DEBTORS / RECEIVABLES MANAGEMENT

Receivables (Debtors): Amount due from customers arising from sales of goods
or services on credit. Credit sales are essential and inevitable in the modern
competitive market. Extension of credit promotes sales and profit. However it
also involves a cost. The goal of Debtor management is to promote sales and
profit upto a profit where return on investment on further extra investment is
less than cost of funds raised to fund the additional credit.
Cost of Maintaining Debtors:
1. Credit Administration and collection costs: Expenses in creating and
maintaining a credit department with staff, records, stationary,
postage, etc. Expenses incurred in collecting credit information.
2. Capital Cost: There is a time lag between a sales and collection of
money from customer. During this period has to pay workers,
suppliers, and others for which additional funds have to be arranged.
This is involves capital cost.
3. Default Cost: This refers to the cost of bad debts.
4. Delinquency Cost: Cost associated with the delay in payment by
customers beyond a due date is delinquency cost e.g. Phone, postage,
legal notice, opportunity cost of money locked up.
BENEFITS OF DEEBTORS
a) Increased sales and profits
Existing customers may buy more and new customers may come in to buy.
Another reason is to protect the firms market share from emerging competition.
CREDIT POLICIES
I. Credit Standard
II. Credit period
III. Cash Discount
IV. Collection effort
V. CREDIT STANDARD
What standard should be applied for granting credit. A firm has a wide range
of choice. On one extreme it may decide to grant credit only to those who pose
no risk. At the other extreme the firm decides to give credit to any customer
irrespective of their credit rating. But the two extremes lie several possibilities.
Liberal credit standards increase sales but leads to higher bad debts, larger
investment in Debtors and higher collection costs. Strict standards have
opposite effect. A cost benefits study made before liberalizing / lightening credit
sales.
1. A Limited company has a sale turnover of 50,00,000 to a few customers with
no risk at all. It plans to extend credit to customers who are in risk category.
Such a policy would increase sales by 10,00,000 on which the firm expects
bad debts losses of 8%. The Purchase Value is 85%. The average collection
period is 60 days and the cost of funds 20% Should the company release its
credit standards.
Solution
Additional profit being contribution
from additional sales (10,00,000 x 15%) 1,50,000

Less: Cost of extending sales

(i) Bad debts (10,00,000 x 8%) 80,000
(ii) Investment in debtors
Interest cost on additional debtors
10,00,000 x 60/360
=1,66,667 x 85% = 1,41,667 x 20% = (+) 28,333
1,08,333
Net benefit (extra profit) 41,667
The credit standard should be liberated since the firm earns extra
profit of Rs.41,667.
Note
1. Debtors will be valued at variable cost only
2. Sales at variable cost will be 10,00,000 x 85% = 8,50,000. Debtors
being 60 days sales. (i.e.) 8,50,000 x 60/360 = 1,41,667
Interest on investment in Debtors 1,41,667 x 20% = 28,333.

II. CREDIT PERIOD

It refers to the length of period allowed to customer to pay their dues.
Extension of the credit period will increase sales and profit, higher bad
debts and longer investment in debtors. Shortening the credit period
will have the opposite effect.
2. X Ltd currently provides 45 days credit to its customers . Existing sales are 1.5 crores.
The cost of capital is 15% and variable cost is 80% of sales. The firm is considering
extending the credit period to 60 days . This will increase sales by rs.15,00,000 of
which 5% bad debts is expected. Should the company extend the credit period.
Solution
SALES – VARIABLE COST = CONTRIBUTION
100 - 80 = 20
Additional profit from additional sales (Rs.15,00,000)
Contribution (15,00,000 x20%) 3,00,000
Less: ADDDITIONAL COST
Bad Debts (1,50,000 x 5%) 75,000
Interest cost on additional Debtors (15,00,000 x 60 x 80 x 15%) 30,000
Interest on delayed collections of existing debtors

