Receivable Management

Accounts receivable represent the amount

due from customers debtors as a result of
selling goods on credit.
Granting credit to the customers is the
essential marketing principle, which expands
the volume of sales for every business unit.
 Transactions leading to of receivables:

Credit Sales of Goods and Services

• A/R (Trade Receivables), Notes, Installment
Receivables
Loans Advanced to Individuals and Other
Entities
• Loan, Notes , Advance to Affiliates, Advance to
Employees
 Transactions leading to A/R…
Leasing Property to Others
• Lease Contract Receivable
Other Revenue Transactions
• Interest, Dividend, Rent, Commissions
Receivable, etc…
Claims in Insurance, Tax, Litigations, etc..
• Claims ,Tax Refund, Damage Claims
Receivable, etc..
 Receivables Management: (R. Mgt)

R. Mgt. is defined as “the process of making decisions

relating to the investment in receivables which will result in
maximizing the overall ROI of the firm.”
R.Mgt. involves decisions on extension of credit, protection
of receivables, timely collections and maintenance of
records.
 Therefore, it requires establishment of sound credit
policies.
 Credit policies involve the duties and responsibilities of the
credit manager, general guidelines as to credit terms,
collections and write-off procedures, etc.
 The policies are usually specified in writing as part of the
firm’s internal control procedures.
 Objectives of R. mgt.
• To attain optimum volume of sales.
• To exercise control over the cost of credit and
maintain it on a minimum possible level.
• To keep investments at an optimum level in the
form of receivables.
• To plan and maintain a short average collection
period.
 Costs of Maintaining Receivables
• Capital Costs
Eg. In the both cases the firm incurs cost is
interest cost.
• Administrative Costs
Eg. salaries to staff
• Collection Costs
• Default Costs
Eg. uncollectible (written off)
 Efficient credit management provides

• Protection of Company’s Liquidity

• Protecting the Investment in Receivables
 good quality accounts to minimize potential losses.
(conditional contract, credit insurance, collateral).
• Profitability
 Operational Controls:
• Make sure that all credit sales are daily recorded.
• Ensure that credit sales are recorded against the
proper accounts.
• Ensure that proper statements are presented on a
timely basis for each account (client) and appropriate
reports provided to management.
• Ensure that collections are credited to the proper
accounts.
Account receivable management involves the careful
consideration of the following basic aspects:

1. Forming/Formulating credit policy

2. Executing the credit policy
3. Formulating and executing the collection procedure
 Credit Policies
 The term credit policy refers to those decisions variables that
influence the amount of trade credit
Objective of credit policy:
• Long-term: increase owner’s wealth
• Short-term: maximize sales and profits.
 The four important decisions variables of credit policy
1. Credit standards -(financial strength and credit worthiness)
2. Credit terms-( Cash Discounts, Credit Period eg 3/20,n60)
3. Credit analysis, - information
(5c’s=carach..,capacity,capit.,coll..,cond..)
4. Collection policy
( Formal collection procedures against delinquent accounts,
Minimize collection float, Varying collection efforts, Analysis and
Control)
 Analysis to be made on basis of PV or NPV
• Invoice amount = $ 10,000
• Term = 3/20, n/30
• Cost of capital = 10%
• Assumption 1: checks clear immediately in both payment
arrangements.
• N/30: PV = 10,000/ (1+ (0.1*30/365)) =$ 9,918.48
• 3/20: PV = 9,700/ (1 + (0.1*20/365)) = $ 9,647.14

