Accounts Receivable Management

Accounts Receivable (AR) are the proceeds or payments which the company will receive from
its customers who have purchased its goods & services on credit. Usually, the credit period is
short, ranging from a few days to months or in some cases maybe a year.
The word receivable refers to the payment not being realized. This means that the company
must have extended the credit line to its customers. Usually, the company sells its goods and
services both in cash as well as on credit.
Why do firms grant credit? Not all do, but the practice is extremely common. The obvious
reason is that offering credit is a way of stimulating sales. The costs associated with granting
credit is a way of stimulating sales. The costs associated with granting credit are not trivial.
First, there is the chance that the customer will not pay. Second, the firm has to bear the costs
of carrying the receivable. The credit policy decision thus involves a trade-off between the
benefits of increased sales and the costs of granting credit.
Component of Credit Policy
If a firm decided to grant credit to its customers, then it must establish procedures for
extending. credit and collecting. In particular, the firm will have to deal with the following
components of credit policy:
1. Terms of sale: The terms of sales establish how the firm proposed to sell its goods and
services. A basic decision is where the firm will require cash or will extend credit. If
the firm does grant credit to a customer, the terms of sale specify (perhaps implicitly)
the credit period, the cash discount, and the type of credit instrument.
2. Credit analysis: In granting credit, a firm determines how much effort to expand trying
to distinguish between customer who will pay and customers who will not pay. Firms
use a number of devices and procedures to determine the probability that customers
will not pay; put together, these are called credit analysis.
3. Collection policy: After credit has been granted, the firm has the potential problem of
collecting the cash, for which it must establish a collection policy.
Terms of the Sale
The terms of sale are made up of three distinct elements:
1. The period for which credit is granted (the credit period)
2. The cash discount and the discount period
3. The type of credit instrument.
The Basic Form
The easiest way to understand the terms of sale is to consider an example. Terms such as
2/10, net 60 are common. This means that customers have 60 days from the invoice date to
pay the full amount; however, if payment is made within 10 days, a 2% cash discount can be
taken.
The Invoice Date
The invoice date is the beginning of the credit period. An invoice is written account of merchandise
shipped to the buyer. For individual items, by convention, the invoice date is usually the shipping
date or the billing date, not the date on which the buyer receives the good or the bill.
The Credit Period
The credit period is the basic length of time for which credit is granted. The credit period varies
widely from industry to industry, but it is almost always between 30 and 120 days. If a cash
discount is offered, then the credit period has two components: the net credit period and the cash
discount.
The net credit period is the length of time the customer has to pay. The cash discount period is the
time during which the discount is available. With 2/10, net 30, the net credit period is 30 days and
the cash discount period is 10 days.
Several factors influence the length of credit period. Two important ones are the buyer's inventory
period and operating cycle. All else equal, the shorter these are, the shorter the credit period will be.
The operating cycle has two components: the inventory period and the receivables period. The
buyer's inventory period is the time it takes the buyer to acquire inventory (from us), process it, and
sell it. The buyer's receivable period is the time it then takes the buyer to collect on the sale. Note
that the credit period we offer is effectively the buyer's payables period.
By extending credit, we finance a portion of ours buyer's operating cycle and thereby shorten the
buyer's cash cycle. If our credit period exceeds the buyer's inventory period, then we are financing
not only the buyer's purchase, but part of the buyer's receivable, as well.
Furthermore, if our credit period exceeds our buyer's operating cycle, then we are effectively
providing financing for aspects of our customer's business beyond the immediate purchase and sale
of our merchandise. The reason is that the buyer effectively has a loan from us even after
merchandise is resold, and buyer can use that credit for other purpose. For this reason, the length of
the buyer's operating cycle is often cited as an appropriate upper limit to the credit period.
There are a number of other factors that influence the credit period. Many of these also influence
our customer's cycle; so, once again, these are related subjects. Among the most important are
these:
1. Perishable and collateral value: Perishable items have relatively rapid turnover and relatively
low collateral value. Credit periods are thus shorter for such goods. A food wholesaler
selling fresh fruit and produce might use net 7 days. Alternatively, jewelry might be sold for
5/30, net 4 months.
