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Management of Receivables: Determination & Evaluation of Credit Policy

Ruchi Gandhi

| Updated: Apr 23, 2020 | Category: CFO Service, Finance & Accounting

Management of Receivables

Why is Management of Receivables needed?

In every organization, huge amounts of money are tied up in accounts receivables. As a result, there are chances of bad debts and the consequential possibility of incurring a cost of collection of debts by the company. On the contrary, if the investment blocked in accounts receivables is low, the sales may become restricted, since the company’s competitors may offer more liberal terms to the customers. Therefore, the management of receivables is an important issue, and it requires proper policies and their implementation on the part of the company’s top management.

Meaning of Management of Receivables

Management of receivables is concerned with planning, monitoring, and controlling of ‘debt’ owed to the firm from a customer(s) on account of credit sales. It is also referred to as trade credit management. The primary objective of management of receivables (or debtors) is to optimize the return on investment on these assets, i.e., debtors.

Responsibilities of the Finance Manager

The finance manager has operating responsibility towards the overall management of the investment in accounts receivables. He must be actively involved in:

  • Supervision of the administration of credit
  • Contribution towards top management’s decisions relating to the best credit policies of the firm
  • Decisions relating to the criteria for selection of credit applications
  • Speeding up the conversion of accounts receivables into cash by aggressive collection policy
  • Strike off a balance between the cost of increased investment in accounts receivables and incremental profits from the higher levels of sales

Most important aspects of Management of Receivables

The management of receivables by the finance manager entails due consideration of the following three important aspects:

(A) Credit Policy: The credit policy of the business firm needs to be determined carefully. The decision pertaining to credit policy comprises decisions relating to credit standards, credit terms and collection efforts. This seeks to include credit period, cash discount and other relevant matters. The credit policy should be determined by establishing a risk-return trade-off between the profits on incremental sales that arise owing to the credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. Or simply put, the expected profit must be compared with the opportunity cost of investment in accounts receivables.

The credit period is usually quoted in terms of net days. For example, if a business entity’s credit terms are “net 50”, it is expected that the customers will repay their credit obligations not later than 50 days. Moreover, the cash discount policy states the rate of cash discount offered, the cash discount period; and the net credit period. For instance, the credit terms may be expressed as “3/15 net 60”. This means that a 3% discount will be provided if the customer pays within 15 days; if he does not avail the offer, he must make the due payment within 60 days.

(B) Credit Analysis: Credit analysis requires the finance manager to determine as to how risky it is to advance credit to a particular customer or party. The credit-worthiness of a prospective customer must be analyzed based on his financial strengths and weaknesses, before according him valuable goods on credit.

(C) Control over Receivables: The finance manager is required to follow up the debtors and take decisions about a suitable credit collection policy for the firm. It not only involves laying down of credit collection policies, but also the execution of such policies. The cost of maintaining and controlling receivables comprises the following costs:

  • The firm would require additional funds since some resources get blocked in accounts receivables. This leads to a cost in the form of interest (on loan funds) or opportunity cost (on own funds).
  • Administrative costs which include record-keeping, investigation of credit-worthiness, etc.
  • Collection costs
  • Defaulting costs

Factors affecting Credit Policy

The credit policy of a business firm is an important factor determining both the quantity and the quality of accounts receivables. Companies may follow a lenient or stringent credit policy. The company that adopts a lenient credit policy sells goods on credit to its customers on very liberal terms and conditions. On the other hand, a company that adopts a stringent credit policy sells goods on credit to its customers on a highly selective basis, i.e., only to those peculiar customers who are financially sound and hold a proper track record strengthening their credit-worthiness.

Any increase in accounts receivables or an additional extension of trade credit granted to customers not only results in higher sales but is also accompanied with additional financing required to support the increased investment in accounts receivables. Moreover, the costs of credit investigations, collection efforts and the chances of bad debts are also increased.

The size of the investment that a company makes in accounts receivables is determined by various factors such as:

  • The effect of granting credit to customers on the volume of a company’s sales
  • The details of credit terms
  • The details of the cash discount
  • The policies and practices adopted by the firm for the selection of appropriate credit customers
  • The paying practices, trends and habits of the company’s customers
  • The company’s policies and practices of collection of debts
  • The degree or extent of operating efficiency in the billing, record-keeping and adjustment functions
  • Other ancillary costs such as interest, collection costs and bad debts, etc. The rising trend in such costs would depress the size of investment in accounts receivables.

Evaluation of Credit Policies

A proper evaluation of credit policies to be adopted by a company and those to be dispensed with by a company is indubitably one of the most significant tasks to be undertaken by finance managers. The firm must work out the optimum amount that it should spend on the collection of its debtors. This involves maintaining a trade-off between the levels of expenditure on the one hand and a decrease in bad debt losses/increase in sales revenue on the other. To apprehend the role of different costs involved in the evaluation of credit policies, let us consider the following example:

A business trader whose present sales are in the bracket of Rs. 12 lakh per annum and an average collection period of 30 days wants to adopt a more liberal policy with a view to enhance sales revenue. The selling price per unit is Rs. 6, the average cost per unit is Rs. 4.5 and variable costs per unit are Rs. 4. The current level of bad debt loss is 1%. The required rate of return on additional investment is 20%. A study executed by a management consultant reveals the following information:

  1. Credit Policy A – Increase in collection period by 10 days – Increase in sales by Rs. 60,000 – Present anticipated default rate 1.5%
  2. Credit Policy B – Increase in collection period by 20 days – Increase in sales by Rs. 96,000 – Present anticipated default rate 2%
  3. Credit Policy C – Increase in collection period by 30 days – Increase in sales by Rs. 1,50,000 – Present anticipated default rate 3%
  4. Credit Policy D – Increase in collection period by 45 days – Increase in sales by Rs. 1,80,000 – Present anticipated default rate 4%

Evaluation of Different Credit Policies

Evaluation of Different Credit Policies

“Fixed cost = [Average Cost per unit – Variable Cost per unit] × No. of Units sold.”
“Opportunity Cost = Total Cost × Collection period/360 × Rate of Return/100”

Here, it is recommended to choose Credit Policy A since the net expected benefits under this policy are higher as compared to other policies.