[15,00,000 x (60 - 45) / 360 * 15%] 93,750

(1,98,750)
1,01,250
III. CASH DISCOUNT
Cash Discount is offered to induce customers to pay before expiry of the
credit period. The credit terms indicate percentage of discount offered and
the period during which it is available. For example, 2/10 net 30 means that
the 2% discount is offered if the payment is made within 10 days otherwise
the full payment is due in 30 days. Liberal policy (indicating the credit
days percentage and lengthening the credit period) enhances the sales
decreases the average collection period .But increases the cost of
discount.
3. The present credit terms of A Ltd are 1/10 net 30. Its sales are 1.2
crores and its average collection period is 24 days. The purchase value
ratio is 20% and cost of capital is 15%. The proportion of sales on which
the customer currently allowed sales discount is 30%. A Ltd wants to
revise discount rates to 2/10 net 30. This will increase sales by
12,00,000 reduce average collective period to 16 days and increases
the proportion of discount sale to 70%. Advice the company.
Solution

Extra benefit (profit)from increased sales by 12,00,000

Contribution 12,00,000 x 20% 2,40,000
Savings in interest cost from reduction in
average collection period On existing debtors
1,20,000 x (24-16) x 15% 40,000
Extra benefit 2,80,000
Less -- Extra costs
(i) Increase in discount additional discount
New discount 1,20,000 + 12,00,000
= 1,32,00,000 x 70% x 2/100 1,84,800

Less: old discount1,20,00,000 x 30% x 1/100 36,000

Increase in discount cost 1,48,800
(ii) Interest cost on investment in new debtors
1,20,000 x 80/100 x 16/360 x15% 6,400
1,55,200
Extra Profit 1,24,800
Extra profit on extension of credit period will be 1,24,800. So credit period should be
IV. COLLECTION EFFORT
It aims at timely collection of Debtors and consists of
 Monetary
 Dispatching reminders
 Telegraphic and Telephone reminder
 Collection of legal action

Rigorous Collection Policy

It reduces sales reduces investment in Debtors, Reduce bad debts and
increase collection expenses. The released collection policy will have
the opposite effect.
4. M Ltd is considering releasing its collection efforts. Existing sales are
50,00,000,average collection period is 25 days pv ratio 25% cost of capital
15% and bad debts 4%. The relaxation of the collection effort will increase
sales by Rs.6,00,000,increase average collection period to 40 days and
increase bad debts to 6% .The company can save collection expenses upto
Rs.10,000. Advice the Company.
Profit from increase in sales (6,00,000 x 25%) 1,50,000
Savings in collection expenses 10,000
Total Benefit 1,60,000
Less: additional cost
New bad debts (50,00,000 + 6,00,000 = 56,00,000 x 6%) 3,36,000
(-) Old bad debts (50,00,000 x 4%) 2,00,000
Increase in bad debts 1,36,000
Interest cost on additional Debtors from old sales
50,00,000 x 15/100 x 40 - 25/360 31,250
Interest cost on additional Debtors from new sales
6,00,000 x 75/100 x 40/360 x 15% 7,500 1,74,750
Loss From Extra Sales (14,750)
The cost is Rs.1,74,750 more than the income Rs.1,60,000,indicating
the loss of Rs.14,750. Therefore collection period should not be raised.
CREDIT EVALUAATION
It involves the determination of the type of customers who are going to
qualify for the trade credit. In judging the credit worthiness of the
customer the 3c’s factors will be considered are Character, Capacity
and Collateral.
a) Character – It means willingness of the customer to honour by
paying as agreed.
b) Capacity - It means the ability of the customer to pay on time – it
depends upon his financial condition working capital position,
profitability and his general business condition.
c) Collateral – It means security offered by the customer.
Evaluation of credit worthiness involves two steps -
a) Collection of the information
b) Analysis of the information.
c) Collection of Information
Sources of information - Bank reference, Trade enquiries, credit agency reports,
published audited financial statements which will throw light of the profitability
and liquidity of the company.
b) Analysis of the information
Such analysis can be through ratio analysis, cash flow analysis, payment history
and risk analysis.
CONTROL OF RECEIVABLES (Monitoring of receivables)
Average collection period = Average Debtors/ Gross sales per day.
The actual collection period calculated above can be compared with the credit
period allowed by the firm. To find out whether collections are made within the
credit period or not.
Ageing schedule of Debtors - The classifies the Debtors at any given point of
time x different age groups
Example
Age group in days % of receivables
Less than 30 days 60%
31 -- 45 days 20%
46 -- 60 days 10%
Above 60 days 10%
Study of the above tells us how long the Debtors are outstanding as from
the date of sale. From this compared to the credit period allowed by the firm we
can identify debtors who have exceeded the credit period. Special attention
with this category and immediate steps must be taken to collect.
5. ABC LTD is considering the following credit policy alternatives
OPTIONS
I II III
Credit Period (days) 30 60 90
Sales (Rs. In Lakhs) 10 11 12
Bad Debts (% of sales) 5% 3% 6%
Cost of credit administration
(Rs, in lakhs) i.e admin exp. .2 . 22 . 25

Average collection period (days) 45 50 70

The PV Ratio is 40%. The firm requires 20% of return on investment.