• Decision should be: Firm better make sales on n/30 basis

• Assumption 2: checks clear immediately in both cases but the company
has the option of investing early receipts at 15%.
N/30: PV = 9,918.48
3/20: PV = 9647.14 + (9647.14 * 15/100 * 10/365) =$9,686.79
Still no incentive to give cash discounts
 Example 2
• Consider the same facts above except that
customers will increase their order by 10% if 3%
cash discount is given; assume also that the
company has variable costs of $0.50 per dollar of
sales.
• N/30: NPV =-5000 + 10,000/ (1 + (.1*30/365)) = $ 4,918.48
• 3/20: NPV = -5500 + 10670/ (1 + (.1* 20/365)) = $
5,111.85
Decision could be: possible to grant 3% cash
discounts
 Quality Ratio:
• if a firm offers the same cash discount for all credit sales, a
ratio known as quality ratio can be calculated to determine the
frequency with which payment is received during the period.
• Quality Ratio = Discounts taken
• Discount Available
• E.g.
• Total annual credit sales = birr720,000, 2/15, n/30
• - Discounts taken = 10,800
• - Discounts Available, (.02*720000) = 14,400
•
• Quality Ratio = 10,800/14400 = 0.75
• It indicates that 75% of the annual credit sales were collected
within the discount period.
 Monitoring of Accounts Receivable
• Once the company has set the credit standards, credit policy
and its collection policy, it is important for the finance
manager to watch and monitor the effectiveness of collections.
• Generally, the finance manager sets targets in terms of
average collection period and the bad debts to sales ratio
and monitors accounts receivable with reference to these
ratios.
• It is important to note the changes in credit standards or
credit policy and revise these indicators appropriately.
• There are possible methods to monitor how well accounts
receivable are managed.
1. Financial ratios and
2. Aging schedules.
 Cont…
• Financial ratios can be used to get an overall
picture of how fast we collect on accounts
receivable.
• Aging schedules, which are breakdowns of the
accounts receivable by how long they have
been around, help you get a more detailed
picture of your collection efforts.
 Cont…
• Days of Credit, which is the ratio of the
balance in accounts receivable at a point in
time (say, at the end of a year) to the credit
sales per day (on average, the dollar amount
of credit sales during a day):
• Number of days of credit = Accounts Receivable
Credit sales per day
 example
• Suppose that Whole Loaves, a wholesale bakery,
has $1 million of credit sales per year and
currently has a balance in accounts receivable of
$80,000. Then:
• Credit sales per day = 1,000,000 = 2,740 per day
• 365days
• Number of days of credit = 80,000 = 29 day
• 2,740
• This means the firm has, on average, 29 days’
worth of sales that have not been paid for as yet.
 Ex1
• A firm extends credit on 2/15, n/45. Sales during the
year were 150,000 units at $ 37 per unit. Unit cost is $
22. Collection costs average $ 0.80 per unit and the
firm’s cost of capital is 15%.
• Compute
a) The cost of carrying A/R if all customers do not take
the discount.
b) The cost of carrying A/R if the discount is taken by all
customers.
c) The cost to the firm in profit for providing the buyers
with a 2% discount.
 Solution

• [150,000 * 22] [.15 * (45/360))) + (150,000 * 0.80) = $ 181,875

• (150,000 * 22) (.15 * (15/360)) + (150,000 * 0.80) = $ 140,625
• Or (9,166.67 * 15) * 0.15 + 120,000 = 140,625
• c) 0.02(150,000 * 37) = $111,000
• OR
• Annual receivables at cost = 150,000 * 22 = 3,300,000
• Daily receivables at cost + 3,300,000/360 = 9,166.67
• Average collection period = 45 days
• Accounts receivable balance = 9,166.67 * 45 = 412,500
• Opportunity cost = 412,500 * 0.15 = 61,875
• Collection costs = 150,000 *0.8 = 120,000
• Total cost of managing A/R = 181,875
 CHANGES IN CREDIT POLICY
Firms may ease their credit policies to stimulate sales
• Credit period may be lengthened
• Credit standards may be relaxed
• Lose collection policy
• Offering cash discounts.
 Increased sales do entail costs
• More labor and materials
 Outstanding receivables increase leading to increase carrying
costs, bad debt losses and cash discounts.
 The effect of credit policy change could also extend to
certain balance sheet items.
Like; cash balances, Inventories, & probably, fixed assets, & A/R
 Cont…
 The increase in these assets would have to be
financed by some sources. Thus, certain liabilities
and /or equity would have to be increased.
 Credit policy change warrants a substantial amount
of analysis due to a number of uncertainties
involved.
• Uncertainty with regard to the projected sales level
• Uncertainty concerning the number of customers
taking cash discounts
• Uncertainty on the impact of policy change on
balance sheet ratios.
• OPTIMAL CREDIT POLICY: -
It is useful to think of the decision to grant credit in
terms of two cost elements: carrying costs and
opportunity costs.
1. Carrying Cost:
Required return on investment in receivables
• Bad debt loses
• Costs of credit management, i.e. clerical, collection,
etc...
• These costs are positively related to the amount of
credit granted.
2. Opportunity Costs: lost sales from refusing to offer
credit. These costs decline as credit is granted.
Total Credit Costs = Carrying Costs + Opportunity
Costs