Monitoring and Controlling of Accounts Receivables

The management of receivables should be such that it strives to reduce the time lag between the sale and collection. In recent years, a number of tools, techniques, and practices have been adopted by firms to enhance effectiveness in the management of accounts receivables. Some of these significant innovations include the following:

1. Re-engineering Receivable Process and Centralization: In some cases, real cost reductions and performance improvements can be achieved by a mere re-engineering of the accounts receivable process. Re-engineering involves fundamental re-thinking and re-designing of business processes by incorporating modern business approaches. Centralization of high value or high nature transactions of accounts receivables and payables is also one of the practices for deriving better efficiency. It puts attention on specialized groups for a speedy recovery.

2. Alternative Payment Strategies: So as to seek efficiencies in the management of accounts receivables, it is observed by businesses that payment of accounts outstanding is likely to be quicker where a number of payment alternatives are made available to the customers. Using alternative modes of payment like Direct Debit, Integrated Voice Response (IVR), Collection by Third Party, Lock Box Processing, Payments via the Internet such as RTGS, NEFT, IPMS UPIs, PayTm, Phone Pe, etc. benefits in attracting and retaining customers.

3. Customer Orientation: For individual customers or a group of customers who showcase some strategic importance to the firm, a critical study approach can be followed to form a strategy for prompt settlement of debt and to develop good customer relations with them.

4. Evaluation of Risk: To establish an effective control mechanism, evaluation of processes and questioning the way that tasks are performed is important. Once risks have been properly assessed, controls can be introduced to either contain the risk to an acceptable level or to eliminate them entirely. It can also provide an opportunity for removing inefficient practices.

5. Automated Accounts Receivable Management Systems: All large companies develop and maintain automated receivable management systems. The manual systems of recording accounts receivable transactions are not only cumbersome but are ultimately costly also. The integrated systems automatically update all the accounting records affected by a particular transaction such as the account of the customer, inventory, and the records of sale.

6. Accounts Receivable Collection Practices: Any delays that lengthen the span between sale and collection cause accounts receivables to unnecessary build up and increase the risk of bad debts. This is equally true for the delays caused by billing and collection procedures as it is for delays caused by the debtor. Some of the major accounts receivable collection practices are an issue of invoice, open account or open-end credit, credit terms or time limits, periodic statements, use of payment incentives and penalties, export factoring, etc.

7. Credit analysis and credit rating: Credit analysis is a financial tool used to evaluate individual customers in respect of their credit-worthiness and the possibility of bad debts. An important job for the finance manager is to assign a rate to several debtors who seek credit facility. The finance manager has to look into the credit-worthiness of a party and sanction credit limit only after he is fully convinced that the party is sound. This would combine an analysis of the financial status of the party, its reputation and previous record of meeting financial commitments. Here, he has to employ a number of sources to obtain credit information. Some of the important sources are Trade references; Bank references; Credit bureau reports; Past experience; Published financial statements; and Salesman’s interview and reports.

8. Ageing Schedule: When accounts receivables are analyzed according to their age or no. of overdue days, the process is known as preparing the ageing schedules of receivables. An ageing schedule often categorizes accounts receivables as current (under 30 days), 1-30 days past due, 30-60 days past due, 60-90 days past due and more than 90 days past due. The main purpose of classifying receivables by age groups is to have closer control over the quality of individual accounts. The calculation of average age of receivables is a quick and effective method of comparing the liquidity of current receivables with the liquidity of receivables in the past and also comparing liquidity of one firm with the liquidity of the other competitive firm. It also assists the firm to predict the collection pattern of receivables in future.

9. Collection policies and collection programme: It is essential that clear-cut procedures regarding credit collection are set up. These procedures may answer questions such as how long should a customer’s balance be allowed to exist before collection is started, what process should be there to follow up with the defaulting customer, should legal action be initiated against doubtful accounts, etc.

Moreover, the collection programme implemented by a business concern may incorporate monitoring of the state of receivables, intimating to customers when the due date approaches, rendering e-mail and telephonic advice to customers on the due date, reminding the legal recourse on overdue accounts, and taking legal action on overdue accounts.

Takeaway

Merely setting up of standards and framing a credit policy by the finance manager is not sufficient; it is, equally important to control the accounts receivables. The objective of debtors’ collection must be to minimize, monitor and control the accounts receivable and at the same time maintain customer goodwill.

How can Enterslice help?

Expert financial advisory services at Enterslice can assist and guide you in strengthening your end-to-end ‘accounts receivables transactions’ right from sales order processing, invoicing, payment follow-ups, credit control and monitoring to bad debts management and recovery suites handling.

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Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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