Lesson 41

Chapter-13
Accounts-Receivables Management
Unit 5
Management of Working Capital

After going through this lecture, you should be able to:

Understand how cash discount & collection programme affects receivables

management.

Hello students,
We discussed credit period & credit standard in the previous class, today we will start
with cash discount.

Cash Discount

I think all of are aware about cash discount. Firms generally offer cash discounts to
induce prompt payments. Credit terms reflect the Percentage of discount and the period
during which it is available. For example, credit term of 1/20, net 30 mean that a discount
of 1 percent is offered if the payment is made by the 20 the day, otherwise the full
payment is due by the 30th day.
A company, which is not offering cash discount, may introduce with the above-
mentioned objectives. Alternatively, a company which has already been offering an
incentive of say 1/10 net 30 day may further liberalize by either increasing the rate of
discount and/or extending the period of discount will only result in customers’ taking the
discount at the end of the extended period and may not be very fruitful. Even in the case
of cash discount the incremental benefits arising out o additional sales and the reduction
in the cost of funds locked up in the form of receivables have to be compared with the
amount to be paid in the form of discount and decision and a decision to provide
liberalize cash discount has to be taken only when the incremental net benefit is positive.
The steps involved in the incremental analysis are explained by means of an example.

Example

The Harjot Company is presently having sales of Rs. 108 lakhs. Its existing credit terms
are 1/10 net 45 days and average collection period of 30 days. Fifty percent of customers
in terms of sales revenue are utilizing the cash discount incentive. The contribution to
sales ration of the company is 20 percent and cost of funds 15 percent. In order to hasten
the collection process further as also to increase sales, if possible, the company is
contemplating liberalization of its existing credit terms to 2/10 net 45 days. It is expected
that sales are likely to increase by Rs 3,00,000 and average collection period to decline to
20 days. Eighty percent of customers to terms of sales revenue are expected to avail
themselves of the cash of the cash discount under the liberalization scheme. Should the
company increase its cash discount?

Let us consider the incremental benefit associated with the liberalization of credit
terms.

These are:
Profit associated with additional sales to be generated
And cost savings on the release of funds locked up in receivables.
The incremental costs are:
The cost of funds invested in the receivables arising out of new sales.
Additional amount to be paid as cash discount.

Profit to be generated by increase in sales

 Contribution
Amount of sales X ------------------
Sales
= Rs. 3,00,000 X 0.2 = Rs. 60,000 …(a)

Exiting cost of carrying receivables

Rs. 108,00,000
= --------------------- X 30 days X 0.15
360 days

= Rs. 1,35,000

Cost of carrying receivables after liberalization

Rs. 108,00,000
= ----------------- X 20 days X 0.15
360 days

= Rs. 90,000

Savings in the cost of carrying receivables

= Rs. 1,35,000 – Rs. 90,000 = Rs. 45,000 …..(b)

Thus incremental benefits = a + b

= Rs. 60,000 + Rs. 45,000

= Rs. 1,05,000 …..( c)
The cost of funds invested in the receivable arising out
of new sales

Rs. 3,00,000
= --------------X 20 days X 0.8 X 1.5
360 days

= Rs. 2,000 ……(d)

Amount of discount presently paid

50 1
= Rs. 1,08,00,000 X ----- X -----
100 100

= Rs. 54,000

Amount of discount payable after liberalization

80 2
= 111,00,000 X -----X ------
100 100

= 1,77,600

The additional amount of discount payable

= 1,77,600 – Rs. 54,000

= 1,23,600 …….(e)
Thus, incremental costs

= (d + e ) = Rs. 2,000 + Rs. 1,23,600

= Rs. 1,25,600 …….(f)

A comparison of items (c) and (f) the total incremental benefits and incremental costs
reveal that the net incremental benefit is

= Rs. 1,05,000 – Rs. 1,25,600 = Rs. 20,600

It is, therefore not advisable to increase the rate of cash discount from 1 to 2 percent.
The effect of such an action on gross profit may be
P= S (1 –V) + k I - DIS
Where
S = increase in sales
V = ratio of variable cost to sales
K = cost of capital
I = savings in receivables management

