Management of Receivables Bcom Notes
Management of Receivables Bcom Notes:- In this post, you will get the notes of B.com 3rd year Financial Management, by reading this post you can score well in the exam, hope that this post has helped you with this post to all your friends and all groups right now I must share it so that every student can read this post and it can also be helped in this post.
Management of Receivables
Meaning of Receivables: Receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and form part of its current assets. Receivables are also known as accounts receivables, trade receivables, customer receivables or book debts. According to J.J. Hampton, “Receivables are asset accounts representing amount owed to the firm as a result of sale goods and services in the ordinary course of business.”
Motives or Purposes of Maintaining Receivables: (1) Increase in Sales, (2) Increase in Profit and (3) Meeting Market Competition. Cost Associated with Receivables (1) Capital Costs or Cost of financing the receivables, (2) Administrative Costs, (3) Collection Costs, (4) Default Cost and (5) Delinquency Costs.
Illustration 1. A firm sells its product at 25 percent profit on cost. Its annual credit sales is 20,00,000 and credit allowed to debtors is 3 months. It finances investment in debtors from bank at 15 per cent p.a. Find out the cost of financing debtors.
Average Debtors = Credit Sales × Credit Allowed to Debtors
20,00,000 × 3/12 = ₹ 5,00,000
Investment in Average Debtors = 5,00,000 × 100/125 = ₹ 4,00,000
Cost of financing average debtors = 4,00,000 × 15% = ₹ 60,000
p.a. Risk Associated with Receivables: (1) Liquidity Risk and (2) Risk of opportunity loss.
Factors Affecting the Size of Investment in Receivables: (1) Level of Credit Sales, (2) Terms of Trade, (3) Credit Policy of the Firm (4) Expansion Plans, (5) Credit Collection Efforts, (6) Paying Habits of Customers and (7) General Factors which are common to all firms.
MEANING AND DEFINITION OF RECEIVABLES MANAGEMENT
The term Receivables Management (RM) may be defined as collection of steps and procedures required to properly weigh the costs and benefits attached with the credit policies. The RM consists of matching the cost of increasing sales (particularly credit sales) with the benefits arising out of increased sales with the objective of maximising the return on investment of the firm. In other words, the credit sales may be promoted upto the point where marginal profit equals the marginal cost of additional credit sales. At this point, the difference between the total sales and total costs, that is the profit, will be maximum and the investment in the receivables will be optimum. Thus, the following are the main objectives of trade-off on receivables:
(i) To obtain optimum (not maximum) volume of sales.
(ii) To minimise costs of credit sales.
(iii) To optimise investment in receivables.
According to S. C. Kuchchal. “Managing receivables means making decisions relating to the investment of funds in this assets as pan of internal short-term operating process.”
Conclusively receivables management is the process of making decisions relating to investment in trade debtors.
OBJECTIVE OF RECEIVABLES MANAGEMENT
According to S.E. Bolten, “The objective of receivables management is to promote sales and profits until that point is reached where the return on investment in further funding or receivables is less than the of funds raised to finance that additional credit i.e., cost of capital.”
In brief, the main objectives of receivables management are as follows:
- To determine the optimum level of credit sales;
- To establish the efficient control on cost associated with receivables;
- To maintain the optimum level of investment in receivables.
SCOPE OR FUNCTIONS OF RECEIVABLES MANAGEMENT
Receivables management involves the careful consideration of the following aspects:
- Formulation and Evaluation of Credit Policy:
- Implementation of Credit Policy:
- Formulation of Collection Procedure:
- Analysis and Control of Receivables;
- Formulation and Evaluation of Credit Policy: A firm-makes significant investment by extending credit to its customers and thus requires a suitable and effective credit policy to control the level of total investment in the receivables. The basic decision to be made regarding receivables is to decide how much credit should be extended to a customer and on what terms. This is what is known as the credit policy. The credit policy may also be defined as the set of parameters and principles that govern the extension of credit to the customers.
There are three elements of a credit policy-credit standards, credit terms and collection policies. Each of these are explained below:
(i) Credit Standards: Credit standards are the criteria which a firm follows in selecting customers for the purpose of credit extension. The firm may have tight credit standards; that is, it may sell mostly on cash basis, and may extend credit only to the most reliable and financially strong customers. Such standards will result in no bad-debt losses, and less cost of credit administration. But the firm may not be able to expand sales.
