Chapter Four

Receivables Management
Credit and Receivables
• When a firm sells goods and services, it can demand cash on
or before the delivery date or it can extend credit to
customers and allow some delay in payment.
• Granting credit is making an investment in a customer—an
investment tied to the sale of a product or service.
• Why do firms grant credit?
• The obvious reason is that offering credit is a way of
stimulating sales.
• However, the costs associated with granting credit are not
negligible.
First, there is a chance that the customer will not pay.
Second, the firm has to bear the costs of carrying the
receivables.
• The credit policy decision thus involves a trade-off between
the benefits of increased sales and the costs of granting credit.
• From an accounting perspective, when credit is granted, an
account receivable is created.
• Such receivables include credit to other firms, called trade
credit, and credit granted to consumers, called consumer
credit.
Components of Credit Policy
• If a firm decides to grant credit to its customers, then it must establish
procedures for extending credit and collecting.
• In particular, the firm will have to deal with the following components
of credit policy:
1. Terms of sale: The terms of sale establish how the firm proposes to
sell its goods and services.
• A basic decision is whether the firm will require cash or will extend
credit.
• If the firm does grant credit to a customer, the terms of sale will
specify (perhaps implicitly) the credit period, the cash discount and
discount period, and the type of credit instrument.
2. Credit analysis: In granting credit, a firm determines how much effort to
expend trying to distinguish between customers who will pay and
customers who will not pay.
• Firms use a number of devices and procedures to determine the
probability that customers will not pay; put together, these are called
credit analysis.
3. Collection policy: After credit has been granted, the firm has the
potential problem of collecting the cash, for which it must establish a
collection policy.
• In the next several sections, we will discuss these components of credit
policy that collectively make up the decision to grant credit.
The Cash Flows from Granting
Credit
• The accounts receivable period is described as the time it takes to
collect on a credit sale.
• There are several events that occur during this period.
• These events are the cash flows associated with granting credit, and
they can be illustrated with a cash flow diagram as follows:
• As the time line indicates, the typical sequence of events when a firm
grants credit is as follows:
1. The credit sale is made,
2. the customer sends a check to the firm
3. the firm deposits the check, and
4. The firm’s account is credited for the amount of the check.
• It is apparent that one of the factors influencing the receivables period is
float.
• Thus, one way to reduce the receivables period is to speed up the check
mailing, processing, and clearing delays.
The Investment in Receivables

• The investment in accounts receivable for any firm depends on the

amount of credit sales and the average collection period.
• A firm’s receivables generally will be equal to its average daily sales
multiplied by its average collection period.
• Thus, a firm’s investment in accounts receivable depends on factors
that influence credit sales and collections.
• Recall that we use the terms days’ sales in receivables, receivables
period, and average collection period interchangeably to refer to the
length of time it takes for the firm to collect on a credit sale.
Terms of the Sale

• The terms of a sale are made up of three distinct elements:

1. The period for which credit is granted (the credit period).
2. The cash discount and the discount period.
3. The type of credit instrument.
• Within a given industry, the terms of sale are usually fairly standard,
but these terms vary quite a bit across industries
THE BASIC FORM
• The easiest way to understand the terms of sale is to consider an
example.
• Terms such as 2/10, net/ 60 is common.
• This means that customers have 60 days from the invoice date to pay
the full amount (say $1000); however, if payment is made within 10
days, a 2 percent cash discount can be taken.
• In such terms, the buyer has an option of paying $980 within the
discount period, or paying the full $1,000 in 60 days.
• In general, credit terms are interpreted in the following way as: take
this discount off the invoice price if you pay in this many days, else
pay the full invoice amount in this many days.
The credit period
• The credit period is the basic length of time for which credit is
granted.
• The credit period varies widely from industry to industry, but it is
almost always between 30 and 120 days.
• If a cash discount is offered, then the credit period has two
components:
the net credit period and
the cash discount period.
• The net credit period is the length of time the customer has to pay.
• The cash discount period is the time during which the discount is
available.
The Invoice Date
• The Invoice Date is the beginning of the credit period.
• Possible arrangements include:
ROG (for receipt of goods), in this case, the credit period starts when
the customer receives the order.
EOM dating, all sales made during a particular month are assumed to
be made at the end of that month. Confusingly, the end of the month
is sometimes taken to be the 25th day of the month.
MOM, for middle of month, is another variation.
Seasonal dating is sometimes used to encourage sales of seasonal
products during the off-season period.
Length of the Credit Period
• Several factors influence the length of the credit period. Two important
ones are;
The buyer’s inventory period, and
Operating cycle (buyer’s inventory + receivables period).
• All else equal, the shorter these are, the shorter the credit period will be.
• The buyer’s inventory period is the time it takes the buyer to acquire
inventory (from us), process and sell it.
• The buyer’s receivables period is the time it then takes the buyer to
collect on the sale.
• On top of customers’ inventory period and operating cycle, there are a
number of other factors that influence the credit period.
• Many of these also influence our customer’s operating cycles; so, once
again, these are related subjects.
• Among the most important are:
1. Perishability and collateral value: Perishable items have relatively
rapid turnover and relatively low collateral value. Credit periods are
thus shorter for such goods.
2. Consumer demand: Products that are well established generally have
more rapid turnover. Newer or slow-moving products will often have
longer credit periods associated with them to entice buyers. Also, as
we have seen, sellers may choose to extend much longer credit
periods for off-season sales (when customer demand is low).
3. Cost, profitability, and standardization: Relatively inexpensive goods
tend to have shorter credit periods. The same is true for relatively
standardized goods and raw materials. These all tend to have lower
markups and higher turnover rates, both of which lead to shorter credit
periods. However, there are exceptions.
4. Credit risk: The greater the credit risk of the buyer, the shorter the
credit period is likely to be (if credit is granted at all).
5. Size of the account: If an account is small, the credit period may be
shorter because small accounts cost more to manage, and the
customers are less important.
6. Competition: When the seller is in a highly competitive market,
longer credit periods may be offered as a way of attracting customers.
7. Customer type: A single seller might offer different credit terms to
different buyers.
• A food wholesaler, for example, might supply groceries, bakeries, and
restaurants. Each group would probably have different credit terms.
• More generally, sellers often have both wholesale and retail
customers, and they frequently quote different terms to the two
types.
Cash discounts
• Cash discounts are often part of the terms of sale.
• One reason discounts are offered is to speed up the collection of
receivables.
• This will have the effect of reducing the amount of credit being
offered, and the firm must trade this off against the cost of the
discount.
• Notice that when a cash discount is offered, the credit is essentially
free during the discount period.
• The buyer pays for the credit only after the discount expires.
Cost of the Credit
• In our examples, it might seem that the discounts are rather
small.
• With 2/10, net 30, for example, early payment gets the buyer
only a 2 percent discount.
• Does this provide a significant incentive for early payment?
Yes and let us see how?
• To see why the discount is important, we will calculate the
cost to the buyer of not paying early.
• To do this, let’s find the interest rate that the buyer is
effectively paying for the trade credit.
• Suppose the order is for $1,000.
• The buyer can pay $980 in 10 days or wait another 20 days and pay
$1,000.
• It’s obvious that the buyer is effectively borrowing $980 for 20 days
and that the buyer pays $20 in interest on the “loan.”
• What’s the interest rate?
• This interest is ordinary discount interest, with the $20 interest on
$980 borrowed: the rate is $20/980=2.0408%.
