Debtors and Recivable Management

7/29/2019 Debtors and Recivable Management

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INTRODUCTION

When a prospective customer asks for trade credit from a seller, he is

careful how to put his request, but if he had to be honest and speak his mind, he

would possibly actually ask the seller something like this:

Id like to borrow some money from your company. Id like the loan for at least

90 days, but I will probably take longer to repay you, if I repay you at all. There

is, in fact a chance that I will not actually repay you and, if I do, it will be after

you have spent a considerable amount of time, effort and money chasing me. I do

not intend to pay any interest on the amount borrowed and, incidentally, Im not

giving you any say in whether to give me the loan or not: Ive simply taken it.

Giving loans is not something that only banks do. Most businesses loan

money to their customers in the way stated above, such customers are known as

debtors, and this is the standard business practice. The only real difference

between bank loans and debtors is that banks get paid interest on the money they

have lent and the companies are not.

The following, again, is a debtor who is actually speaking his mind:

The one contribution that debt collectors do make is that every time they

telephone me, I have to think up an even more imaginative reason for further

delaying the payment: none of the directors are here to sign the cheque, I have run

out of cheques and the bank has run out of chequebooks, Malta post is becoming

more inefficient by the day, somebody has set fire to the post office box

Though this may seem a rather light-hearted approach, the problem is very

real, very costly, and has resulted in the failure of many organizations, particularly

in the last few years. It is often not the lack of profit flow that has caused these

failures, but the lack of cash flow caused by poor and slow payments bycustomers. So, with all this risk and hassle, why sell on credit at all? The reason is

to facilitate the sales process, and as an inducement or aid in the marketing of the

goods or services of the seller. Because all other sellers give credit, the company

would find it impossible to sell if it does not give credit.


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Objectives of Receivable Management

From creation of receivables the firm gets a few advantages & it has to bear

bad debts, administrative expenses, financing costs etc. In the management of

receivables financial manager should follow such policy through which cash

resources of the firm can be fully utilized. Management of receivables is a process

under which decisions to maximize returns on the investment blocked in them are

taken. Thus, the main objective of receivable management is to maximize the

returns on investment in receivables & to minimize risk of bad debts etc. Because

investment in receivables affects liquidity and profitability, it is, therefore,

significant to maintain proper level of receivables. In other words, the basic

objectives of receivables management are to maximize the profits. Efficient credit

management helps to increase the sales of the firm. Thus, following are the main

objectives of receivables management:-

(1) To optimize the amount of sales.

(2) To minimize cost of credit.

(3) To optimize investment in receivables.

Therefore, the main objective of receivable management is to establish a

balance between profitability and risk (cost). A business can afford to invest in its

receivables unless the marginal costs and marginal profits are the same. Althoughthe level of receivables is affected by various external factors like standards of

industry, economic conditions, seasonal factors, rate of competition etc,

management can control its receivables. Though credit policies, credit terms, credit

standards and collection procedures.
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Determinants of size of Receivables

Level of sales: The most important factor that determines the size of receivables isthe level of sales. Increased sales increase the size of receivables.

Credit policy: If the firm has a liberal credit policy, the receivables are likely to be

a more rigid policy which may restrict the size of receivables.

Terms of credit: The terms of credit include the period of credit and the rate of

cash discount. They affect the size of investment in receivables. The firms credit

terms should be comparable with those of the competitors. A longer credit period

may attract more customers and increase the sales and this size of receivables isalso likely to increase. A higher rate of cash discount may include the customers to

pay early and thus size of receivables may reduce.

Paying habits of the customers: The size of receivables also depends upon the

credit worthiness and paying habits of the customers. The nature of businessand

conventions prevailing in the trade also determine the blend of cash and credit sales

and thereby the size of receivables.

Operating efficiency: The strength and collection efforts i.e. the operating

efficiency of the firm also determine the level of its receivables.


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Different types of costs associated with receivables

management

Except for few monopolistic firms, most firms are required to sell goods on

credit because of trade customs. When competitors are allowing credit to customersand our firm does not extend credit, they may switch over to other firms. If the firm

offers credit, it can attract more customers and expand its sales.

