WORKING CAPITAL MANAGEMENT PART 4

Management of Receivables

A firm needs to offer its goods and services on credit to customers as a business strategy to boost sales. This represents a considerable investment of funds. The basic objective of Receivables management is to optimize the return on investment in this asset. If large amounts are tied up in debtors, there will be chances of bad debts and there will be cost of collection of debts. On the contrary, if the investment is low, the sales may be restricted. Therefore management of debtors is an important issue.

Finance manager can affect the volume of credit sales and collection period and consequently, the investment in receivables through the credit policy. Credit policy is a combination of three components

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• Credit a standard which is the criteria to decide the types of customers to whom goods could be sold on credit.

• Credit terms specify the duration of credit and terms of payments by customers.

• Collection efforts determine actual collection period.

Aspects of Management of Debtors

Credit policy

Credit policy is concerned with the profits that could be generated from additional sales that could be generated by extending credit on one hand and cost of carrying those debtors and bad debt losses on other hand. There are various factors which determine credit policy such as effect of credit on sales, credit terms, cash discounts, paying habits of customers etc.

For example, the credit term may be expressed as “2/15 net 40” means that a 2% discount will be granted if the customers pays within 15 days; if he does not avail offer he must make payment within 40 days.

Credit analysis

Finance manager determine as to how risky it is to advance credit to a particular party.

Control of receivable

It involves follow up of debtors and decides about a suitable credit collection policies.

Maintaining receivables comprises of various costs such as collection cost, defaulting cost, and administrative cost record keeping.

Financing Receivable

• Pledging: firms receivables are used as a security for short term loan as receivables are most liquid assets and this serve as prime collateral for a secured loan. The lender scrutinizes the quality of accounts receivables, selects acceptable accounts, creates a lien on the collateral and fixes a percentage of financing receivables which ranges around 50 to 90%. The major advantage of pledging accounts receivable is the ease and flexibility it provides to the borrower. But the cost of financing is high.

•  Factoring: it is a new concept in financing accounts receivables. This refers to outright sale of accounts receivables to a factor or a financial agency. A factor is firm that acquires the receivables of other firms. The factoring lays down the conditions of the sale in factoring agreement. The factoring agency bears the right of collection and services the accounts for fee. Normally, factoring is a non recourse arrangement which means in the event of default the loss is born by the factor. However in the case of with recourse arrangement such loss is born by the seller. The biggest advantages of factoring are immediate conversion of receivables into cash and it helps company to have liquidity without creating net liability on its financial condition. Some of the commercial banks provide this service.

Tool and Techniques of Receivable Management

Re-engineering Receivable Process: Re-engineering is a fundamental rethinking and redesigning of business processes by incorporating modern business approach. Some of the organizations have achieved real cost savings and performance improvements through re-engineering receivables.

• Centralization of high nature transactions of accounts receivables and payables is one of the practices for better efficiency.

• Alternate payment strategies direct transfer of funds from purchasers bank account, collection by third party, lock box processing and payments via internet.

• Customer orientation: where individual customers or a group of customers have some strategic importance to a firm a case study approach may be followed to develop good customer relationship. A critical study of this group may lead to formation of a strategy for prompt settlement of debt.

Use of Latest Technology such as E-commerce, Automated receivable management system.

Use of financial tools/technique such as Credit rating and decision tree analysis of granting credit.

Example of decision tree analysis: if the chances of recovery are 8 out of 10 then probability of recovery is 0.8 and that of default is 0.2. Suppose cost of goods is Rs 4 lakh and revenue is Rs 7 lakh. Now weighted net benefit should be calculated

= [(700000-400000)*0.8] – [400000*0.2]

= 160000

As there is net benefit hence credit should be granted.

Collection policy: if a firm spends more resources on collection of debts, it is likely to have smaller bad debts. Thus a firm must work out optimum amount that it should spend on collection of debtors. This involves trade off between the levels of expenditure on the one hand and decreases in bad debt losses and investment in debtors on the other hand.

Ageing schedule: When receivables are analysed according to their age, the process is known as preparing ageing schedules of receivables. The computation of average age of debtors is a quick and effective method of comparing liquidity of receivables with the liquidity of receivables in the past and also comparing liquidity of one firm with it competitor. It also helps the firm to predict the collection pattern of receivable in future.

The credit collection procedure must answer the following:

·         How long should a debtor balance be allowed to exist before collection process is started?

·         Should there be collection machinery whereby personal calls by company’s representatives are made?

·         What should be the procedure of follow up with defaulting customers?

·         How reminders are to be sent and how should each successive reminder be drafted?

·         What should be the procedure for dealing with defaulting customers? Is legal action to be instituted?

The fundamental rule of sound receivable management should be to reduce the time lag between the sale and collections, at the same time maintain customer goodwill.