S0 S
= ------- (ACP0 – ACPn) – V ----- ACP n
360 360

DIS = increase in discount cost

= pn (S0 + S) dn – p0-s0 d0

Where
Pn = proportion of discount sales after liberalizing
S0 = sales before liberalizing
 S = increase in sales.
dn = new discount percentage
P0 = proportion of discount sales before liberalizing
d0= old discount percentage

The above example can also be solved using the equation as follows:

P= S (1 – V) + k I- DIS

S0 DS
I = ------- (ACP0- ACPn) – V ---- ACPn
360 360

108 3
= ------ (30 –20) – 0.8 X ----- X 20
360 360

= Rs. 2,86,667

DIS = pn ( S0 + S) dn- P0 S0 D0
= 0.8 X 111 X 0.02 – 0.5 X 108 X 0.01
= Rs. 1,23,600

DP = 3,00,000 (0.2) + 0.15 X 2,86,667 – 1,23,600

= Rs. –20,600

Liberal cash discount policy involves increasing the discount percentage or lengthening
the discount period. Such a policy tends to enhance sales (because the discount is regard
as price reduction), reduce the average collection period (as customers pay promptly),
and increase the cost of discount.
I hope cash discount is clear to you. I am saying again, this only & only
involves logic. Now we will talk about collection programme.

The collection effort of a company is decided by the collection policy, which is a part of
the company. The objective of collection policy is to achieve timely collection of
receivables, thereby releasing funds locked up in receivables for a longer period than they
should have been under the credit terms and to minimize bad debt losses.

The collection program consists of the following.

• Monitoring the state of receivables;

• Dispatch of letters to customers whose due date is approaching
• Telegraphic and telephonic advice to customers around the due date
• Threat of legal action to overdue accounts
• Legal action against overdue accounts.

While formulating the collection policy a company should reckon with the factor that a
very rigorous collection policy might act as an irritant to customers, thereby jeopardizing
the good customer relations built over the years. Further, the sales of the company may
decline as customers with some overdue may fear to place further orders. However, the
amount of receivables and bad debt losses will reduce to a certain extent as the company
increases the collection expense associated with collection programs.

The general pattern of the relationship between collections expenses and bad debt losses
will be such that initial increase may not have perceptible impact while subsequent
amounts up to a certain level will have a pronounced impact in reducing bad debt losses.

Similarly, deliberate laxity on the part of the company in the rigor of collection effort is
likely to increase sales, increase average collection period, increase bad debt losses and to
some extent reduce collection expenses.
Once again, the incremental financial benefits in the form of the cost of funds released by
a reduction in the level of receivables and the reduction in bad debt losses have to be
compared with the incremental costs associated with additional collection expenses and
policy change is warranted only when the incremental net benefits are positive. The
following example is intended to illustrate the analytical approach to be adopted in taking
decision on collection effort.

Example

The present sales of Vijay Ltd. are Rs. 108 lakhs, the average collection period 60 days,
bad debt losses 6 percent of sales and collection expenses Rs. 1 lakh. The company’s cost
of funds is 15 percent. It is contemplating to increase the collection effort through special
programs to reduce the amount of receivables and the incidence of bad debt losses. Two
separate programs called A and B are under consideration. Program A is likely to reduce
the average collection period to 45 days, decrease bad debt losses to 4 percent of sales
and involve collection expenses of Rs. 3 lakhs. Program b is envisaged to reduce the
average collection period to 30 days, decrease bad debt losses to 3 per cent sales and
involve collection expenses of Rs. 5 lakhs. On the assumption that sales are not likely to
get affected should the company go in for any of the programs under consideration?

Solution

Let us consider the incremental benefits and costs associated with each of the programs
under consideration.

Relaxation of Collection Effort: Incremental Costs and Benefits

Present program Program A Program B

Rs. Rs. Rs.