Maximization of sales alone cannot be the objective of the firm. The

increased sales cannot be achieved without incurring additional costs. The firm

should evaluate its credit policy in terms of additional benefits and costs.

Additional sales should add to the operating profits of the firm.

The various costs associated with receivables management are as follows:

Costs of financing: Though credit sales increase the profits of the firm, they too

result in some costs. Till the receivables are converted into cash, the firm has to

arrange funds to meet its own obligation towards payment to its suppliers and

payment of other expenses. These funds are to be procured at some cost. These are

known as financing costs.

Administration costs: Extending credit facility to customers involves some costsof administration. First of all costs are incurred in obtaining information regarding

credit worthiness of customers. Later, costs are incurred in collecting money from

them. It also involves additional costs of administration for maintaining the

accounts of the customers.

Delinquency costs: If there is any delay on the part of the customer in making

payments, the firm may incur additional costs. It includes costs arising on account

of funds getting blocked up for an extended period and costs associated with steps

to be taken to recover the amounts including legal charges. These costs are calleddelinquency costs.

Cost of default: If the customers do not pay either full or any part of the amounts

due from them, it is a loss to the firm. This is what is called bad debts loss.


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Important Dimension of Receivables Management

One of the favourite sayings is that if you do not manage debtors, debtors

will manage you. Another is that, in spite of what accountants say, a sale is not

made until you get paid. It is not enough for a business to induce the customer

to choose its product or service over that of its competitor, but it must ensure

that it actually receives the cash and receives it in proper time. This objective

can only be achieved if we have in place a propercredit policy. The following

are the essential elements of a proper credit policy:

1. Setting the credit policy

Most organizations have no formal or even clear credit policy, and fewer

still have any sort of policy set out in writing. This often sets the stage for

problems for these organizations. In a properly set-up organization there is

usually a credit manager, it is often the Accountant whose function is to monitor

and chase trade debtors. However, the setting of the firms credit policy is done

by the top management because of the following reason.

The reason is that credit policy should not be viewed in isolation, but

must support the firms objectives. Only top management should decide what

these objectives should be. Once such objectives are determined, top

management, in consultation with the credit manager, will devise a credit

management policy that will complement and support corporate objectives. In

this way one eliminates from the start those conflicts that often arise between thesales and credit departments: the sales department wants to increase sales at all

costs, irrespective of the creditworthiness of the customer, while the credit

department does not want to run any risk of bad debts. This gives rise to

conflict. However, when the policy is clear, sales do not over-reach, while credit

policy is not so strict that it seeks to avoid total risk to the detriment of sales.


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The credit policy of a firm provides the framework to determine (a)

whether or not to extend credit to a customer, and (b) how much credit to

extend. The credit policy decision of firm has two broad dimensions:

I. Credit Standards and

II. Credit Analysis.

A firm has to establish and use standards in making credit decisions, develop

appropriate sources of credit information and methods of credit analysis.

I. Credit Standards

The term "credit standards" represents the basic criteria for the extension of

credit to customers. The quantitative basis of establishing credit standards is factors

such as credit ratings, credit references, average payments period and certainfinancial ratios. The overall standards can be divided into two categories:

i. Tight or restrictive.

ii. Liberal or non-restrictive.

That is to say, our aim is to show what happens to the trade-off when standards are

relaxed or, alternatively, tightened. The trade-off with reference to credit standards

covers

(a) The collection cost,

(b) The average collection period,

(c) Level of bad debt losses, and


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(d) Level of sales.

These factors should be considered while deciding whether to relax credit standards

or not. If standards are relaxed, it means more credit will be extended while if

standards are tightened, less credit will be extended. The implications of the fourfactors are elaborated below:

(a) Collection Costs

The implications of relaxed credit standards are

(i) More credit,

(ii) A large credit department to service accounts receivable and related matters,

(iii) Increase in collection costs.

