The role of "Receivables" in the operating cash cycle was dealt upon. previous Section dealt with credit policy as a determinant of Working Capital (WC). brought out the importance of the strategy of speedy collection of accounts receivable. Notations in communicating discounts offered were discussed in Section.More details of "Receivables Management", called also as "trade credit management", are now presented.
Deciding Criterion
"Receivables" is the debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business. When payment is not immediately received for sale of goods or services, the firm grants trade credit and creates an accounts receivable which would be collected in due course ahead. Credit sales we generally made on an open account as discussed in previous Section. Yet, extension of credit involves risk and cost. Thus, the objective as well as the criterion of receivables management is to promote sales and profit just until when the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit. The types of costs and benefits associated with receivables management are as follows.
Costs Relevant to Receivables Management
Costs associated with extending of credit are : (i) collection cost; (ii) capital cost;(iii) deliquency cost; and (iv) default cost. As regards construction management,every running bill presented by the contractor to the owner is a receivable, besides the withheld amounts (retentions) thereon till when the running bill is eventually paid. For this reason, each of these zosts is relevant for construction management also. The second item of cost, viz. capital cost, in the context of construction through contracting, has been dealt (under the extending title of "Effect of Considering the Contractor's Working Capital as Borrowed Money").
Collection Costs
These are administrative costs incurred in collecting the receivables from the customers to whom credit sales have been made. There are expenses in terms of staff employed, maintenance of records, stationery, postage, etc. Also, there are continuing and nonspecific expenses in acquiring credit information on customers through specialist agencies taken on consultancy or hiring basis.
Capital Cost
Accounts receivable constitute an investment in assets. Their financing involves a cost depending on the amount involved and the time lag from sales till actual receipt of funds. Also, supplies received in the interim must have to be paid for out of additional funds that must be arranged, again at a cost. These add up to the capital cost of the receivables.
Delinquency Cost
Capital cost can be considered as restricted to the period of credit and, if the customer pays by that time, so much is so good. If the customer fails to meet this obligation to pay on the credit sales given to him even after the expiry of the credit period, this delinquency adds to the cost of receivables for reasons of : (i) extended period of blocking up of the funds; and (ii) costs for organising the recovery of the overdues, e.g. reminders, visits, legal charges, etc.
Default Cost
When all efforts at recovery of the receivables fail, the debts become bad debts and have to be written off causing a loss to the creditor. These are default costs.Benefits from Credit Sales (resulting in Receivables) Costs apart, there are benefits attributable to credit sales. These are : possibility and, often, realisation of increased sales and profits. Sales may expand by more purchases by existing customers and by induction of new customers. Also, emerging competitors may not walk away with some of the existing customers if the latter get the benefit of purchasing on credit.
Trade-off Called For
Accounts receivable management should be towards a trade-off between profits (by benefits) and risks (by costs). The costs and benefits to be compared in determining the optimum level of receivables are marginal costs and marginal benefits. That is to say, the firm should consider only the additional, or incremental, benefits and costs that result from a change in the receivables due to the trade credit policy.
The level of accounts receivable that can be maintained is affected by the general economic conditions and the trade practices adopted by comparable concerns and also by the firm's internal policy on investments in this type of current assets. As with other current assets, the firm can vary the level of receivables in keeping with the trade-off between profitability and risk. By increasing the level, demand is stimulated and higher quantum of profits would result. But there will as well be a greater risk of bad debt losses at the same time. The trade-off between these is to be analysed. For this, the policy variables include :
(a) the quality of trade accounts accepted (or credit policy)
(b) ' the length of the credit period,
(c) the cash discount given, and
(d) the collection program of the firm.Mutuality and interaction between these policy variables is inevitable.
In other words, it must be appreciated that relaxation of credit standards would mean several things at once : Increase in sales, higher average accounts receivable,credit extended to less-credit-worthy customers, these customers taking Ionger period to pay the dues. With increase in sales and increase in collection time, there will be higher carrying cost. Also, bad debt expenses would be expected to increase. The ensuing examples illustrate decisions to be made considering the trade-off in the respective context.
Example
Consider the following data :
(a) Current sales are at Rs. 200 per unit of which Rs. 130 is the variable cost before taxes including credit department costs.
(b) The firm is operating at less than full capacity and an increase in sales can be accommodated without any increase in fixed costs.
(c) As of now, annual credit sales are at a level of Rs. 60 lakhs with a collection period averaging to one month.
(d) The firm intends to adopt a liberal extension of credit which is expected to . result in 30% increased sales with the average collection period increasing to two months.
(e) Opportunity cost of carrying the additional receivables is 20% before taxes.
Let us investigate if the firm should relax its credit standards as intended ? (The computations can be tabulated as in Example 20.8 that follows.)
Solution
Number of units sold presently =(60,00,000/200)= 30,000
Number of units sold on credit liberalisation = 30000 x 1.3 = 39000
Receivables turnover at present = 12 (being monthly collection)
Present level of receivables = (Rs. 60,00,000 /12) = Rs. 5,00,000
Receivables turnover on credit liberalisation = 6 (being collection in 2 months)
Level of receivables after credit liberalisation =(Rs. 60,00,000 x 1.3)/6= Rs. 13,00,000
Increase in receivables = Rs. 8,00,000
Opportunity cost of additional receivables = Rs. 1,60,000 (A)
Profit on additional sales
= Rs. 9000 x (200 - 130)
= Rs. 6,30,000 (B)
Since (B) exceeds (A), relaxation of credit standards can be adopted. The additional profit, adjusted for opportunity cost of additional receivables, will be by difference, equal to Rs. 4,70,000.