2. Consumer demand: Products that are well established generally have more rapid turn-over.
Newer or slow-moving products often will have longer credit periods associated with them
to entice buyers. Also, as we have seen, sellers may choose to extend much longer credit
periods for off-season sales (when customer demand is low).
3. Costs, profitability, and standardization: Relatively inexpensive goods tend to have shorter
credit periods. The same is true for relatively standardized goods and raw materials. These
all tend to have lower markups and higher turnover rates, both of which lead to shorter credit
 periods. However, there are exceptions, auto dealers, for example, generally pay for car as
they received.
4. Credit risk: The greater the credit risk of the buyer, the shorter the credit period is likely to be
(if credit is granted at all).
5. Size of the account: If an account is small, the credit period may be shorter because small
accounts cost more to manage and the customers are less important.
6. Competition: when the seller is in highly competitive market, longer credit period may be
offered as a way of attracting customers.
7. Customer type: A single seller might offer different credit terms to different buyers. A food
wholesaler might supply groceries, bakeries, and restaurants. Each group would probably
have different credit terms. More generally, sellers often have both wholesale and retail
customers, and they frequently quote different terms to the two types.
Analyzing Credit Policy
Granting credit makes sense only if the NPV from doing so is positive. Thus, we need to look at the
NPV of the decision to grant credit.
Credit Policy Effects
In evaluating credit policy, there are five basic factors to consider:
1. Revenue effects: If the firm grants credit, then there will be a delay in revenue collections as some
customers take advantage of the credit offered and pay later. However, the firm may be able to
charge a higher price if it grants credit and it may be able to increase the quantity sold. Total revenue
thus may increase.
2. Cost effects: although the firm may experience delayed revenues if it grants credit, it still will
incur the costs of sales immediately. Whether the firm sells for cash or credit, it still will have to
acquire or produce the merchandise (and pay for it).
3. The costs of debt: when the firm grants credit, it must arrange to finance the resulting receivables.
As a result, the firm's cost of short-term borrowing is a factor in the decision to grant credit.
4. The probability of nonpayment: If the firm grants credit, some percentage of the credit buyers will
not pay. This can't happen, of course, if the firm sells for cash.
5. The cash discount: when the firm offers a cash discount as part of its credit terms, some customers
will choose to pay early to take advantage of the discount.
Credit Information
If a firm wants credit information about customers, there are a number of sources. Information
sources commonly used to assess creditworthiness include the following:
1. Financial statements: A firm can ask customers to supply financial statements such as balance
sheets and income statements. Minimum standards and rules of thumb based on financial ratios can
be used as a basis for extending r refusing credit.
2. Credit report about the customer's payment history with other firms: Quite a few organizations sell
information about the credit strength and credit history of the business firms.
3. Banks: Banks will generally provide some assistance to their business customers in acquiring
information about the creditworthiness of other firms.
4. The customer's credit history with the firm: The most obvious way to obtain information about the
likeliness of customers not paying is to examine whether they have settled past obligations (and how
quickly).
Credit Evaluation and Scoring
There are no magical formulas for assessing the probability that a customer will not pay. In very
general terms, the classic five C's of the credit are the basic factors to be evaluated:
1. Character: The customer's willingness to meet credit obligations.
2. Capacity: The customer's ability to meet credit obligations out of operating cash flows.
3. Capital: The customer's financial reserves.
4. Collateral: An asset pledged in the case of default.
5. Condition: General economic conditions in the customer's line of business.
Credit Scoring is the process of calculating a numerical rating for a customer based on information
collected; credit is then granted or refused based on the result. A firm might rate a customer using all
the information available about the customer. A credit score could then be calculated by totaling
these rating. Based on experience, a firm might choose to grant credit only to customers with a score
above, say,30.
Firms such as credit card issuers have developed statistical models for credit scoring. Usually, all of
the legally relevant and observable characteristics of a large pool of customers are studied to find
their historic relation to defaults. Based on results, it is possible to determine the variables that best
predict whether a customer will pay and then calculate a credit score based on those variables.
