Accounts Receivable Management

After studying this theme, you should be able to:
List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved.
Understand how the level of investment in accounts receivable is affected by the firm's credit policies.
Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount.
Describe possible sources of information on credit applicants and how you might use the information to analyze a credit applicant.

Credit and Collection Policies
Analyzing the Credit Applicant

Credit and Collection Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program

Credit Standards
The financial manager should continually lower the firm’s credit standards as long as profitability from the change exceeds the extra costs generated by the additional receivables.
Credit Standards -- The minimum quality of credit worthiness of a credit applicant that is acceptable to the firm.
Why lower the firm’s credit standards?

Credit Standards
A larger credit department
Additional clerical work
Servicing additional accounts
Bad-debt losses
Opportunity costs
Costs arising from relaxing credit standards

Example of Relaxing Credit Standards
Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their credit standards will enhance profitability.
The firm is currently producing a single product with variable costs of $20 and selling price of $25.
Relaxing credit standards is not expected to affect current customer payment habits.

Example of Relaxing Credit Standards
Additional annual credit sales of $120,000 and an average collection period for new accounts of 3 months is expected.
The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit standards?

Example of Relaxing Credit Standards
Profitability of ($5 contribution) x (4,800 units) =
additional sales $24,000
Additional ($120,000 sales) / (4 Turns) =
receivables $30,000
Investment in ($20/$25) x ($30,000) =
add. receivables $24,000
Req. pre-tax return (20% opp. cost) x $24,000 =
on add. investment $4,800
Yes! Profits > Required pre-tax return

Credit and Collection Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program

Credit Terms
Credit Period -- The total length of time over which credit is extended to a customer to pay a bill. For example, “net 30” requires full payment to the firm within 30 days from the invoice date.
Credit Terms -- Specify the length of time over which credit is extended to a customer and the discount, if any, given for early payment. For example, “2/10, net 30.”

Example of Relaxing the Credit Period
Basket Wonders is considering changing its credit period from “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” (which is expected to result in 6 A/R “Turns” per year).
The firm is currently producing a single product with variable costs of $20 and a selling price of $25.
Additional annual credit sales of $250,000 from new customers are forecasted, in addition to the current $2 million in annual credit sales.

Example of Relaxing the Credit Period
The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit period?

Example of Relaxing the Credit Period
Profitability of ($5 contribution)x(10,000 units) =
additional sales $50,000
Additional ($250,000 sales) / (6 Turns) =
receivables $41,667
Investment in add. ($20/$25) x ($41,667) =
receivables (new sales) $33,334
Previous ($2,000,000 sales) / (12 Turns) =
receivable level $166,667

Example of Relaxing the Credit Period
New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333
Investment in $333,333 - $166,667 =
add. receivables $166,666
(original sales)
Total investment in $33,334 + $166,666 =
add. receivables $200,000
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment $40,000
Yes! Profits > Required pre-tax return

Credit and Collection Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program

Credit Terms
Cash Discount -- A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “2/10” allows the customer to take a 2% cash discount during the cash discount period.
Cash Discount Period -- The period of time during which a cash discount can be taken for early payment. For example, “2/10” allows a cash discount in the first 10 days from the invoice date.

Example of Introducing a Cash Discount
A competing firm of Basket Wonders is considering changing the credit period from “net 60” (which has resulted in 6 A/R “Turns” per year) to “2/10, net 60.”
Current annual credit sales of $5 million are expected to be maintained.
The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 9.

The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should the competing firm introduce a cash discount?
Example of Introducing a Cash Discount

Example of Using the Cash Discount
Receivable level ($5,000,000 sales) / (6 Turns) =
(Original) $833,333
Receivable level ($5,000,000 sales) / (9 Turns) =
(New) $555,556
Reduction of $833,333 - $555,556 =
investment in A/R $277,777

Pre-tax cost of .02 x .3 x $5,000,000 =
the cash discount $30,000.
Pre-tax opp. savings (20% opp. cost) x $277,777 =
on reduction in A/R $55,555.
Yes! Savings > Costs
The benefits derived from released accounts receivable exceed the costs of providing the discount to the firm’s customers.
Example of Using the Cash Discount

Seasonal Dating
Avoids carrying excess inventory and the associated carrying costs.
Accept dating if warehousing costs plus the required return on investment in inventory exceeds the required return on additional receivables.
Seasonal Dating -- Credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period.

Credit and Collection Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program

Default Risk and Bad-Debt Losses
Present
Policy Policy A Policy B
Demand $2,400,000 $3,000,000 $3,300,000
Incremental sales $ 600,000 $ 300,000
Default losses
Original sales 2%
Incremental Sales 10% 18%
Avg. Collection Pd.
Original sales 1 month
Incremental Sales 2 months 3 months

Default Risk and Bad-Debt Losses
Policy A Policy B
1. Additional sales $600,000 $300,000
2. Profitability: (20% contribution) x (1) 120,000 60,000
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000
5. Inv. in add. receivables: (.80) x (4) 80,000 60,000
6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-debt losses +
additional required return: (3) + (6) 76,000 66,000
8. Incremental profitability: (2) - (7) 44,000 (6,000)
Adopt Policy A but not Policy B.