The effect of tightening of credit standards will be exactly the opposite. These costs

are likely to be semi-variable. This is because up to a certain point the existing staff

will be able to carry on the increased workload, but beyond that, additional staff

would be required. These should be included in the variable cost per unit and need

not be separately identified.

(b) Investments in Receivables or the Average Collection Period

The investment in accounts receivable involves a capital cost, as funds have

to be arranged by the firm to finance them till customers make payments.

Moreover, the higher the average accounts receivable, the higher is the capital or

carrying cost. A change in the credit standards? Relaxation or tightening? Leads to

a change in the level of accounts receivable either through a change in sales, or

through a change in collections.

A relaxation in credit standards implies an increase in sales, which, in turn,

would lead to higher average accounts receivable. Further, relaxed standards would

mean that credit is extended liberally so that it is available to even less creditworthy

customers who will take a longer period to pay over dues. The extension of trade


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credit to slow-paying customers would result in a higher level of accounts

receivable.

In contrast, a tightening of credit standards would signify (a) a decrease in

sales and lower average accounts receivable, and (b) an extension of credit limitedto more creditworthy customers who can promptly pay their bills and thus, a lower

average level of accounts receivable.

Thus, a change in sales and change in collection period together with a

relaxation in standards would produce higher carrying costs, while changes in sales

and collection period results in lower costs when credit standards are tightened.

These basic reactions also occur when changes in credit terms or collection

procedures are made.

(c) Bad Debt Expenses

Another factor, which is expected to be affected by changes in the credit standards,

is bad debt expenses. They can be expected to increase with relaxation in credit

standards and decrease if credit standards become more restrictive.

(d)Sales Volume

Changing credit standards can also be expected to change the volume of sales. Asstandards are relaxed, sales are expected to increase. Conversely, a tightening is

expected to cause a decline in sales.

II. Credit Analysis

Besides establishing credit standards, a firm should develop procedures for

evaluating credit applicants. The second aspect of credit policies of a firm is credit

analysis and investigation. Two basic steps are involved in the credit investigation

process:

(a) Obtaining credit information, and

(b) Analysis of credit information.


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It is on the basis of credit analysis that the decisions to grant credit to a customer as

well as the quantum of credit would be taken.

The customer who applies for credit should be required to produce proof of

his ability to settle within an agreed period the amount he owes. This is the time tomake sure that the customer is creditworthy. Most debtors fully intend to pay their

debts, but many executives tend to be too optimistic about their financial condition

and future prospects, and thus find themselves short of funds.

The initial credit application, which should be done in writing, is intended to

provide the credit manager with certain information that can be readily verified.

Greater detail can be sought later, if necessary, in the form of financial statements.

The information included in the initial application should enable the seller,

however, to avoid considering doing business with those customers who have little

prospect of success or whose past performance indicates that they are unable to

meet their obligations when due. The seller should not deal with customers who ask

for credit but who refuse to supply the information requested.

Obtaining Credit Information

The first step in credit analysis is obtaining credit information on which to base the

evaluation of a customer. The sources of information are

(1) Internal

(2) External

Internal

Usually, firms require their customers to fill various forms and documents

giving details about financial operations. They are also required to furnish trade

references with which the firms can have contacts to judge the suitability of the

customer for credit. This type of information is obtained from internal sources of

credit information. Another internal source of credit information is derived from

the records of the firms contemplating an extension of credit. It is likely that a

particular customer may have enjoyed credit facility in the past. This type of


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information may not be adequate and may have to be supplemented by information

from other sources.

External

The availability of information from external sources to assess the

creditworthiness of customers depends upon the development of institutional

facilities and industry practices. Depending upon the availability, the external

sources such as financial statements, bank references, trade references, credit

bureau reports, and so on can be employed to collect information.

The decision whether the customer is eligible for credit terms generally

involves a detailed analysis of some of the attributes of the customers. Credit

analysis normally groups the attributes in order to assess the credit worthiness ofcustomers. One traditional way of organizing the information is by characterizing

the applicant along five dimensions namely, Capital, Character, Collateral,

Capacity and Conditions. These five dimensions are also popularly called five Cs

of credit analysis.