Because credit scoring models and procedures determine who is and who is not creditworthy, it is
not surprising that they have been the subject of government regulation. In particular, the kind
background and demographic information that can be used in the credit decision are limited.
Collection Policy
The collection policy is the final element of the credit policy. Collection policy involves monitoring
receivables to spot trouble and obtaining payment on past-due accounts.
Monitoring Receivable: Two of the statistical indices
Days Sales Outstanding (DSO): Day Sales Outstanding or DSO refers to the average number of days
a business takes to collect its receivables after a sale. It is considered a popular metric by diverse
industries to estimate their financial health. Days Sales Outstanding (DSO) represents the average
number of days it takes credit sales to be converted into cash or how long it takes a company to
collect its account receivables.
Account Receivable Aging: Accounts receivable aging is a periodic report that categorizes a
company's accounts receivable according to the length of time an invoice has been outstanding. It is
used as a gauge to determine the financial health and reliability of a company's customers.
Collection Efforts
A firm usually goes through the following sequences of procedures for customers whose payments
are overdue:
 1. It sends out a delinquency letter informing the customer of the past-due status of the account.
2. It makes a telephone call to the customers.
3. It employs a collection agency.
4. It takes legal action against the customer.
At times, a firm may refuse to grant additional credit to customers until arrearages are cleared up.
This may antagonize a normally good customer, which points to a potential conflict between the
collections department and the sales department.
Costs of Accounts Receivable
The costs associated with the extension of credit and accounts receivables are identified as follows:
1. Collection Cost: This cost is incurred in collecting the receivables from the customers to
whom credit sales have been made.
2. Capital Cost: This is the cost of using additional capital to support credit sales that could have
been employed elsewhere.
3. Administrative Cost: This is an additional administrative cost for maintaining accounts
receivable in the form of salaries to the staff kept for maintaining accounting records relating
to customers, cost of investigation, etc.
4. 4. Default Cost: Default costs are overdue that cannot be recovered. A business may be
unable to recover the overdue because of the customers' inability.
Mathematical Problems:
Problem 1 (Determining the level of Accounts Receivable)
If a company's credit sales are $120,000, the collection period is 60 days, and the cost is 80%
of the sales price, what is (a) the average accounts receivable balance and (b) the average
investment in accounts receivable?
Problem 2 (Analyzing the credit terms) Lakeside Corporation provides the following data
Current Account Credit Sales $1,20,00,000
Collection Period 2 months
Terms net/30
Rate of Return 15%
Lakeside proposes to offer a 3/10 net/30 discount. The corporation anticipates 25% of its
customers will take advantage of the discount. As a result of the discount policy, the
1
collection period will be reduced to 1 months. Should Lakeside offer the new terms?
2
Problem 3 (Analyzing discount policy) Stevens company presents the following
information:
Current annual credit sales: $24,000,000
Collection period: 3 months
Terms: net/30
Rate of return: 18%
The company is considering offering a 4/10 net/30 discount. It anticipates that 30 % of its
customers will take advantage of the discount. The collection period is expected to decrease
to 2 months. Should the discount policy be implemented?
Problem 4 (Analyzing the credit terms) Wise Corporation is considering liberalizing its
credit term to encourage more customers to purchase on credit. Currently, 80 percent of sales
are on credit, with a gross margin of 30 percent. Other relevant data are:
Particulars Current Proposed
Sales $3,00,000 $4,50,00
Credit Sales $ 2,40,000 $3,60,000
Collection expenses 4% of credit sales 5% of credit sales
Accounts receivable turnover 4.5 3
Should they liberalize their term?

Problem 5 (Analyzing the credit terms) Simon Corporation is evaluating a relaxation of its
credit policy. Currently, 70 percent of sales are on credit, and there is a gross margin of 20
percent. Additional data are:
Particulars Current Anticipated
Sales $500,000 $640,000
Credit sales $410,000 $520,000
Collection expenses 3% of credit sales 4% of credit sales
Collection period 72 days 90 days
Using 360 days in a year, answer the following questions: (a) What is the change in gross
profit associated with the proposal? (b) What is the incremental change in collection
expenses? (c)What is the change in average accounts receivable?
