Chapter 5

Accounts Receivable Management

AA/ /RR

Copyright  2005 by Thomson Learning, Inc.

 The Cash Flow Timeline

Order
Order Order
Order Sale
Sale Payment
PaymentSent
Sent Cash
Cash
Placed
Placed Received
Received Received
Received
Accounts
Accounts Collection
Collection
<<Inventory
Inventory>> << Receivable
Receivable >> << Float
Float >>

Time
Time==>
==>
Accounts
Accounts Disbursement
Disbursement
<< Payable
Payable >> << Float
Float >>

Invoice
InvoiceReceived
Received Payment
PaymentSent
Sent Cash
Cash
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Disbursed
Disbursed
by Thomson Learning, Inc.
Learning Objectives

❖ Define credit policy and indicate its components.

❖ Describe the typical credit-granting sequence.
❖ Apply net present value analysis to credit extension
decisions.
❖ Define credit scoring and explain limitations.
❖ List the elements in a credit rating report.
❖ Describe how receivables management can benefit
from EDI.

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Trade Credit and Shareholder Value

❖ Trade credit arises when goods sold under delayed

payment terms
❖ Traced to Romans due to obstacles faced in transferring
money through various trading areas
❖ Credit terms are taken for granted today
❖ Value can be added by managing three areas:
– aggregate investment in receivables
– credit terms
– credit standards
❖ Over-investing in receivables can be costly
❖ ...but, if credit terms are not competitive, then lost sales
can be costly

Copyright  2005 by Thomson Learning, Inc.

Conclusion

❖ Minimize bad debts and outstanding receivables

❖ Maintain financial flexibility
❖ Optimize mix of company assets
❖ Convert receivables to cash in a timely manner
❖ Analyze customer risk
❖ Respond to customer needs

Copyright  2005 by Thomson Learning, Inc.

 A/R Management and Shareholder
Value
Marketing Strategy

Market Share Obj.

Aggregate Inv. in A/R Credit Terms Credit Standards

Total Dollar Investment Length of Time to Pay Acceptance of Marg Cust.

Max Shareholder Value

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Trade vs. Bank Credit

❖ Length of terms
❖ Security
❖ Amounts involved
❖ Resource transferred (goods vs. money)
❖ Extent of analysis

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Why Extend Credit?

❖ Financial Motive
❖ Operating Motive
❖ Contracting Motive
❖ Pricing Motive
❖ All reasons are related to market imperfections

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Financial Motive

❖ Potential of getting a higher price

❖ Sellers raise capital at lower rates than customers
and have cost advantages vis-a-vis banks due to:
– similarity of customers
– the information gathered in the selling process
– lower probability of default (the goods purchased are an
essential element of the buyer’s business)
– seller can more easily resell product if payment is not made.

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Operating Motive

❖ Respond to variable and uncertain demand

❖ Change credit terms rather than:
– install extra capacity,
– building or depleting inventories,
– or forcing customers to wait.

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Contracting Cost Motive

❖ Buyer gets to inspect goods prior to payment

❖ Seller has less theft with separation of collection
and product delivery

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Pricing Motive

❖ Change price by changing credit terms

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Trends Affecting Trade Credit

❖ Zero net working capital objective

❖ Improved internal and external credit-related
information
❖ Electronic commerce

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The Credit Decision Process

Marketing contact

Credit investigation

Customer contact for information

Time

Finalize written documents, e.g.. security agreements

Establish customer credit file

Financial analysis
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 Basic Credit Granting Model

S - EXP(S)
NPV = ----------------- - VCR(S)
1 + iCP

Where:

NPV = net present value of the credit sale

VCR = variable cost ratio
S = dollar amount of credit sale
EXP = credit administration and collection expense ratio
i = daily interest rate
CP = collection period for sale

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Managing the Credit Policy

❖ Should we extend credit?

❖ Credit policy components
❖ Credit-granting decision

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Should We Extend Credit?

❖ Follow industry practice

❖ Extent and form of credit offer
– in-house credit card
– sell receivables to a factor
– captive finance company?