Capacity: It is the most critical factor that assesses your ability to repay the

loan. How you intend to repay the loan is the primary concern of lenders.

The lenders will take into account the factors like the timing of the

repayment, cash flow, and the likelihood of a successful repayment of the

loan.

Capital: This is another important criterion that most lenders look out for

while analyzing a loan application. Capital is the amount of money you have

personally invested in the business and is an indication of the available

financial resources you have to deal with the debt. Many a time's credit

analysts place more importance on it. Interested creditors, lending

institutions and investors expect you to contribute at least 25% from yourown assets before asking them to offer you any kind of funds.

Collateral: While perusing your loan application the lenders will also

consider the additional forms of security that you can provide in case you

default. Giving a collateral implies that you pledge an asset you own, such as


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your home, car or any valuable property, to the lender with the agreement

that in case of default, the lender has the absolute power and authority to take

hold of your property to make up the loss from the loan default.

Character: It is the impression you form on a lender or an investor. Thelender will form a subjective opinion on you after a series of talks to gauge

your willingness to repay the loan. Your financial history, educational

background and experience in business are some of the factors that are

considered by the lender.

Conditions: It describes the proposed motive of the borrower to apply for

the loan. Prospective lenders will consider the purpose of the loan: will the

loan be used for working capital, supplementary equipments or inventory?

The lending institution will also look at the external conditions that couldaffect your business.

Beyond the simple requirement of getting the signatures of those executives

who can bind the company normally the directors and managers, this question is

intended to find out something about the character of the owner and the senior

executives. The reputation of the companys Chief Executive Officer carries great

weight when it comes to such decisions.

Again, the owner of a business may have large personal resources and be

willing to pledge them to support his business. Such a factor would be carefully

considered by the credit manager, and weigh heavily in the customers favour. An

unwillingness to do so is also an important pointer, but in the opposite direction.

Whilst the materiality of the amount will dictate the degree of analysis

involved, the major sources of information available to companies in assessing

customers credit worthiness are:

Bank References: Banks can be sources of useful information

about customers, though nowadays laws dealing with privacy

have restricted the information which banks can supply. Banks

also tend to be reluctant to commit themselves formally to

recommending a customer lest they be held responsible if that


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customer should default. However, the credit manager may often

obtain useful information by talking to the customers bank

manager, especially if the client has given permission to do so. In

addition, the credit manager may ask his own banker for

indications he may have of the clients creditworthiness, asbankers hear a lot of things. Information can be passed on by the

banker in general terms without violating any confidentiality.

Professional Credit Rating Agencies: These agencies can also be consulted. Their

information is useful as an indicator of performance for an established business, but

they can usually report little or nothing about one just getting started

Trade References: A customer can also be asked to provide trade references from

suppliers he is already dealing with. Keep in mind, however, that no customer is

going to list a reference on a credit application if he has ever failed to pay that

supplier in time. The credit manager should therefore try to check with other

suppliers in the same line and find out if the applicant has ever done business with

them and what the results were. This cross checking is done regularly among

insurance companies when they have doubts about a customer.

Field Visit: Through visiting the premises and interviewing senior management,

staff should gain an impression of the efficiency and financial resources ofcustomers and the integrity of its management.

Financial Accounts: The most recent accounts of the customer can be obtained

either direct from the business, or from Companies House. While subject to certain

limitations past accounts can be useful in inspecting customers. Where the credit

risk appears high or where substantial levels of credit are required, the supplier may

ask to see evidence of the ability to pay on time. This demands access to internal

future budget data.

Past Experience: For existing customers, the supplier will have access to their past

payment record. However, credit managers should be aware that many failing

companies preserve solid payment records with key suppliers in order to maintain

supplies, but they only do so at the expense of other creditors. Indeed, many

companies go into liquidation with flawless payment records with key suppliers.