(ii) Credit Terms: These refer to the terms and conditions in respect of payments which are agreed with the customers as a part of commercial deal. Credit terms have two components: (a) Credit Period, and (b) Cash Discount. The approach to be adopted by the firm in respect of each of these components is discussed below:
(a) Credit Period: The length of time for which credit is extended to customers is called the credit period. It is generally stated in terms of a net date. For example, if the firm’s credit terms are ‘net 30’, it is expected that customers will repay credit obligation not later than 30 days.
(b) Size and Policy of Cash Discount: A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms, indicate the rate of discount and the period for which it is available. If the customer does not avail the offer, he must make payment within the normal credit period. In practice, credit terms would include: (a) the rate of cash discount, (b) the cash discount period, and (c) the net credit period. For example, credit terms may be expressed as ‘2/10, net 30.” This implies that the customer will be allowed 2 percent discount if he makes the payment within 10 days. In case the customer does not exercise this option, then he will have to pay the full amount on or before 30th day. In other words it can be said that 2 percent is the interest for keeping the net proceeds (amount payable-cash discount) for 20 days. The annual financing cost may be ascertained as follows:
Annual financing cost
= [% Discount / 100 – % Discount] × [365 / Credit Period – Discount Period] ×100
Illustration 2. A company offers standard credit terms of ’60 days net’. Its cost of short-term borrowings is 16% per annum. Determine whether a 2.5% discount should be offered for payment within 7 days to customers who would normally pay after (i) 60 days, (ii) 80 days, and (ii) 105 days.
Solution. The annual percentage cost of the discount in each case is:
The discount should be offered to customers who would have paid after 80 or 105 days, and not to those who would have paid after 60 days. The reason being that the cost of funds is 16% and the customers who I would have paid after 60 days, would inflict a cost of 17.7% if the discount terms are offered to them.
(iii) Collection Policies: Collection Policy lays down the collection procedures followed to collect the amounts from the customers who do not pay within the credit period allowed to them. Collection procedures should be applied very tactfully and only after consulting the sales department.
A firm needs to continuously monitor and control its receivable to ensure the success of collection efforts. For this, number of measures are available as follows:
(a) Receivables Turnover: It is also called as ‘debtors-turnover’. This ratio establishes relationship between credit sales and receivables. In brief, following formula is used for calculating this ratio.
Debtors or Receivables Turnover Ratio = [Net Credit Sales / Average Receivables]
(b) Average Collection Period: It is another device to evaluate the level of investment in receivables. It is also known as ‘ Debtors Velocity’. Average collection period is found out by dividing the amount of receivables by the value of average daily credit sales. It indicates as to how many days of credit sales are represented by funds tied-up in receivables. Symbolically:
Average Collection Period (in months or weeks or days)
= [Average Trade Receivables / Net Credit Sales] × No. of Months or Weeks or Days in a year
(c) Aging Schedule of Receivables: Aging schedule of receivables is prepared to find out how much old are the receivables. Receivables are classified on the basis of their age. It helps the management in determining the level of collection procedures which should be initiated for each such class of receivables.
- Implementation of Credit Policies: After formulating the credit policy its proper execution is very important. It involves the following two steps: (a) Evaluation of Credit Applicants, (b) Financing the investment in receivables.
- Formulation of Collection Procedure: Once a firm decides to extend credit and defines the terms of credit sales, it must develop a policy for dealing with slow paying customers. The firm should have a built-in system under which the customer may be reminded a few days in advance about the bill becoming due. After the expiry of due date of the payment, the firm should make statements, reminders, telephone calls and even personal visits to the paying customer. Ultimately legal action for recovery of due amount may also be resorted to, though it can be very costly and time consuming. No doubt, that legal actions may have little effect on the ability of the customer to pay, but it can definitely speed up the legal relief. The overall collection procedure of the firm should neither be too lenient (resulting in mounting receivables) nor too strict (resulting sometimes even loss of customers). A strict collection policy can affect the goodwill and damage the growth prospects of the sales. If a firm has a lenient credit policy, the customer with a natural tendency towards slow payments, may become even slower to settle his accounts. Thus, the objective of collection procedure and policies should be to speed up the slow paying customer and reduce the incidence of bad debts.
- Analysis and Control of Receivables: Once the business concern has set credit standards, credit terms, collection policies, etc., it is important for the financial manager to control and monitor the effectiveness of the collections. For this purpose some targets in terms of average collection period as well as ratio of bad debts to sales may be set up by the finance manager and he may monitor the receivables particularly the debtors with reference to these ratios. These targets are however subject to revision due to changes in credit policies and/or credit standards.