The sum of the carrying costs and the opportunity

costs of a particular credit policy is called the total-
credit-cost curve.
A point is identified as the minimum of the total-
credit-cost
curve.
 Inventory management
• Financial manager of a firm will not normally have primary control
over inventory management
– Other functional areas (e.g., purchasing, production, and marketing)
will usually share decision-making authority regarding inventory
• For a manufacturer, inventory is normally classified into one of three
categories:
1. Raw material is whatever the firm uses as a starting point in its
production process.
2. Work-in-progress is unfinished products
3. Finished goods are products ready to ship or sell
• Keep in mind three things concerning inventory types:
– Names for different types of inventory can be misleading because one
company’s raw materials can be another’s finished goods
– Various types of inventory can be different in terms of liquidity
– Derived (or dependent demand) items versus independent items
 Inventory costs
• Carrying costs represent all the direct and opportunity costs of
keeping inventory on hand and include:
1. Storage and tracking costs
2. Insurance and taxes
3. Losses due to obsolescence, deterioration, or theft
4. The opportunity cost of capital on the invested amount
• Shortage costs are associated with having inventory on hand and
consist of two components:
1. Restocking or order costs are either the costs of placing an order
with suppliers or the costs of setting up a production run
2. Costs related to safety reserves are opportunity costs such as lost
sales and loss of customer goodwill that result from having
inadequate inventory
• Basic trade-off exists in inventory management because carrying costs
increase with inventory levels, whereas shortage or restocking costs
decline with inventory levels
 Inventory management techniques:
1. ABC approach
• The ABC System is means of categorizing inventory
items into three classes `A`` B`` and C`` according to the
potential amount to investment to be controlled
• As Figure shows, “A” Group comprises only 10% of
inventory by item count, but represents more than half
of the value of inventory
– Items monitored closely; inventory levels are kept
relatively low
• “C” Group are basic inventory items (e.g., nuts and
bolds); crucial and inexpensive, so large quantities are
ordered and kept on hand
• “B” Group consists of in-between items
Inventory management techniques:
ABC approach
 Inventory management techniques:
2. Economic Order Quantity (EOQ) model
• Best-known approach for explicitly establishing an
optimal inventory level
• Basic idea illustrated in Figure, which plots various
costs associated with holding inventory against
inventory levels
• With the EOQ model, we will attempt to specifically
locate the minimum total cost point, Q*
• Keep in mind is the cost of the inventory itself is not
included
– This is because the total amount of inventory the firm needs in a
given year is dictated by sales
 Inventory management techniques:
Economic Order Quantity (EOQ) model
 EOQ model: Inventory Depletion
• To develop the EOQ, we will assume that the firm’s inventory is
sold at a steady rate until it hits zero
– At that point, firm restocks its inventory back to some
optimal level
• Suppose the Eyssell Corporation starts out today with 3,600
units of a particular item in inventory. Annual sales of this item
are 46,800 units, which is about 900 per week.
• If Eyssell sells off 900 units of inventory each week, then all the
available inventory will be sold after four weeks, and Eyssell will
restock by ordering (or manufacturing) another 3,600 units and
start over.
• This selling and restocking process produces a sawtooth pattern
for inventory holdings
• Eyssell always starts with 3,600 units and ends up at zero
– On average, then, inventory is half of 3,600, or 1,800 units
 EOQ model: The Carrying costs
• Carrying costs are normally assumed to be directly proportional
to inventory levels
• Suppose we let Q be the quantity of inventory that Eyssell
orders each time (3,600 units); we will call this the restocking
quantity
– Average inventory would then be Q/2, or 1,800 units
• If we let CC be the carrying cost per unit per year, Eyssell’s total
carrying costs will be:
Total carrying costs = Average inventory × Carrying cost per