1. Sales Revenue 108,00,000 108,00,000 108,00,000
2. Average Collection 60 days 45 days 30 days
108,00,000X60 108,00,000X45 108,00,000X30
3. Accounts Receivable ------------------ --------------- -----------------
360 360 360
=18,00,000 = 13,50,000 = 9,00,000

4. Reduction in
Receivable from prom present
level =4,50,000 9,00,000

5.Cost saving A@ 15 % in
receivable = 67,500 = 1,35,000

6.Bad Debt losses on 6% 4% 3%

Sales

7. Amount of Bad debt 6,48,000 4,32,000 3,24,000

losses

8. Reduction in bad debt 2,16,000 3,24,000

losses from present level

9. Increment benefits of
program A due to Cost
saving and reduction
in bad debt losses compared
to present program (5+8)

10. Collection Expense 1,00,000 3,00,000 5,00,000

11, Incremental 2,00,000 4,00,000

collection expenses from
present level

12, Incremental Net 83,500 59,000

benefit (9-11)

From the calculation presented, it can be seen that the incremental net benefits associated.
With program is Rs. 83,500 while program B has resulted in an incremental net gain of
Rs. 59,000. It is, therefore, financially prudent to go in for program A instead of program
B.

We have discussed all the four aspects of receivables management, there is one very
important thing that requires discussion i.e. Credit Evaluation.
Before granting credit to customer the firm seeks certain information what that
information is covered through the following paragraphs.

How to Make Better Credit Decisions

Extending credit, it's the careful balance of limiting risk and maximizing profitability
while maintaining a competitive edge in a complex, global marketplace. How can you do
this effectively for your business? Many financial managers use the "Four C's of Credit"
as their guide. We've listed the "Four C's" below.

The "Four C's of Credit" include character, capacity, capital and conditions of the times.
The significance of each factor may vary from case to case. The credit executive must
measure the account against each factor before giving a final opinion.

1. Character

The history of the business and experience of its management are critical factors
in assessing a business ability to satisfy its financial obligations. Look at how long
the business has been under the same control, and check for any previous
 litigation or bankruptcy information. Also, get a clear understanding of who owns
the business, and who is ultimately liable if a problem arises. Always get a list of
the business's officers with their ages and backgrounds. Research the financial
worth of principals for proprietorships and partnerships. Identify the exact
business name and legal form of the organisation. What products does it sell? On
what terms? Is it a seasonal business? What are its margins? Get a sense of the
character of the owners and the business's ability to compete in its markets.

2. Capacity

Make sure to assess the capacity of the business to operate as an ongoing concern
in every credit decision. Principals in small businesses are often forced to wear
many hats. Businesses must be able to allocate resources evenly to the various
functions of the organisation such as marketing and sales, production and finance.
If the production manager has to put production work aside to make collection
calls, or if finance is asked to telemarketer, efficiency within the business could
deteriorate. Keep an eye on management. Assess their experience and their ability
to manage all aspects of the business without compromising efficiency. Does the
organisation have the facilities to handle your business needs?

3. Capital

Analyse the financial capacity of the organisation in order to determine its ability
to meet financial obligations in a timely fashion. Above we discussed the
willingness of a business to pay its obligations, however, its ability to pay may be
much more important. It is critical to understand the difference. For example, you
may conduct business with customers unable to pay quite differently than with
those unwilling to pay. Terms could be worked out for customers unable to pay
immediately, but customers unwilling to pay on time could be priced for the
inherent risk or denied altogether.

Watching customer payment habits over time is an excellent indication of cash

flow. Also, check, as well as any pending litigation or contingent liabilities.
 Check for a parent business relationship. A parent business's guarantee may be
available. Inter-business loans might affect financial solvency.

4. Conditions of the times

General economic conditions in the nation, in the community, and in the industry
will exert a modifying influence on the financial analysis of an account. What
industries are growing or shrinking? Is your prospect in a dying industry? During
prosperous times, risk of credit loss is generally less than during a depressed
period. Watch for any news items or special events that could affect the firm's
ability to continue as an ongoing concern.

Use Financial Ratio Analysis

When entering into a relationship with a new customer; consider these two very
important questions.

Will I be paid slowly?

And, will I be paid at all?