• This rate is relatively low, but remember that this is the rate per 20-
day period.
• There are 365/20 = 18.25 such periods in a year, so by not taking the
discount, the buyer is paying an effective annual rate (EAR) of:
EAR= 1.020408 18.25-1= 44.6%
• From the buyer’s point of view, this is an expensive source of
financing!
• Meaning, the customer is hardly going to decide not to take the
discount.
• Given that the interest rate is so high here, it is unlikely that the seller
benefits from early payment.
• Ignoring the possibility of default by the buyer, the decision of a
customer to forgo the discount almost surely works to the seller’s
advantage.
Credit Instruments
• The credit instrument is the basic evidence of buyer’s indebtedness.
• Most trade credit is offered on an open account.
• This means that the only formal instrument of credit is the invoice,
which is sent with the shipment of goods and which the customer
signs as evidence that the goods have been received.
• Afterward, the firm and its customers record the exchange on their
books of account.
• At times, the firm may require that the customer sign a promissory
note.
• This is a basic IOU (I Owe You) and might be used when the order is
large, when there is no cash discount involved, or when the firm
anticipates a problem in collections.
• Promissory notes are not common, but they can eliminate possible
controversies later about the existence of debt.
• One problem with promissory notes is that they are signed after delivery
of the goods.
• One way to obtain a credit commitment from a customer before the
goods are delivered is to arrange a commercial draft.
• Typically, the firm draws up a commercial draft calling for the customer to
pay a specific amount by a specified date.
• The draft is then sent to the customer’s bank with the shipping invoices.
• If immediate payment is required on the draft, it is called a sight draft.
• If immediate payment is not required, then the draft is a time draft.
• When the draft is presented and the buyer “accepts” it, meaning that the
buyer promises to pay it in the future, then it is called a trade acceptance
and is sent back to the selling firm.
• The seller can then keep the acceptance or sell it to someone else.
• If a bank accepts the draft, meaning that the bank is guaranteeing payment,
then the draft becomes a banker’s acceptance.
• This arrangement is common in international trade, and banker’s
acceptances are actively traded in the money market.
• A firm can also use a conditional sales contract as a credit instrument.
• With such an arrangement, the firm retains legal ownership of the goods
until the customer has completed payment.
• Conditional sales contracts usually are paid in installments and have an
interest cost built into them.
How to Create Credit &
Collections Policy?
• Knowing the firm’s level of risk tolerance, cash-on-hand and access to capital
will go a long way in helping a firm to determine its credit and collection policy.
• Firm’s credit and collection policy can be liberal, moderate, conservative or
some combination such as:
❖ Liberal on credit/conservative(tight) on collections
❖ Moderate on credit/moderate on collections
❖ Conservative(tight) on credit/liberal on collections
• The mentioned above alternative policies do have their own cost:
1. Opportunity cost of lost contribution/profit , and
2. Credit administration costs and bad debt losses.
• As you can see from the figure1 on the next slide, these two costs
behave contrary to each other.
• As a firm moves from tight to lose credit policy, the opportunity cost
declines; that is the firm recaptures lost sales and thus lost
contribution/profit.
• However, the credit administration costs and bad debt losses increases.
• Firm’s credit policy can be determined by the tradeoff between the
opportunity cost, credit administration costs and bad debt loses.
• In the figure below, such trade-off occurs at point A where total of
opportunity costs of lost contribution, and credit administration costs
and bad-debt- loses is minimum.
• Thus, investment in accounts receivable should be evaluated
following the four steps below:
1) Estimation of incremental operating profit,
2) Estimation of incremental investment in accounts
receivable
3) Estimation of incremental required rate of return of the
investment in receivable
4) Comparison of the incremental rate of return with required
rate of return.
Analyzing Credit Policy
Credit Policy Effects
• In evaluating credit policy, there are five basic factors to consider:
1. Revenue effects: If the firm grants credit, then there will be a delay
in revenue collections as some customers take advantage of the
credit offered and pay later. However, the firm may be able to
charge a higher price if it grants credit and it may be able to
increase the quantity sold. Total revenues may thus increase.
2. Cost effects: Although the firm may experience delayed revenues if
it grants credit, it will still incur the costs of sales immediately.
Whether the firm sells for cash or credit, it will still have to acquire
or produce the merchandise (and pay for it).
3. The cost of debt: When the firm grants credit, it must arrange to
finance the resulting receivables. As a result, the firm’s cost of short-
term borrowing is a factor in the decision to grant credit.
4. The probability of nonpayment: If the firm grants credit, some
percentage of the credit buyers will not pay. This can’t happen, of
course, if the firm sells for cash.
5. The cash discount: When the firm offers a cash discount as part of its
credit terms, some customers will choose to pay early to take
advantage of the discount.
Credit Analysis
