Chapter 5 Accounts Receivable Management

A/R

Copyright 2005 by Thomson Learning, Inc.

The Cash Flow Timeline

Order Placed

Order Received < Inventory >

Payment Sent Cash Received Accounts Collection < Receivable > < Float >

Sale

Time ==>
Accounts < Payable > Disbursement < Float >

Invoice Received

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 (Electronic Data Interchange).

Copyright 2005 by Thomson Learning, Inc.

Trade Credit and Shareholder Value

Trade credit arises when goods are 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

Credit Terms

Credit Standards

Total Dollar Investment

Length of Time to Pay

Acceptance of Marg Cust.

Max Shareholder Value

Copyright 2005 by Thomson Learning, Inc.

Trade vs. Bank Credit

Length of terms
TC: Short, Usually < 90 days BC: Longer and may be repaid on a seasonal basis

Security
TC: Unsecured BC: Usually secured, relatively high standards if not

Amounts involved
TC: Small BC: Larger

Copyright 2005 by Thomson Learning, Inc.

Trade vs. Bank Credit cont.

Resource transferred (goods vs. money)

TC: Goods and services BC: Money

Extent of analysis
TC: Varies with exposure BC: Usually more in-depth

Copyright 2005 by Thomson Learning, Inc.

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.

Copyright 2005 by Thomson Learning, Inc.

Contracting Cost Motive

Buyer gets to inspect goods prior to payment Seller has less theft with separation of collection and product delivery

Copyright 2005 by Thomson Learning, Inc.

Pricing Motive

Change price by changing credit terms

Copyright 2005 by Thomson Learning, Inc.

Trends Affecting Trade Credit

Zero net working capital objective Improved internal and external credit-related information Electronic commerce

Copyright 2005 by Thomson Learning, Inc.

The Credit Decision Process

Marketing contact

Credit investigation

Customer contact for information

Time

Finalize written documents, e.g.. security agreements

Establish customer credit file

Financial analysis
Copyright 2005 by Thomson Learning, Inc.

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 (per $ of sale) S = dollar amount of credit sale EXP = credit administration and collection expense ratio (per $ of sale) i = daily interest rate CP = collection period for sale (days)
Copyright 2005 by Thomson Learning, Inc.

Managing the Credit Policy

Should we extend credit? Credit policy components Credit-granting decision

Copyright 2005 by Thomson Learning, Inc.

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 Size of proposed credit limit Large Indepth credit invest. Medium Moderate credit invest. Small No Yes Material change in customer status No

Redo credit investigation

Check new A/R total vs credit lmt Record disposition

No
Minimal credit invest. Extend Credit Yes Set up,post A/R, ship
Copyright 2005 by Thomson Learning, Inc.

Credit Standards

Based on five C's of Credit

Character willingness to pay Capital net worth Capacity ability to generate cash flows Collateral pledged assets Conditions - general economic and industry conditions

Determine risk classification system Link customer evaluations to credit standards

Copyright 2005 by Thomson Learning, Inc.

Gathering Information
credit reporting agencies, e.g.. Dun & Bradstreet credit interchange bureaus, NACM (National Association of Credit Management) bank letters references from other suppliers financial statements field data gathered by sales reps

Copyright 2005 by Thomson Learning, Inc.

Credit Analysis: Applying the Standards

Non-financial
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)

Risk analysis
Use Expected NPV (see page 169)

Copyright 2005 by Thomson Learning, Inc.

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

Copyright 2005 by Thomson Learning, Inc.

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

Copyright 2005 by Thomson Learning, Inc.

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.