Financial Management subject For undergraduate students (semester 4)

1. Receivables Management
Meeting 5

2. • 1. Accounts receivable and trade receivable.
• 2. Credit sales policies and the role of credit managers.
• 3. Changes in the variable credit sales policy.
• 4. Receivable control (DSO / Days Sales Outstanding, Aging Schedule,
and Payment Pattern Approach)

3. • Receivables are also known as accounts receivables, trade
receivables, customer receivables or book debts

4. Determining the Credit Policy
• Establishing a credit policy involves three steps that we will discuss in
turn:
• 1. Establishing credit standards
• 2. Establishing credit terms
• 3. Establishing a collection policy

5. Credit Policy
Establishing credit
standards
Assessing the credit
risk of each customer
before deciding
whether to grant
credit
Establishing credit
terms
Firm decides on the
length of the period of
payment must and
chooses whether to offer
a discount (% and period)
Establishing a
collection policy
Sending inquiry or
charging interest on
payment after
deadline

6. Establishing Credit Standards
• Management must first decide on its credit standards.
• Will it extend credit to anyone who applies for it?
• Or will it be selective and extend credit only to those customers who have very low credit
risk?
• Unless the firm adopts the former policy, it will need to assess the credit risk of each
customer before deciding whether to grant credit.
• Large firms often perform this analysis in-house with their own credit departments.
• Many small firms purchase credit reports from credit rating agencies.
• The decision of how much credit risk to assume plays a large role in determining how
much money a firm ties up in its receivables. While a restrictive policy can result in a
lower sales volume, the firm will have a smaller investment in receivables. Conversely,
a less selective policy will produce higher sales, but the level of receivables will also
rise.

7. Establishing Credit Standards
• Restrictive policy – sales ↓ – investment in receivables ↓
• Less selective policy – sales ↑ – the level of receivables ↑

8. Establishing Credit Terms
• After a firm decides on its credit standards, it must next establish its
credit terms.
• The firm decides on the length of the period before payment must be
made (the “net” period) and chooses whether to offer a discount to
encourage early payments.
• If it offers a discount, it must also determine the discount percentage
and the discount period. If the firm is relatively small, it will probably
follow the lead of other firms in the industry in establishing these
terms.

9. Establishing a Collection Policy
• The last step in the development of a credit policy is to decide on a
collection policy.
• The content of this policy can range from doing nothing if a customer
is paying late (generally not a good choice), to sending a polite letter
of inquiry, to charging interest on payments extending beyond a
specified period, to threatening legal action at the first late payment.

10. COMPONENTS OF CREDIT POLICY
• 1. Terms of sale: The terms of sale establish how the firm proposes to sell
its goods and services. A basic decision is whether the firm will require
cash or will extend credit. If the firm does grant credit to a customer, the
terms of sale will specify (perhaps implicitly) the credit period, the cash
discount and discount period, and the type of credit instrument.
• 2. Credit analysis: In granting credit, a firm determines how much effort to
expend trying to distinguish between customers 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.

11. COMPONENTS OF CREDIT POLICY
Terms of sale
how the firm
proposes to
sell its goods
and services
Cash or credit?
Credit analysis
distinguishing
between
customers who
will pay and
customers who
will not pay
Collection
policy
Identifying
potential
problem of
collecting the
cash

12. 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 revenues may thus increase.
• 2. Cost effects: Although the firm may experience delayed revenues if it grants credit, it
will still gain the costs of sales immediately. Whether the firm sells for cash or credit, it
will still have to acquire or produce the merchandise (and pay for it).
• 3. Cost effects: 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.

13. Credit Policy Effects
Revenue effects
If the firm grants
credit, then there
will be a delay in
revenue collections
but the firm also
may be able to
charge a higher
price
Cost effects
Although the firm
may experience
delayed revenues
if it grants credit,
it will still gain the
costs of sales
immediately
Cost effects
When the firm
grants credit, it
must arrange to
finance the
resulting
receivables
The probability
of non-payment
If the firm grants
credit, some
percentage of
the credit
buyers will not
pay
The cash
discount
When the firm
offers discount
some customers
will choose to
pay early

14. CREDIT POLICY VARIABLES
• The important dimensions of a firm's credit policy are:
• Credit standards
• Credit period
• Cash discount
• Collection effort
• These variables are related and have a bearing on the level of sales,
bad debt loss, discounts taken by customers, and collection expenses.
For purposes of expository convenience we examine each of these
variables independently.

15. Credit Policy Variables
Credit
standards
Credit period Cash discount Collection
effort

16. DSO / Days Sales Outstanding
• The days sales outstanding (DSO) at a given time T may be defined as
the ratio of accounts receivable outstanding at that time to average
daily sales figure during the preceding 30 days, 60 days, 90 days, or
some other relevant period.

17. DSO question

18. DSO answer

19. DSO answer
• Looking at the DSO we see that it decreased slightly over last year,
suggesting that the collections improved a little.
• According to this method, accounts receivable are considered to be in
control if the DSO is equal to or less than a certain norm.
• If the value of DSO exceeds the specified norm, collections are
considered to be slow.

20. Aging Schedule
• Monitoring Accounts Receivable
• After establishing a credit policy, a firm must monitor its accounts
receivable to analyze whether its credit policy is working effectively.
Two tools that firms use to monitor the accounts receivable are the
accounts receivable days (or average collection period) and the aging
schedule.
• Aging schedule categorizes accounts by the number of days they have
been on the firm’s books.
• It can be prepared using either the number of accounts or the dollar
amount of the accounts receivable outstanding.

21. Aging Schedule example 1
• For example, assume that a firm selling on terms of 2/15, Net 30 (that means
that the discount period is 15 days, and there are 30 days to pay before the
account is overdue)
• So the number of days of credit received = 30 days -15 days = 15 days
• The Firm has $530,000 in accounts receivable that has been on the books for 15
or fewer days in 220 accounts
• Another $450,000 has been on the books for 16 to 30 days and is made up of 190
accounts
• And $350,000 has been on the books for 31 to 45 days and represents 80
accounts
• The firm has $200,000 that has been on the books for 46 to 60 days in 60
accounts
• Yet another $70,000 has been on the books for more than 60 days and is made up
of 20 accounts.

22. • The term 2/10, n/30 is a typical credit term and means the following:
• "2" shows the discount percentage offered by the seller.
• "10" indicates the number of days (from the invoice date) within which the
buyer should pay the invoice in order to receive the discount.
• "n/30" states that if the buyer does not pay the (full) invoice amount within
the 10 days to qualify for the discount, then the net amount is due within
30 days after the sales invoice date.
• The terms offered by the seller usually depend on the trade custom. Some
variations of the cash discount terms, among others, may be "2/15, n/30"
(2% discount for the payment within 15 days and the full amount to be
paid within 30 days) or "n/10 EOM" (the invoice is due and payable 10 days
after the end of the month in which the sale occurred).

23. Aging Schedule example 1
• Table includes aging schedules based on the number of accounts and
dollar amounts outstanding.
• In this case, if the firm’s average daily sales is $65,000, its accounts
receivable days is $1,600,000/$65,000=25 days.
• But on closer examination, using the aging schedules in Table, we
can see that 28% of the firm’s credit customers (and 39% by
dollar amounts) are paying late.

24. Aging Schedule example 1

25. Aging Schedule example 2
• The aging schedule is a second basic tool for monitoring receivables.
To prepare one, the credit department classifies accounts by age.
• Suppose a firm has $100,000 in receivables. Some of these accounts
are only a few days old, but others have been outstanding for quite
some time. The following is an example of an aging schedule:

26. Aging Schedule example 2

27. Aging Schedule example 2
• If this firm has a credit period of 60 days, then 25 % of its accounts
are late
• Whether or not this is serious depends on the nature of the firm’s
collections and customers
• It is often the case that accounts beyond a certain age are almost
never collected
• Monitoring the age of accounts is very important in such cases.

28. Aging Schedule example 2
• Firms with seasonal sales will find the percentages on the aging
schedule changing during the year
• For example, if sales in the current month are very high, then total
receivables will also increase sharply
• This means that the older accounts, as a percentage of total
receivables, become smaller and might appear less important
• Some firms have refined the aging schedule so that they have an idea
of how it should change with peaks and valleys in their sales.

29. Aging schedule question

30. Aging schedule answer

31. Payment Pattern Approach
• If the aging schedule gets “bottom-heavy”—that is, if the percentages in
the lower half of the schedule begin to increase—the firm will likely need
to revisit its credit policy.
• The aging schedule is also sometimes augmented by analysis of the
payments pattern, which provides information on the percentage of
monthly sales that the firm collects in each month after the sale.
• By examining past data, a firm may observe that 10% of its sales are usually
collected in the month of the sale, 40% in the month following the sale,
25% two months after the sale, 20% three months after the sale, and 5%
four months after the sale.
• Management can compare this normal payments pattern to the current
payments pattern. Knowledge of the payments pattern is also useful for
forecasting the firm’s working capital requirements.