Problem 6 (Analyzing the credit terms) The following information is from an oil-
producing company that is considering lengthening its terms of sale option:
Particulars Present Policy Proposed Policy
Account Receivable 8 times per year (45 days) 6 times per year (60 days)
Turnover
Current year sale is Tk Sales will be Tk 20,00,000 next Sales will be Tk 22,00,000
19,04,762 year with a growth rate of 5% next year with a growth rate of
5%
Maximum Sales An additional production capacity An additional production
of will be needed at the end of capacity will be needed at the
capacity is Tk 23,00,000
4years of Tk 1,50,000 end of 2 years of Tk 1,75,000
Salvage Value Tk 80,000 Tk 75,000
Bad Debt 2% 2.5%
The variable Cost of Production is 65% of Gross Sales.
The risk-Adjusted Discount Rate is 15%
The life of the product is 5 years.
The firm has to pay a tax of 34%, and depreciation will be incurred at the straight-line
method.
Inventory turnover is 20 times.
 The firm does not provide any cash discount, and the collection costs will not change with
the changed policy.
At the end of the product’s life, inventory will be liquidated, and accounts receivables will
be collected on book value.
Requirements: From the given information, decide whether the firm should make the
proposed change in its terms of sale when the current policy provides a net present value of
Tk 17,06,249?.
Problem 7 (Credit granting decision) TGD Corporation has three credit categories (X, Y,
and Z) and is considering changing its credit policy for categories Y and Z. The pertinent
data are:
Category Bad debt (%) Collection period Credit terms Additional annual sales
(Days) if credit restriction is
eased
X 2 30 Full $ 1,00,000
Y 5 50 Restricted $4,00,000
Z 13 80 No credit $9,00,000
Gross profit is approximately 15% of sales, and the rate of return is 16%. TGD is considering
extending credit to categories Y and Z. Analyze their new decision.
Problem 8 (Credit granting decision) Wilder Corporation is considering granting credit to
currently limited customers or no-credit customers. The following information is given:
Category Bad debt (%) Collection period Credit terms Additional annual sales
if credit restriction is
(Days)
eased
A 3 20 Full $2,50,000
B 6 45 Restricted $5,40,000
C 10 90 No credit $8,00,000
Gross profit approximates 12 percent of sales. The rate of return is 18 percent. Should credit
be extended to categories B and C?
Problem 9 (Credit granting decision) Drake Company is planning a sales campaign, during
which Drake will offer credit terms of 4/20, net/60. Drake anticipates its collection period
will rise from 70 days to 90 days. Data for the contemplated campaign are:
Particulars % of sales prior to the % of sales during the
campaign campaign
Cash sales 30 20
 Payment from:
1-20 days 50 45
21-100 days 20 35
The proposed strategy will likely increase sales from $6 million to $7 million. The gross
profit rate is 20 percent, and the rate of return is 12 percent. Sales discounts are given on cash
sales. Should Drake initiate the sales campaign program?
Problem 10 (Credit granting decision) Jones Corporation is considering a sales campaign
in which it will offer credit terms of 3/15, net/80. The finance manager expects that the
collection period will increase from 90 days to 110 days. Information before and during the
proposed campaign follows:
Particulars % of sales prior to the campaign % of sales during the
campaign
Cash sales 20 10
Payment from:
1-15 days 35 25
16-120 days 45 65
The sales campaign is expected to increase from $5 million to $6 million. The gross profit
rate is 30 percent, and the rate of return is 16 percent. Sales discounts are given on cash sales.
Should the sales campaign be initiated?
Problem 11 (Monitoring Accounts Receivables)
Assume that a firm makes 5% of sales for cash, 65% of a month's sales are paid in the next
month,25% in the second month following, and the remaining 5% in the third month
following the sale. Last year in November and December sales were Tk 2,00,000 and
Tk1,75,000respectively. Following are sales forecasts for the next six months of 2018:
Months January February March April May June
Sales (Tk.) 1,00,000 1,50,000 3,00,000 2,00,000 1,00,000 1,75,000

Interpret the Days Sales Outstanding statistics (DSO) and compute the DSO using 2 monthly
averages for the next six months from the above information. Also, compute the aging
fraction for each month.