Some businesses are willing to accept some level of slow pay based on their goals and
objectives and how much risk they are willing to take. Few firms are willing to accept no
payment at all. Financial analysis will help you determine a prospect's financial capacity
to pay obligations in a timely fashion as well as their ability to maintain an ongoing
relationship. Your decision to conduct business with this firm will vary based on whether
they appear to be a one-time purchase or a long-term account.
When trying to understand the financial capacity of a prospect, a financial ratio analysis
is a good place to start. Do check the Solvency, Turnover,& Profitability Ratios

Track Trends

We discussed trend analysis in tools for analysing financial statements. An assessment of

the financial capacity of a business should always include an evaluation of trends.
Businesses can have a bad year, without resulting in financial difficulty. If a firm has a
strong enough net worth it might be able to sustain losses for five consecutive years.
Evaluate trends to get a clear picture of the direction a firm is heading. Look at a
business's profitability and cash flow. Assess their receivables. Are they selling inventory
fast enough to generate needed working capital? Is the business retaining profits to help
the business grow?
Profitability over time is an excellent indicator of management's efficiency. Raising
revenue will not help if the firm cannot control costs. A reduction in expenses may have a
minimal impact if revenues do not increase. Look at the trends of these key indicators.
They'll tell a clear story of a business's direction. These and a host of other questions can
be answered with a thorough analysis of a business's financial capacity.

Compare to a Peer Group

Ratio results should always be compared to a peer group for an industry comparison. Is
the firm collecting faster or slower than the rest of the industry? Is this business more
profitable than other businesses just like them? Make maximum use of ratios by
comparing the firm to its peers using established benchmarks. Compare the business to
firms in the same line of business, geographic area and employee size for a more accurate
comparison.

In summary, when making credit decisions about businesses of which you have little or
no knowledge, use the "Four C's of Credit" and financial ratio analysis, trends and
industry comparisons to help you make more informed credit decisions.
Now we will talk about how to monitor receivables

Monitoring receivables

An important aspect of receivables management is to monitor the payment of receivables.

The credit manager can employ several measures for this purpose, as explained below:

(i) Days sales outstanding

(ii) Ageing schedule and
(iii) Collection matrixes are some of the measures employed.

The average collection period is based on year-end balance of receivables. For the
purpose of internal control, monitoring has to be made more frequently. Further, year-end
balance can be misleading when the sales are subject to seasonality or have grown
towards the end of the year. For this reason two approaches, viz, days sales outstanding
and aging schedule of receivables’ are followed for control purpose. Theses are described
below.

Day’s sales outstanding

The average number of days’ sales outstanding at any time, say end of the month or end
of the quarter is obtained by the following formula which is not very different from the
usual formula for average collection period.
Table 16.3
Behavior of aging schedule

Month Sales( End of Are group Percent Daily DSO average period is
Rs.’0 quarter (days) of total sales if
00) receivable average
s (Rs. period
‘000) is
30days 60days 90days 30 60 90days
(Rs.’000) days days (Rs.’000)
April 60 6 61-90 7.1
May 60 24 31-60 28.6
June 60 54 0-30 64.3
84 100 2 2 2 42 42 42
July 30 3 61-90 2.8
August 60 24 31-60 22.2
September 90 81 0-30 75.0
108 100.0 3 2.5 2 36 43 54
October 90 9 61-90 15.0
November 60 24 31-60 40.0
December 30 27 0-30 45.0
60 100.0 1 1.5 2 60 40 30

Days’ sales outstanding (DSO)

Accounts receivables at the time chosen

=-------------------------------------------------
Average daily sales

to illustrate the calculation of this measure, consider the monthly sales and month end
accounts receivables for a product line as given in the table 16.4 below.

Table 16.4
Sales and receivables data

Rupees in lakhs
Month Sales Receivable Month Sales receivables
January 200 460 July 200 340
February 225 360 August 200 360
March 230 315 September 220 360
April 150 310 October 230 390
May 150 300 November 245 500
June 180 320 December 250 520

If the average collection period is calculated at the end of each quarter, we get the

following picture.

Quarter average collection period

315
First --------------------------- = 43 days
(200+225+230)/ 90
320
Second ` -----------------------------= 61 days
(150+ 150+ 180) / 91
360
Third ------------------------------- = 53 days
(200+ 200+220) /92
520
Fourth ------------------------------ =66 days
(230+ 245+ 250) /92

In case the daily sales outstanding is within a pre-specified norm linked to the credit
period followed by the company then the status of receivables is regarded to be under
control. In case it is found to be higher, then the collection policy has to be strengthened,
as the collection is slow.