Deciding Criterion
"Receivables" is the debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business. When payment is not immediately received for sale of goods or services, the firm grants trade credit and creates an accounts receivable which would be collected in due course ahead. Credit sales we generally made on an open account as discussed in previous Section. Yet, extension of credit involves risk and cost. Thus, the objective as well as the criterion of receivables management is to promote sales and profit just until when the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit. The types of costs and benefits associated with receivables management are as follows.
Costs Relevant to Receivables Management
Costs associated with extending of credit are : (i) collection cost; (ii) capital cost;(iii) deliquency cost; and (iv) default cost. As regards construction management,every running bill presented by the contractor to the owner is a receivable, besides the withheld amounts (retentions) thereon till when the running bill is eventually paid. For this reason, each of these zosts is relevant for construction management also. The second item of cost, viz. capital cost, in the context of construction through contracting, has been dealt (under the extending title of "Effect of Considering the Contractor's Working Capital as Borrowed Money").
Collection Costs
These are administrative costs incurred in collecting the receivables from the customers to whom credit sales have been made. There are expenses in terms of staff employed, maintenance of records, stationery, postage, etc. Also, there are continuing and nonspecific expenses in acquiring credit information on customers through specialist agencies taken on consultancy or hiring basis.
Capital Cost
Accounts receivable constitute an investment in assets. Their financing involves a cost depending on the amount involved and the time lag from sales till actual receipt of funds. Also, supplies received in the interim must have to be paid for out of additional funds that must be arranged, again at a cost. These add up to the capital cost of the receivables.
Delinquency Cost
Capital cost can be considered as restricted to the period of credit and, if the customer pays by that time, so much is so good. If the customer fails to meet this obligation to pay on the credit sales given to him even after the expiry of the credit period, this delinquency adds to the cost of receivables for reasons of : (i) extended period of blocking up of the funds; and (ii) costs for organising the recovery of the overdues, e.g. reminders, visits, legal charges, etc.
Default Cost
When all efforts at recovery of the receivables fail, the debts become bad debts and have to be written off causing a loss to the creditor. These are default costs.Benefits from Credit Sales (resulting in Receivables) Costs apart, there are benefits attributable to credit sales. These are : possibility and, often, realisation of increased sales and profits. Sales may expand by more purchases by existing customers and by induction of new customers. Also, emerging competitors may not walk away with some of the existing customers if the latter get the benefit of purchasing on credit.
Trade-off Called For
Accounts receivable management should be towards a trade-off between profits (by benefits) and risks (by costs). The costs and benefits to be compared in determining the optimum level of receivables are marginal costs and marginal benefits. That is to say, the firm should consider only the additional, or incremental, benefits and costs that result from a change in the receivables due to the trade credit policy.
The level of accounts receivable that can be maintained is affected by the general economic conditions and the trade practices adopted by comparable concerns and also by the firm's internal policy on investments in this type of current assets. As with other current assets, the firm can vary the level of receivables in keeping with the trade-off between profitability and risk. By increasing the level, demand is stimulated and higher quantum of profits would result. But there will as well be a greater risk of bad debt losses at the same time. The trade-off between these is to be analysed. For this, the policy variables include :
(a) the quality of trade accounts accepted (or credit policy)
(b) ' the length of the credit period,
(c) the cash discount given, and
(d) the collection program of the firm.Mutuality and interaction between these policy variables is inevitable.
In other words, it must be appreciated that relaxation of credit standards would mean several things at once : Increase in sales, higher average accounts receivable,credit extended to less-credit-worthy customers, these customers taking Ionger period to pay the dues. With increase in sales and increase in collection time, there will be higher carrying cost. Also, bad debt expenses would be expected to increase. The ensuing examples illustrate decisions to be made considering the trade-off in the respective context.
Example
Consider the following data :
(a) Current sales are at Rs. 200 per unit of which Rs. 130 is the variable cost before taxes including credit department costs.
(b) The firm is operating at less than full capacity and an increase in sales can be accommodated without any increase in fixed costs.
(c) As of now, annual credit sales are at a level of Rs. 60 lakhs with a collection period averaging to one month.
(d) The firm intends to adopt a liberal extension of credit which is expected to . result in 30% increased sales with the average collection period increasing to two months.
(e) Opportunity cost of carrying the additional receivables is 20% before taxes.
Let us investigate if the firm should relax its credit standards as intended ? (The computations can be tabulated as in Example 20.8 that follows.)
Solution
Number of units sold presently =(60,00,000/200)= 30,000
Number of units sold on credit liberalisation = 30000 x 1.3 = 39000
Receivables turnover at present = 12 (being monthly collection)
Present level of receivables = (Rs. 60,00,000 /12) = Rs. 5,00,000
Receivables turnover on credit liberalisation = 6 (being collection in 2 months)
Level of receivables after credit liberalisation =(Rs. 60,00,000 x 1.3)/6= Rs. 13,00,000
Increase in receivables = Rs. 8,00,000
Opportunity cost of additional receivables = Rs. 1,60,000 (A)
Profit on additional sales
= Rs. 9000 x (200 - 130)
= Rs. 6,30,000 (B)
Since (B) exceeds (A), relaxation of credit standards can be adopted. The additional profit, adjusted for opportunity cost of additional receivables, will be by difference, equal to Rs. 4,70,000.
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