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Components of Credit Policy

❖ Development of credit standards

– profile of minimally acceptable credit worthy customer
❖ Credit terms
– credit period
– cash discount
❖ Credit limit
– maximum dollar level of credit balances
❖ Collection procedures
– how long to wait past due date to initiate collection efforts
– methods of contact
– whether and at what point to refer account to collection agency

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Credit-Granting Decision

❖ Development of credit standards

❖ Gathering necessary information
❖ Credit analysis: applying credit standards
❖ Risk analysis

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 Grant-Granting Sequence
Order and credit
request received

No Material Yes
New/increased Redo credit
credit limit change in
investigation
customer status
Yes No Check
Checknew
newA/R
A/R
Size of proposed total
total vs creditlmt
vs credit lmt
credit limit
Record
disposition
Large Medium Small
No
Extend Credit
Indepth
Indepth Moderate Minimal Yes
credit
creditinvest.
invest. credit invest. credit invest.
Set up,post
A/R, ship
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Credit Standards

❖ Based on five C's of Credit

– Character
– Capital
– Capacity
– Collateral
– Conditions
❖ Determine risk classification system
❖ Link customer evaluations to credit standards

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Gathering Information

❖ credit reporting agencies, e.g.. Dun & Bradstreet

❖ credit interchange bureaus, NACM
❖ bank letters
❖ references from other suppliers
❖ financial statements
❖ field data gathered by sales reps

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Credit Analysis: Applying the
Standards

❖ Nonfinancial
– concerned with willingness to pay, character
❖ Financial
– ability to pay, financial ratios etc.. (other C’s of credit)
❖ Credit scoring models
– Example:

Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)

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Emergence of Expert Systems

❖ Example of decision rule:

“If gross income is equal to or grater than $20,000

and the applicant has not been delinquent and
gross income per household member is equal to or
greater than $12,000 and debt/equity ratio is equal
to or greater than 30% but less than 50% and
personal property is equal to or greater than
$50,000, then grant credit.”

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Factors Affecting Credit Terms

❖ Competition
❖ Operating cycle
❖ Type of good (raw materials vs finished goods,
perishables, etc.)
❖ Seasonality of demand
❖ Consumer acceptance
❖ Cost and pricing
❖ Customer type
❖ Product profit margin

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Cash Discounts

❖ The lower the VC, the higher the feasible discount

❖ Based on company’s cost of funds
❖ Consider timing effect when changing discounts
❖ Should be based on product’s price elasticity
❖ Higher the bad debt experience, higher the optimal
discount

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Practice of Taking Cash Discounts

❖ 51% of firms always took cash discount

❖ 40% sometimes
❖ 9% take discount and pay late
❖ Study found that 4 or 5 companies would be more
profitable if cash discount was eliminated

Copyright  2005 by Thomson Learning, Inc.

A/R Management in Practice

❖ Discounts appear to be changed to match

competitors, not inflation or interest rates
❖ The higher a firm’s contribution margin, the more
likely the firm should be to offer discounts.
❖ A price cut is thought to have more impact than
instituting a cash discount
❖ The more receivables a firm has, does not
necessarily relate to use of penalty fees
❖ The greater amount of receivables does not relate
to a more active credit evaluation.

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Receivables, Collections, and EDI

❖ If credit approval is delayed...

– buyers using EDI purchase orders and JIT manufacturing can
encounter serious problems.
– sellers can now ship within hours of receiving orders...thus
seller must be able to handle electronically transmitted orders.
❖ Seller may also issues electronic invoices and be
paid electronically using an EDI-capable bank so
that remittance data can be automatically read by
seller’s A/R system
❖ Trend is for use of data transmission to automate
the cash application process

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Summary
❖ Investment in A/R represents a significant investment.
❖ Key aspects outlined
– credit policy
– credit standards
– credit granting sequence
– credit limits
– credit terms
❖ Management of A/R is influenced by what competitors are
doing not by shareholder wealth considerations.
❖ Proper use of NPV techniques can ensure that credit
decisions enhance shareholder value.

Copyright  2005 by Thomson Learning, Inc.