Ageing schedule
The age-wise distribution of accounts receivables at a given time is depicted in the ageing
schedule. For example, the ageing schedule at the end of various quarters may be as
follows:
Outstanding accounts receivable

Age 1st quarter 2nd quarter 3rd quarter 4th quarter

0-30 40% 42% 44% 46%
31-60 30% 28% 26% 25%
61-90 20% 22% 25% 23%
120 10% 8% 5% 6%

A comparison of ageing schedules at periodic intervals helps to identify change in the

payment Behaviour of customers.

The ageing schedule can be compared with the credit period extended by the company.
When the percentage of receivables belonging to higher age groups is above a stipulated
norm action has to be initiated before they turn into bad debts. If the company’s credit
terms are say ‘net sixty days,’ then control needs to be exercised in the form of follow up
measures in respect of the bottom 20 percent accounts.

The average collection period and the ageing schedule have traditionally been popular
measures for monitoring receivables. However, they suffer from a limitation. They are
influenced by the sales pattern as well as the decreasing, average collection period and
the ageing schedule will differ from what they would be if sales are constant. This holds
even when the payment Behaviour of customers remains unchanged. The reason is
simple: a greater portion of sales is billed currently. Similarly, decreasing sales lead to the
same results. The reason here is that a smaller portion of sales is billed currently. It can
be well explained with an example.

Example

Below presented are the monthly sales of ABC company ltd. For the period April to
December with quarterly break-up. Collections are made at the rate of ten percent during
the month of sales followed by 50 percent, 30 percent and 10 percent during the three
succeeding months. Consequently the receivables balance at the end of a quarter will be
the sum of ten percent of the sales of first month. 40 percent of the sales of second month
and 90 percent of the sales of the third month. The daily sales are calculated by
considering a period of 30 days, 60 days and 90 days. The end of quarter receivables, the
DSO and the Behaviour ageing schedule at the end of quarter, for the three periods
chosen for averaging are calculated by using the formula stated earlier.
The daily sales with an average period of 30 days is obtained by dividing the sale of the
most recent month i.e. during the second quarter for a 30 day average period daily sales
of Rs. 3,000 are calculated by dividing Rs.90,000 ?( sale of the most recent month i.e.
September ) by 30. for a 60 day average period during the same quarter daily sales are
Rs.2,500 [i.e.(9,000+60,000)/ 60].
It can be noticed the table that during the first quarter when the sales are uniform the
DSO is also uniform at Rs. 2,000 and during the second quarter when the sales decrease
and DSO increase with an increase in the averaging period. During the third quarter when
the sales are decreasing the daily sales increase and DSO decrease with an increase in the
average period.
And as far as the ageing schedule is concerned it can be noticed sales( quarter july –sept)
larger proportion of current receivables i.e. receivables belonging to the lowest age group
emerged during the third quarter, relatively low percentage 45 as compared to 75 of
quarter II belonging to the age group 0-30 days. This need not imply that liquidity of
receivables is higher in quarter II as compared to quarter III. It just so happens that
because of the increasing pattern of sales in quarter II a larger percentage of sales is billed
during September and exactly the opposite situation prevailed in quarter III.

Collection matrix
In order to study correctly the changes in the payment Behaviour of customers, it is
helpful to look at the pattern of collections associated with credit sales. table 16.5 below
shows an illustrative collection matrix. For example, the credit sales during the month of
January ( the month of sales), 42 percent in February ( the first following month), 36
percent in march ( the second following month), and 12 percent in April ( the third
following month).
From the collection pattern, one can judge whether the collection is improving, stable, or
deteriorating. A secondary benefit of such an analysis is that it provides a historical
record of collection percentages that can be useful in projecting monthly receipts for each
budgeting period.
Table 16.5
Collection matrix
Percentage of receivables January February March April May June
collected during the sales sales sales Sales sales Sales
Month of sales 10 14 15 12 9 13
First following month 42 35 40 38 35 31
Second following month 36 40 21 26 26 26
Third following month 12 11 24 19 25 25
Fourth following month 5 5 5

Though various technique have been discussed here for management of accounts
receivables in practice very few Indian companies have a stated and systematic credit
policy. Companies have to strengthen their management of receivables by having explicit
and articulate credit policies, an efficient collection program and better co-ordination
between productions. Sales and finance departments.