines for managing receivables:

1. Invoice properly Send the invoice the same day the order is
shipped and state clearly the terms of payment.
2.
Ensure the cooperation of administrative and marketing
personnel There has to be a consistency between the
communications and actions of finance, administration, and
marketing departments.
3.
Communicate professionally with delinquent accounts In
communicating with delinquent accounts maintain the right
balance between cordiality and firmness. Use motivational tactics
such as As we had agreed upon, and In order to prevent future
problems.

SUMMING UP
The important dimensions of a firms credit policy are : credit
standards, credit period, cash discount, and collection effort
In general, liberal credit standards tend to push sales up by
attracting more customers. However, this is accompanied by a
higher incidence of bad debt loss, a larger investment in
receivables, and a higher cost of collection. Stiff credit standards
have opposite effects.
Three broad approaches are used for credit evaluation :
traditional credit analysis, numerical credit scoring, and
discriminant 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 accounts
receivable : days sales outstanding, ageing schedule, and
collection matrix.

Centre for Financial Management , Bangalore