Suggest a suitable credit policy for the Firm.
Solution
Statement showing cost Benefit Analysis
Particulars Option I Option II Option III
Benefit:
Sales 10,00,000 11,00,000 12,00,000
Contribution(sales x PVR) 4,00,000 4,40,000 4,80,000
Less Cost
i. Bad debts (%of sales) 50,000 33,000 72,000
ii. Cost of administration 20,000 22,000 25,000
iii.Interest cost of investment in Debtors
 10,00,000 x 45/365 x 20% 24,658 --- ----
 11,00,000 x 50/365 x 20% --- 30,137 ----
 12,00,000 x 70/365 x 20% --- --- 46,027
NET BENEFIT (Benefit - Cost) 3,05,342 3,54,863 3,36,973

Option II which gives the highest profit and hence should be selected.
Note:
For Debtors calculation sales should be foreseen at total cost that is
fixed cost + variable cost.
Since the problem into fixed cost, Debtors are taken at sale value.
Likewise the benefit should be profit which is contribution - fixed cost.
Since fixed costs are not given we will take contribution benefit.
6. X Ltd. manufacturers of T.V. sets. From the Credit period and likely
sales of T.V.’s are given below. Recommend the credit period to be
adopted each of the customers A, B, & C
CREDIT PERIOD NUMBER OF TV SETS LIKELY TO BE SOLD
A B C
30 DAYS 1000 1500 NIL
60 DAYS 1000 2300 1000
90 DAYS 1000 2500 1500
Selling Price 0f TV is Rs.9000, PV Ratio 20% and the cost of capital is
20%. Assume a year is 360 days.
Solution
Since the quantity purchased by A is 1000 TV’s whatever be the credit
period offered, the firm will give only the shortest credit period which
is 30 days.
Statement showing cost benefit from sales to B
Credit Period
Sales (qty. x S.P) 1,35,00,000 2,07,00,000 2,25,00,000
Benefit:
Contribution (sales x PVR) 27,00,000 41,40,000 45,00,000
Less: Interest cost in Debtors
= Sales x cr. period /360 x COC
1,35,00,000 x 30/360 x 20% 2,25,000 NIL NIL
2,07,00,000x60/360x20% NIL 6,90,000 NIL
2,25,00,000x90/360x20% NIL NIL 11,25,000
Net Benefit 24,75,000 34,50,000 33,75,000

60 days credit should be selected because it has higher profits than in other
credit periods.
Statement showing cost benefit from sales to C
Credit Period 30 days 60 days 90 days
Sales (Qty. x S.P) NIL 90,00,000 1,35,00,000
Benefit:
Contribution (Sales x PVR) NIL 18,00,000 27,00,000
Interest cost in Debtors
= Sales x Cr. period /360 x coc
90,00,000 x 60/360 x 20% NIL 3,00,000 NIL
1,35,00,000 x 90/360 x 20% NIL NIL 6,75,000
Net Benefit 15,00,000 20,25,000