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General Sources of Information: Credit managers should scout trade journals,

business magazines and the columns of the business press to keep abreast of the

key factors influencing customers' businesses and their sector generally. Sales

staffs that have their ears to the ground can also prove an invaluable source of

information.

The general economic situation, and the industry conditions, will certainly

have a bearing on the credit decision, though most credit managers give more

importance to character and past performance. Some companies always manage to

survive bad economic conditions and succeed even when times are bad. However,

if credit has already been given and suddenly conditions get bad, then credit

managers should watch over their accounts more carefully, check the outstanding

balances especially the bigger ones more frequently, and revise the credit limits

more often.

Purpose

The purposeof all this checking before giving credit is to ensure as much as

possible the creditworthiness of the customer. Creditworthiness, however, is rarely

assessable in absolute terms, and it will be a matter of judging the risk in each case

and categorizing the customer accordingly. Some risk is inevitable when business

is done on credit, and this must be balanced against the expected returns from theadditional sales. Initially, a new customers credit limit should be set at a low level

and increased only if his payment record justifies it. Even in the case of old

customers, the credit limit and period should be periodically revived, and should be

raised only at request of the customer and if his credit performance has been good.

2. Credit Limits and Credit Periods

Credit Limits and Credit Periods should be established when the initial

request for credit is being considered. The credit period is an important aspect ofthe credit policy. It refers to the length of time over which the customers are

allowed to delay the payment. The credit period generally varies from 3 days to 60

days.


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In a computerized setting this is a simple matter. The customer is assigned an

account number and all payments and charges enter the computer system before an

invoice is issued. The credit limit is programmed into the computer for each

account, and any new sale which will lead to exceeding the limit is automatically

rejected. Rejections would then normally be brought to the attention of the creditmanager for a decision. He may approve a small excess and override the system,

but any large excess would call for an investigation and perhaps a demand on the

customer to prove that he can settle the amount soon.

In most cases the period of credit is set by the principle of the trade, and

very little flexibility is available to the individual business. It is usual to find credit

periods of 30, 60, or 90 days i.e. payment has to be made within that interval

following the date of the invoice.

It is useless demanding cash with orders if ones competitors are giving,

say, 30 days credit. Only a very marked price or quality advantage would make

this possible. On the other hand, there is usually little point in offering more credit

than your competitors. This would tie up more of your funds, and although it will

possibly attract more customers, there is a risk that many of these will be less

creditworthy, leading to higher bad debts.

However, if a firm is considering extending credit to attract more customers, it isfirst necessary to determine:

1. The expected additional sales volume;

2. The profitability of the extra sales;

3. The extra length of the average debt-collection period;

4. The return on the investment in additional debtors.


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3. Cash Discounts

Many firms offer a cash discount for the quick settlement of accounts.

Different discount rates may be offered for different periods. A typical invoice

might state: Terms 2.5% cash discount within 7 days, otherwise 30 days net.This means that the debtor is allowed up to 30 days to settle his bill at the stated

amount, but if he pays it within the first 7 days of this period he may deduct 2.5%

from the total. If the debtor takes up the discount offer, the effect would be to

reduce the average level of trade debtors; so one would expect that the amount of

cash discount would be related to the firms cost of capital.

E.g., 3% if payment made within 10 days; 2%discount if payment made within 20

days etc. Both the discount rate and the period within which it is available are

reflected in credit terms e.g, 3/10, 2/20. Net 30 means that 3%cash discount if the

payment made within 10 days; 2% discount if the payment made within 20 days;

otherwise full payment by the end of 30 days from the date of sale. When a firm

offers a cash discount, its intention is to accelerate the flow of cash into the firm to

improve its cash position. The length of cash discount affects the collection period.

In practice, however, the discount is usually more generous than this. This is

because early payment not only reduces capital requirements for the seller, but also

saves his administration costs in pursuing outstanding debtors, and also reduces therisk of bad debts. There may also be a hidden element of price reduction in the cash

discount. It is a concealed way of offering lower prices to a sector of the market

which might otherwise go to competitors.