• Thus far, we have focused on establishing credit terms.
• Once a firm decides to grant credit to its customers, it must
then establish guidelines for determining who will and who
will not be allowed to buy on credit.
• Credit analysis refers to the process of deciding whether or
not to extend credit to a particular customer.
• Imagine that a firm is trying to decide whether or not to
grant credit to a customer.
• This decision can get complicated.
• The answer depends on what will happen if credit is refused.
• Will the customer simply pay cash?
• Or will the customer not make the purchase at all?
• Credit analysis is important simply because potential losses on
receivables can be substantial.
• Companies report the amount of receivables they expect not to
collect on their balance sheets.
• Credit analysis usually involves two steps:
Gathering relevant information and
determining creditworthiness.
A. Credit information
• If a firm wants credit information about customers, there are a number
of sources.
• Information sources commonly used to assess creditworthiness
include the following:
1. Financial statements: A firm can ask a customer to supply financial
statements such as balance sheets and income statements.
2. Credit reports- about the customer’s payment history with other
firms:
3. Banks: Banks will generally provide some assistance to their business
customers in acquiring information about the creditworthiness of
other firms.
4. The customer’s payment history with the firm
Credit Evaluation and Scoring
• There are no magical formulas for assessing the probability that a
customer will not pay.
• In very general terms, the classic five Cs of credit are the basic factors
to be evaluated:
1. Character: The customer’s willingness to meet credit obligations.
2. Capacity: The customer’s ability to meet credit obligations out of
operating cash flows.
3. Capital: The customer’s financial reserves.
4. Collateral: An asset pledged in the case of default.
5. Conditions: General economic conditions in the customer’s line of
business.
Credit scoring
• Credit scoring is the process of calculating a numerical rating for a
customer based on information collected; credit is then granted or
refused based on the result.
• For example, a firm might rate a customer on a scale of 1 (very poor)
to 10 (very good) on each of the five Cs of credit using all the
information available about the customer.
• A credit score could then be calculated by totaling these ratings.
• Based on experience, a firm might choose to grant credit only to
customers with a score above, say, 80.
Collection Policy
• Collection policy is the final element in credit policy.
• Collection policy involves monitoring receivables to spot trouble and
obtaining payment on past-due accounts (collection Efforts).
Monitoring Receivables
• To keep track of payments by customers, most firms will monitor
outstanding accounts.
• First of all, a firm will normally keep track of its average collection
period (ACP) through time.
• If a firm is in a seasonal business, the ACP will fluctuate during the year;
but unexpected increases in the ACP are a cause for concern.
• Either customers in general are taking longer to pay, or some percentage
of accounts receivable are seriously overdue.
• The aging schedule is a second basic tool for monitoring receivables.
To prepare one, the credit department classifies accounts by age.
• Suppose a firm has $100,000 in receivables.
• Some of these accounts are only a few days old, but others have been
outstanding for quite some time.
• The following is an example of an aging schedule:
• If this firm has a credit period of 60 days, then 25 percent of its
accounts are late.
• Whether or not this is serious depends on the nature of the firm’s
collections and customers.
• It is often the case that accounts beyond a certain age are almost
never collected.
• Monitoring the age of accounts is very important in such cases. (For
details refer Bringham p.541)
Collection Efforts
• A firm usually goes through the following sequence of procedures for
customers whose payments are overdue:
1. It sends out a delinquency letter informing the customer of the past-
due status of the account.
2. It makes a telephone call to the customer.
3. It employs a collection agency.
4. takes legal action against the customer.
• At times, a firm may refuse to grant additional credit to customers until
arrearages are cleared up.
• This may antagonize a normally good customer, which points to a
potential conflict between the collections department and the sales
department.
• In probably the worst case, the customer files for bankruptcy.
When this happens, the firm can simply wait, or it can sell its
receivable.
• Besides, Cash Discount encourages customers to pay early,
and hence could be used as collection tool proactively.
• It will shorten the receivables period and, all other things
being equal, reduce the firm’s investment in receivables.
• For example, suppose a firm currently has terms of net 30
and an average collection period (ACP) of 30 days.
• If it offers terms of 2/10, net /30, then perhaps 50 percent of
its customers (in terms of volume of purchases) will pay in 10
days.
• The remaining customers will still take an average of 30 days to pay.
• What will the new ACP be? If the firm’s annual sales are $15 million
(before discounts), what will happen to the investment in receivables?
• If half of the customers take 10 days to pay and half take 30, then the

• 𝑁𝑒𝑤 𝐴𝐶𝑃= 0.50*10 𝑑𝑎𝑦𝑠+ 0.50∗30 𝑑𝑎𝑦𝑠=20 𝑑𝑎𝑦𝑠

new average collection period will be:

• The ACP thus falls from 30 days to 20 days.

THANK
YOU!!!