unit
= (Q/2) × CC
• In Eyssell’s case, if carrying costs were $.75 per unit per year,
total carrying costs would be the average inventory of 1,800
units multiplied by $.75, or $1,350 per year
 EOQ model: The Restocking costs
• Restocking costs are normally assumed to be fixed
• Suppose we let T be the firm’s total unit sales per year
• If the firm orders Q units each time, then it will need to place a total
of T/Q orders
• For Eyssell, annual sales are 46,800, and the order size is 3,600
– Eyssell places a total of 46,800/3,600 = 13 orders per year
• If the fixed cost per order is F, the total restocking cost for the year
would be:
Total restocking cost = Fixed cost per order × Number of orders
= F × (T/Q)
• For Eyssell, order costs might be $50 per order, so the total restocking
cost for 13 orders would be $50 × 13 = $650 per year
 EOQ model: The total costs
• Total costs associated with holding inventory are the
sum of the carrying costs and the restocking costs:
Total costs = Carrying costs + Restocking costs
= (Q/2) × CC + F × (T/Q)
• Our goal is to find the value of Q, the restocking
quantity, that minimizes this cost
– For Eyssell, carrying costs (CC) were $.75 per unit
per year, fixed costs (F) were $50 per order, and
total unit sales (T) were 46,800 units
 With these numbers, here are some possible total
costs:
 EOQ model: the total costs …
• We can find the minimum point by setting carrying costs equal
restocking costs and solving for Q*:
Carrying costs = Restocking costs (RC)
(Q*/2) × CC = F × (T/Q*)
• With a little algebra, we get:
Q*2 = (2T×F)/CC
• Economic order quantity (EOQ) is the restocking quantity that
minimizes the total inventory costs
 Carrying Costs and Restoring Costs
Carrying Costs
•Thiewes shoes begins each period with 100 pairs of
hiking boots in the stock. This stock is depleted each
period and reordered. If the carrying cost per pair of
boots per year is $3, what are the total carrying costs
for the hiking boots?
•Inventories always stars at 100 items and end up at
zero, so average inventory is 50 items. At an annual cost
of $3 per item, total carrying costs are $150.
 Carrying Costs and Restoring …
Restocking Costs
•Suppose Thiewes sells a total of 600 pairs of boots in a
year. How many times per year does Thiewes restock?
Suppose the restocking cost is $20 per order. What are
total restocking costs?
•Thiewes orders 100 items each time. Total sales are
600 items per year, so Thiewes restocks six times per
year, or about once every two months. The restocking
costs would be (RC=F*T/Q= 20*600/100=$20*6=$120)
The EOQ
 Based on the above information, get
summary.
 Extensions to the EOQ model
• We have assumed a company will let its inventory run down to zero
and then reorder, but a company will wish to reorder before its
inventory goes to zero for two reasons:
1. By always having some inventory on hand, firm minimizes risk of a
stockout (and resulting losses of sales and customers)
2. When a firm does reorder, there will be some time lag before the
inventory arrives

• Safety stock is minimum level of inventory a firm keeps on hand

– Inventories are reordered whenever the level of inventory falls to the
safety stock level
• To allow for delivery time, a firm will place orders before inventories
reach a critical level
– Reorder points are the times at which the firm will actually place its
inventory orders
 3. Managing derived-demand inventories
• Materials requirement planning (MRP) is a set of
procedures used to determine inventory levels for
demand-dependent inventory types, such as work-in-
progress and raw materials
– Basic idea behind MRP is that, once finished goods
inventory levels are set, it is possible to determine
what levels of work-in-progress inventories must
exist to meet the need for finished goods
– Particularly important for complicated products for
which a variety of components are needed to create
the finished product
 Managing derived-demand inventories
4. Just-in-time inventory is a system for managing
demand-dependent inventories that minimizes inventory
holdings c
– Goal is to minimize inventories, thereby maximizing
turnover
– Began in Japan and is a fundamental part of
Japanese manufacturing philosophy
– Result is that inventories are reordered and
restocked frequently
• End of the Chapter