Account receivable

1. Copyright  2005 by Thomson Learning, Inc.
Chapter 5
Accounts Receivable Management
A / R

2. Copyright  2005 by Thomson Learning, Inc.
The Cash Flow Timeline
Order Order Sale Payment Sent Cash
Placed Received Received
Accounts Collection
< Inventory > < Receivable > < Float >
Time ==>
Accounts Disbursement
< Payable > < Float >
Invoice Received Payment Sent Cash Disbursed

3. Copyright  2005 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

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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

6. 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

7. Copyright  2005 by Thomson Learning, Inc.
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.

10. Copyright  2005 by Thomson Learning, Inc.
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
Finalize written documents, e.g.. security agreements
Establish customer credit file
Financial analysis
Time

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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

16. Copyright  2005 by Thomson Learning, Inc.
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?

18. Copyright  2005 by Thomson Learning, Inc.
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

19. Copyright  2005 by Thomson Learning, Inc.
Credit-Granting Decision
 Development of credit standards
 Gathering necessary information
 Credit analysis: applying credit standards
 Risk analysis

20. Copyright  2005 by Thomson Learning, Inc.
Grant-Granting Sequence
No
Order and credit
request received
New/increased
credit limit
Material
change in
customer status
Redo credit
investigation
Size of proposed
credit limit
Medium Small
Large
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Check new A/R
total vs credit lmt
No Yes
Yes
Extend Credit
No
Yes
Record
disposition
Set up,post
A/R, ship

21. Copyright  2005 by Thomson Learning, Inc.
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

23. Copyright  2005 by Thomson Learning, Inc.
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)

24. Copyright  2005 by Thomson Learning, Inc.
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.”

25. Copyright  2005 by Thomson Learning, Inc.
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

28. 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.

29. Copyright  2005 by Thomson Learning, Inc.
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

30. Copyright  2005 by Thomson Learning, Inc.
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.