Working capital management 4

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Working capital management 4

  1. 1. Working Capital Management Roshankumar S Pimpalkarroshankumar.2007@rediffmail.com
  2. 2. WORKING CAPITAL MANAGEMENT PART 4Management of ReceivablesA firm needs to offer its goods and services on credit to customers as a businessstrategy to boost sales. This represents a considerable investment of funds. Thebasic objective of Receivables management is to optimize the return on investmentin this asset. If large amounts are tied up in debtors, there will be chances of baddebts and there will be cost of collection of debts. On the contrary, if the investmentis low, the sales may be restricted. Therefore management of debtors is an importantissue.Finance manager can affect the volume of credit sales and collection period andconsequently, the investment in receivables through the credit policy. Credit policy isa combination of three components Credit a standard which is the criteria to decide the types of customers to whom goods could be sold on credit. Credit terms specify the duration of credit and terms of payments by customers. Collection efforts determine actual collection period.Aspects of Management of DebtorsCredit policyCredit policy is concerned with the profits that could be generated from additionalsales that could be generated by extending credit on one hand and cost of carryingthose debtors and bad debt losses on other hand. There are various factors whichdetermine credit policy such as effect of credit on sales, credit terms, cash discounts,paying habits of customers etc.For example, the credit term may be expressed as “2/15 net 40” means that a 2%discount will be granted if the customers pays within 15 days; if he does not availoffer he must make payment within 40 days.Credit analysisFinance manager determine as to how risky it is to advance credit to a particularparty.Control of receivableIt involves follow up of debtors and decides about a suitable credit collection policies.Maintaining receivables comprises of various costs such as collection cost,defaulting cost, and administrative cost record keeping.roshankumar.2007@rediffmail.com
  3. 3. Financing Receivable 1. Pledging: firms receivables are used as a security for short term loan as receivables are most liquid assets and this serve as prime collateral for a secured loan. The lender scrutinizes the quality of accounts receivables, selects acceptable accounts, creates a lien on the collateral and fixes a percentage of financing receivables which ranges around 50 to 90%. The major advantage of pledging accounts receivable is the ease and flexibility it provides to the borrower. But the cost of financing is high. 2. Factoring: it is a new concept in financing accounts receivables. This refers to outright sale of accounts receivables to a factor or a financial agency. A factor is firm that acquires the receivables of other firms. The factoring lays down the conditions of the sale in factoring agreement. The factoring agency bears the right of collection and services the accounts for fee. Normally, factoring is a non recourse arrangement which means in the event of default the loss is born by the factor. However in the case of with recourse arrangement such loss is born by the seller. The biggest advantages of factoring are immediate conversion of receivables into cash and it helps company to have liquidity without creating net liability on its financial condition. Some of the commercial banks provide this service.Tool and Techniques of Receivable ManagementRe-engineering Receivable Process: Re-engineering is a fundamental rethinking andredesigning of business processes by incorporating modern business approach.Some of the organizations have achieved real cost savings and performanceimprovements through re-engineering receivables. Centralization of high nature transactions of accounts receivables and payables is one of the practices for better efficiency. Alternate payment strategies direct transfer of funds from purchasers bank account, collection by third party, lock box processing and payments via internet. Customer orientation: where individual customers or a group of customers have some strategic importance to a firm a case study approach may be followed to develop good customer relationship. A critical study of this group may lead to formation of a strategy for prompt settlement of debt.Use of Latest Technology such as E-commerce, Automated receivable managementsystem.Use of financial tools/technique such as Credit rating and decision tree analysis ofgranting credit.Example of decision tree analysis: if the chances of recovery are 8 out of 10 thenprobability of recovery is 0.8 and that of default is 0.2. Suppose cost of goods is Rs 4lakh and revenue is Rs 7 lakh. Now weighted net benefit should be calculatedroshankumar.2007@rediffmail.com
  4. 4. = [(700000-400000)*0.8] – [400000*0.2]= 160000As there is net benefit hence credit should be granted.Collection policy: if a firm spends more resources on collection of debts, it is likely tohave smaller bad debts. Thus a firm must work out optimum amount that it shouldspend on collection of debtors. This involves trade off between the levels ofexpenditure on the one hand and decreases in bad debt losses and investment indebtors on the other hand.Ageing schedule: When receivables are analysed according to their age, the processis known as preparing ageing schedules of receivables. The computation of averageage of debtors is a quick and effective method of comparing liquidity of receivableswith the liquidity of receivables in the past and also comparing liquidity of one firmwith it competitor. It also helps the firm to predict the collection pattern of receivablein future.The credit collection procedure must answer the following: How long should a debtor balance be allowed to exist before collection process is started? Should there be collection machinery whereby personal calls by company’s representatives are made? What should be the procedure of follow up with defaulting customers? How reminders are to be sent and how should each successive reminder be drafted? What should be the procedure for dealing with defaulting customers? Is legal action to be instituted?The fundamental rule of sound receivable management should be to reduce the timelag between the sale and collections, at the same time maintain customer goodwill.roshankumar.2007@rediffmail.com

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