90 days credit period should be selected because it gives higher profit than
others.
7. X Ltd. has an existing sales of 10,000 units at rs.300 per unit
variable cost is 200 per unit and fixed cost is 3,00,000 per annum.
Present credit policy is one month credit period. The company plans
to increase credit period for two months or three months and has
made the following estimates:
Existing Proposed
Credit Period 1 Month 2 Months 3 Months
Increase in Sales NIL 15% 30%
% of bad debts 1% 3% 5%
There will be in increase in fixed cost by Rs.50,000 if sales increases
beyond 25%of the present level. The cost of capital is 20%. Suggest
the suitable credit period to be adopted.
Solution
2 MONTHS CREDIT OFFERED
New Sales 10,000 x 15% = 1,500 x 300 = 4,50,000
Benefit:
Contribution from additional sales 1,500 units x 100
(Or) PVR = C/3 = 100/300 x 100 = 33.33% or 1/3
Contribution = 4,50,000 x 1/3 1,50,000
Less: Cost
(i) %of bad debts on additional sales 4,50,000 x 3% 13,500
(ii) Interest cost on investment in Debtors
Old Debtors (10,000 x 300) = 30,00,000 x 2 - 1/12 x 20% 50,000
New Debtors = Sales x COC x Cr. period
= 1,500 x 300 x 2/3 x 2/12 x 20% or 10,000 73,500
1500 X 200 x 2/12 X 20 %
Net Benefit 76,500
3 MONTHS CREDIT IS OFFERED
NEW SALES (10,000 X 30% = 3,000 X 300) 9,00,000
BENEFIT:
Contribution from additional Sales
3000 x 100 (or) 9,00,000 x 1/3 3,00,000
Less: Extra Fixed Cost Benefit 50,000
BENEFIT 2,50,000
Less: Cost
(i)Bad Debts (9,00,000 x 5%) 45,000
(ii) Interest cost on investment in Debtors
(a) Old Debtors
10,000 x 300 x 3-1/12x20% = 1,00,000
(b) New Debtors
Sales x(UC x VC) x COC
= Sales x (uc + fc) x Cr. period /12 x coc
= 3000 x 200 + 50,000 x 3/12 x 20%
= 6,00,000 + 50,000 x 3/12 x 20%
= 6,50,000 x 3/12 x 20% 32,500
1,77,500
NET BENEFIT 72,500
2 Months credit period should be selected, as it gives a higher profit.

8. Existing Sales RS.2,40,000, Average collection period 30 days. The

company proposes to re organize its credit period as follows:
Proposed increase in credit period Increase over existing
Beyond 30 days Sales
15 days 12,000
30 days 18,000
45 days 21,000
60 days 24,000
P.V Ratio is 33 1/3%, Cost of capital 20%.
Evaluate the alternatives
Solution
Credit period (in days) 15 30 45 60
Benefit
Contribution (from inc sales) 4,000 6,000 7,000 8,000
Less: Sales x PVR
Cost
Interest cost on investment
in debtors
(i)old debtors
Old sales x Extra period x COC
2,40,000 x 15/360 10,000
2,40,000 x 30/360 20,000
2,40,000 x 45/360 30,000
2,40,000 x 60/360 40,000
(ii) New Debtors
(Inc in sales x V.C x Cr. period/360)
12,000 x 2/3 x 45/360) 1,000 - - -
18,000 x 2/3 ( 60/360) - 2,000 - -
21,000 x (75/360) x 2/3 - - 2,917 -
24,000 x 2/3 x (90/360) - - - 4,000
Increase in Debtors 11,000 22,000 32,917 44,000
Less
Interest cost on increased debtors
Inc. in Debtors x COC 2,200 4,400 6,583 8,800
NET BENEFIT 1,800 1,600 417 -- 800
EXTENDING CREDIT PERIOD BY 15 DAYS SHOULD BE RECOMMENDED.
9. A Ltd Company has current sales of Rs.10,00,000 p.a. On credit
terms of 60 days average collection period is 80 days. It is
considering offering discount @ 3% for payment within 7 days. It
expects that 60% of existing customers will take the discount. The
reminder will equally spread between those paying in 80 days and
those paying in 100 days. The new policy will result in additional
sales of Rs.50,000 Variable cost is 80% of sale. The cost of capital
is 14%. Is the discount worth offering, if
(1) No new sales are obtained
(2) New sales as expected results.
Assume a year is 365 days.
Solution
OPTION I: If no new sales results
Savings in interest cost
Existing interest cost
10,00,000 x 80/365 x (80/100 + F.C.) x 14% 24,548
Less:
New interest cost on Debtors:
10,00,000 x 80% x 60% x 7/365 x 14% 1,289
10,00,000 x 80% x 20% x 80/365 x 14% 4,910
10,00,000 x 80% x 20% x 100/365 x 14% 6,137
Total Cost 12,336
Net Benefit 12,212
Less cost involved:
Discount 10,00,000x60/100x3/100 (18,000)
Net Loss (5,788)
OPTION II: IF NEW SALES RESULTS
Net Loss (as calculated under option I) (5,788)
CONTRIBUTION 50,000X20% 10,000
+ 4,212
LESS:
Interest on new Debtors
= 50,000 x 80% x 7/365 x 14% (107)
Cost of discount 50,000 x 3% (1,500)
(1,607)
Profit 2,605