Account Receivables Management

& Credit Policy

Presented by --
 INTRODUCTION
 What are receivables?
• Receivables are sales made on credit basis.

 Why do we need receivables?

• To increase total sales
• To increase profits
• To meet increasing Competition

 Characteristics
• Element of risk
• Economic value
• Futurity
 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 called
trade debtors or debtors
 CHARACTERISTICS OF CREDIT
SALES

 It involves an element of risk that should be carefully

analyzed.

 It is based on economic value.

 It implies futurity.
 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 & type of customer

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 creditworthiness.
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
minimize erosion of sales.
 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.
 DIFFERENT TYPES OF COSTS
ASSOCIATED
 ADMINISTRATIVE COST:
Administrative costs In form of salaries to clerks who maintain records
of debtors, expenses on investigating the creditworthiness of debtors,
etc.

 CAPITAL COST:
Cost incurred in terms of interest (if financed from outside) or
opportunity cost (if internal resources they could have been put to some
other use)

 COLLECTION COST
Cost incurred for collection of amounts at the appropriate time from the
customers.

 DEFAULTING COST:
Amounts which have to written off as bad debts.

• DELINQUENCY COST
Cost arising out of failure of customers to pay on due date.
 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.
 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
 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
1. Numerical credit scoring models
a. Adhoc approach:
b. Simple discriminant analysis
(E.g.:- ratio of EBDIT to sales)
b. Multiple discriminant analysis
CREDIT GRANTING DECISION
Credit granting decision

Grant Credit
No Credit

Payment Payment
received Not received

Benefit Cost
PV of Future PV of Lost
Net Cash Investment
Flow
No Pay-off
Net Payoff
PV of
Benefit-cost
 CREDIT TERMS
The stipulations under which the firm sells on credit to
customers are called credit terms.

These include…

1. Credit period
2. Cash discount
 COLLECTION POLICY
Collection policy is needed to accelerate collections from
slow payers and reduce bad debt losses.
1. It should ensure prompt and regular collection.
2. It should lay down clear cut collection procedures.
3. The responsibility for collection and follow up should be
explicitly fixed.( Accounts or sales)
4. The firm should decide on cash discounts to be allowed for
prompt payment
5. It should be flexible
 CREDIT EVALUATION

The credit evaluation procedure includes:

1. Credit information
2. Credit investigation
3. Credit limits
4. Collection procedures
 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 scrutinize 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:
1. Type of customer, whether new or existing
2. The customer’s business line, background and the related
trade risks.
3. The nature of the product- perishable or seasonal
4. Size of the customer’s order and expected further volumes
of business with him
5. Company’s credit policies and practices.
 CREDIT INVESTINGATION AND
ANALYSIS
Steps involved in credit analysis are…

1. Analysis of the credit file

2. Analysis of financial ratios

3. Analysis of business and its management

Steps in Credit Analysis by investigating the customer by
Ratio Analysis:
 
The financial strengths and weaknesses can be gauged
by the application of ratio analysis. Some of the important ratios are:

Current Assets
Current ratio = ----------------------
Current Liabilities

Current Assets - Inventory

Quick ratio = -----------------------------------------
Current Liabilities

The above two ratios are widely used to assess the liquidity position of a
company in meeting its short-term obligations.
 
 Average Balance of sundry Creditors
c) Average payment period = ----------------------------------------------------
Average Daily Credit purchases
 
Average Balance of sundry Debtors
d) Average collection period = -----------------------------------------------------
Average Daily Credit Sales

Debt
e) Capital Structure ratio = ---------------------
Equity

Net profit after tax and preference share dividend

f) Return on Equity = -------------------`-----------------------
Owner Equity
 
•Steps in Credit Analysis by Credit Evaluation Report X co. Ltd.

Item Head For X Co. Ltd Standard Remarks

Current Ratio 1.70 1.75 Liquidity Position
Quick Ratio 1.15 1.00 is good.
Average 45 Days 40 Days Can be
Payment Period persuaded to pay
within 40 days.
 
Average 40 Days 30 Days This may have
Collection period caused delay in
payments.
 
Debt-Equity 1.5:1 2:1 Lower because of
Ratio capital structure.
Return on 15% 18%  
•Steps in Credit Analysis by Risk Classification Scheme

Risk Class Description

1 Customer with no risk of default

 
2 Customer with negligible risk of default
( default rate less than 2 % )
 
3 Customer with a little risk of default
( default rate between 2 % and 5 % )
 
4 Customer with some risk of default
(Default rate between 5 % and 10 %)
 
5 Customer with significant risk of default
( default rate in excess of 10 % )
 
 Incremental Cost vs. Incremental Sales

Incremental Cost
>Cost incurred with every additional unit
produced

Incremental Sales
>Amount of sale created over and above
break-even pt.<Net profit>
 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 strength.
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
2. Aging schedule
3. Collection Experience Matrix
 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:
1. It provides an average picture of collection experience and is
based on aggregate data.
2. 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 analyzing
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