4. Collection Procedures and Credit Control

A customer who has been paying regularly suddenly starts slowing down his

payments. This is always a danger signal, and so the credit manager must try and

discover immediately the reason for this, either perhaps by asking the salesman tocall on the customer, or by phoning the customer, or asking around for information.

The worst thing to do is to sit and wait for developments. In any case discovering,

hopefully, that there is nothing to really worry about will set your mind at rest.


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One danger signal that should not be ignored is the sudden unavailability of

any of the people that you usually contact. This often starts to happen after

collection efforts have been started but with no success. The firms managers and

directors, at a loss what to do and embarrassed by constant demands for payment,

are abroad, sick, or in a meeting.

When a debtor starts acting suspiciously, the best method of enforcing

payment is to stop any further supplies to him while you investigate. This will

show him that you really mean business, and in any case will ensure that your

problem does not grow any bigger. If the customer finally pays up, you should

still not relax and go back to the old arrangements before you are fully satisfied

that he has no long-term underlying problem. In fact it would be strongly advised

to start all over again the whole process of assessing his creditworthiness.

If companys efforts to collect do not give results, the company must decide

their next step. If the company believes that the customer is in deep trouble, then it

should not hesitate to take strong measures.

Collection letters are rapidly losing popularity among modern credit

managers. The telephone is a better way to get results. Some still use letters which

may begin as polite reminders and go on to threats of court action. Here again,

credibility plays an important role. A firm that sends out half a dozen pre-printedor computer-generated letters, each threatening something worse than the last,

loses credibility. If the company threatens to sue unless payment is effected within

a week, make sure that the action is taken if payment is not effected within the

week. Of course, this will probably mean the end of your relationship with the

customer, who will probably go to your competitor. By doing so, he will be doing

you a favour in helping to ruin him. The companies certainly do not need such

customers.


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FACTORING

Factoring involves raising funds against the security of a company's trade

debts; so that cash is received earlier than if the company waited for its credit

customers to pay. Three basic services are offered, frequently through subsidiaries

of major clearing banks:

Sales ledger accounting, involving invoicing and the collecting of debts;

Credit insurance, which guarantees against bad debts;

Provision of finance, whereby the factor immediately advances about 80% of

the value of debts being collected.

There are two types of factoring service:

Non-recourse factoring is where the factoring company purchases the debts

without recourse to the client. This means that if the clients debtors do not pay

what they owe, the factor will not ask for his money back from the client.

Recourse factoring, on the other hand, is where the business takes the bad debt

risk. With 80% of the value of debtors paid up front i.e. usually electronically into

the clients bank account, by the next working day, the remaining 20% is paid over

when either the debtors pay the factor i.e. in the case of recourse factoring, or,

when the debt becomes due i.e. non-recourse factoring. Factors usually charge fortheir services in two ways: administration fees and finance charges. Service fees

typically range from 0.53% of annual turnover. For the finance made available,

factors levy a separate charge, similar to that of a bank overdraft.

Advantages:

Provides faster and more predictable cash flows;

Finance provided is linked to sales, in contrast to overdraft limits, which tend

to be determined by historical balance sheets;

Growth can be financed through sales, rather than having to resort to externalfunds;

The business can pay its suppliers promptly (perhaps benefiting from

discounts) and because they have sufficient cash to pay for stocks, the firm

can maintain optimal stock levels;

management can concentrate on managing, rather than chasing debts;


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The cost of running a sales ledger department is saved and the company

benefits from the expertise and economies of scale of the factor in credit

control.

Disadvantages:

The interest charge usually costs more than other forms of short-term debt;

the administration fee can be quite high depending on the number of debtors,

the volume of business and the complexity of the accounts;

By paying the factor directly, customers will lose some contact with the

supplier. Moreover, where disputes over an invoice arise, having the factor in

the middle can lead to a confused three-way communication system, which

hinders the debt collection process;

Traditionally the involvement of a factor was perceived in a negative light

(indicating that a company was in financial difficulties), though attitudes arerapidly changing.

Debtors and Recivable Management

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