Chapter 5

Accounts Receivable Management

A/R

Copyright 2005 by Thomson Learning, Inc.

The Cash Flow Timeline

Order
Placed

Order
Received
< Inventory >

Sale

Payment Sent Cash

Received
Accounts
Collection
< Receivable > < Float >

Time ==>
Accounts
< Payable >

Invoice Received

Disbursement
<
Float
>

Payment Sent
Cash Disbursed
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.

Copyright 2005 by Thomson Learning, Inc.

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

Copyright 2005 by Thomson Learning, Inc.

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

Copyright 2005 by Thomson Learning, Inc.

A/R Management and Shareholder

Value
Marketing Strategy

Market Share Obj.

Aggregate Inv. in A/R

Total Dollar Investment

Credit Terms

Length of Time to Pay

Credit Standards

Acceptance of Marg Cust.

Max Shareholder Value

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

Copyright 2005 by Thomson Learning, Inc.

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 buyers business)
seller can more easily resell product if payment is not made.

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

Time

Customer contact for information

Finalize written documents, e.g.. security agreements

Establish customer credit file

Financial analysis
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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
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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?

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

Copyright 2005 by Thomson Learning, Inc.

Credit-Granting Decision
Development of credit standards
Gathering necessary information
Credit analysis: applying credit standards
Risk analysis

Copyright 2005 by Thomson Learning, Inc.

Grant-Granting Sequence
Order and credit
request received
New/increased
credit limit
Yes

No

Yes
Material
change in
customer status
No

Size of proposed
credit limit
Large

Medium

Redo credit
investigation

Check new A/R

total vs credit lmt
Record
disposition

Small

No
Indepth
credit invest.

Moderate
credit invest.

Minimal
credit invest.

Extend Credit
Yes
Set up,post
A/R, ship
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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

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Credit Analysis: Applying the

Standards

Nonfinancial
concerned with willingness to pay, character

Financial
ability to pay, financial ratios etc.. (other Cs of credit)

Credit scoring models

Example:
Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)

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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.

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 companys cost of funds
Consider timing effect when changing discounts
Should be based on products 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

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 firms 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.

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
sellers A/R system
Trend is for use of data transmission to automate
the cash application process

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.

Copyright 2005 by Thomson Learning, Inc.