Introduction to Receivable Management
Account receivable are the money receivable in some future date for the credit sale of goods and services at present. These days, most business transactions are in credit. Most companies, when they face competition, use credit sales as an important tool for sales promotion. As a sales promotion tool, credit sale enhances firm’s sales revenue and ultimately pushes up the profitability. But after the credit sale has been made, the actual collection of cash may be delayed for months. As these late payments stretch out over time, they may cause substantial drop in a company’s profit margin. Since the extension of credit involves both cost and benefits, the firm’s manager must be able to measure them to determine the ultimate effect of credits sales. In this prospective, we define the receivable management as the aspect of a firm’s current assets management, which is concerned with determining optimum credit policy associated to a firm, such that the benefit from extension of credit is greater than the cost of maintaining investment in accounts receivables.
Significance and Purpose of Receivable Management
The basic purpose of firm’s receivable management is to determine effective credit policy that increases the efficiency of firm’s credit and collection department and contributes to the maximization of value of the firm. The specific purposes of receivable management are as follows:
- To evaluate the creditworthiness of customers before granting or extending the credit.
- To minimize the cost of investment in receivables.
- To minimize the possible bad debt losses.
- To formulate the credit terms in such a way that results into maximization of sales revenue and still maintaining minimum investment in receivables.
- To minimize the cost of running credit and collection department.
- To maintain a trade off between costs and benefits associated to credit policy.
Determinants of Investment in Receivables
The size of investment in receivables is influenced by number of factors. Among them two factors, the volume of credit sales, and the average length if time between sales and collection are important.
To illustrate, suppose ABC Enterprise, a newly established firm makes a credit sales of $ 5000 per day and its customers are allowed 15 days of credit. At the start of business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts receivables stand $ 5000 in the firm’s book. During the second day, it sold another $ 5000 on credit increasing the book receivables to $10,000. If it goes on granting a credit of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end of 15th day. However in 16th day it will make another $ 5000 credit sales, but payments for sales made on first day will reduced receivables by $ 5000, so that total account receivable will remain constant at $ 75000 in 16th day and the each day thereafter throughout the year. The average account receivable the firm must carry during the year is, therefore $ 5000 X 15 days = $ 75000.
Account receivable = Credit sales per day X Average length of collection period
Above illustration shows that the change in credit sales or change in collection period or both will affect the investment in account receivable. However in turn, the volume of credit sales and collection is affected by several factors such as industrial norms, credit standards, credit terms, collection policy, payment habits of customers, nature of business, size of enterprise, cost of investment in receivables and so on. Therefore, the financial manager must be able to look in depth and analyze the impact of these factors in volume of sales and the cost-benefit trade off associated to credit decisions.
Costs of Maintaining Receivables and Their Calculation
Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:
1. Cost of Investment in Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:
Cost of receivables = Investment in receivables X Opportunity costs
Here, investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.
2. Bad Debt Losses
This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:
Bad debt losses = Annual credit sales X Percentage default customer
3. Collection Expenses
This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.
4. Cash Discount
It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:
Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount