Copyright 2005 by Thomson Learning, Inc.

Chapter 5
Accounts Receivable Management

A / R
Copyright 2005 by Thomson Learning, Inc.
The Cash Flow Timeline



Order Order Sale Payment Sent Cash
Placed Received Received
Accounts Collection
< Inventory > < Receivable > < Float >


Time ==>
Accounts Disbursement
< Payable > < 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.
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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
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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
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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.
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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


Customer contact for information


Finalize written documents, e.g.. security agreements


Establish customer credit file


Financial analysis
T
i
m
e

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
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?
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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
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Credit-Granting Decision
Development of credit standards
Gathering necessary information
Credit analysis: applying credit standards
Risk analysis
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Grant-Granting Sequence
No
Order and credit
request received
New/increased
credit limit
Material
change in
customer status
Redo credit
investigation
Size of proposed
credit limit
Medium Small Large
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Check new A/R
total vs credit lmt
No Yes
Yes
Extend Credit
No
Yes
Record
disposition
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 I nformation
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.
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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
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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
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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.