Management of Receivables

Receivables, or accounts receivable, refer to the amounts owed to a company by its customers
for goods or services that have been delivered or used but not yet paid for. Receivables are
recorded as assets on the company's balance sheet, representing a legal obligation for the
customer to remit cash for the transaction.

Key Points about Receivables

1. Nature:
o Receivables are typically short-term, meaning they are expected to be paid
within a year.
o They arise from sales made on credit rather than cash transactions.
2. Types:
o Trade Receivables: Amounts due from customers from selling goods or
services.
o Notes Receivable: Written promises for receiving amounts, which can include
interest.
3. Importance:
o Essential for maintaining liquidity and cash flow.
o Provide a measure of a company’s efficiency in extending credit and
collecting debts.
4. Management:
o Involves assessing creditworthiness, setting credit terms, and implementing
collection strategies to minimize bad debts and maximize cash inflow.

Example

If a company sells ₹10,000 worth of products to a customer on credit with terms of net 30 days,
the ₹10,000 is recorded as a receivable. The company expects to receive this amount within 30
days.

Accounting for Receivables

Receivables are recorded in the accounts receivable ledger, which tracks all amounts owed to
the business. When payment is received, the receivable is reduced, and the cash or bank
balance is increased.

Risks Associated with Receivables

• Credit Risk: The risk that the customer may default on the payment.
• Liquidity Risk: If receivables are not collected in a timely manner, the business may
face cash flow issues.

Financial Metrics Involving Receivables

Proper management of receivables is crucial for maintaining a healthy cash flow and ensuring
the financial stability of a business.

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Definition and Features of Receivable Management

Receivable Management involves the processes and strategies a business uses to manage the
money customers owe for credit sales. This function is crucial for maintaining liquidity and
ensuring that the company has adequate cash flow to meet its obligations.

Features:

1. Credit Policy:
o Defines criteria for extending credit.
o Example: A company might decide to extend credit only to customers with a
credit score above 700.
2. Credit Analysis:
o Evaluation of the creditworthiness of potential customers.
o Example: Analyzing a customer’s financial statements to assess their ability to
pay.
3. Credit Terms:
o Payment terms, including period and discounts.
o Example: Offering a 2% discount if payment is made within 10 days;
otherwise, full payment in 30 days (2/10, net 30).
4. Collection Policy:
o Procedures for collecting overdue payments.
o Example: Sending reminder emails after 30 days, phone calls after 45 days,
and involving collection agencies after 60 days.
5. Monitoring Receivables:
o Tracking outstanding receivables.
o Example: Regularly generating aging reports to identify overdue accounts.

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Purpose of Receivables:

The purpose of receivables, or accounts receivable, is multifaceted and essential for a

business's financial health and operational efficiency. Here are the key purposes:

1. Enhancing Sales and Revenue

• Credit Sales: By extending credit to customers, businesses can increase sales by

attracting more customers who prefer or need to buy on credit. This can be especially
important in competitive markets.
• Customer Retention: Offering credit can help in retaining customers and encouraging
repeat business, contributing to long-term revenue growth.

Example: A furniture company offers a 60-day credit term to its customers. This allows businesses and
individuals who cannot afford to pay upfront to purchase furniture. As a result, the company sees a 15%
increase in sales as more customers take advantage of the credit terms to buy now and pay later.

2. Customer Convenience

• Flexible Payment Terms: Giving customers the option to pay later can make
purchasing easier, especially for large orders or high-value items. This convenience can
improve customer satisfaction and loyalty.

Example: An electronics retailer offers a "buy now, pay later" option with 30-day credit terms. A
customer needs a new laptop immediately but won't have the funds until the next paycheck. The credit
option allows the customer to get the laptop immediately and pay for it next month, enhancing customer
satisfaction and loyalty.

3. Competitive Advantage

• Market Differentiation: Businesses that offer favorable credit terms can differentiate
themselves from competitors who may have stricter payment policies. This can be a
significant selling point in the market.

Example: Two competing office equipment suppliers are vying for the same client. Supplier A offers a
30-day credit term, while Supplier B demands payment upon delivery. The client chooses Supplier A
due to the more flexible payment terms, giving Supplier A a competitive edge and securing the sale.

4. Cash Flow Management

• Revenue Timing: While receivables represent money not yet received, managing
them effectively ensures a steady flow of cash coming into the business, which is
critical for meeting operational needs and investment opportunities.
• Forecasting: Accurate tracking of receivables helps forecast future cash inflows,
aiding in better financial planning and budgeting.

Example: A wholesaler sells goods worth ₹50,000 on credit with net 30 terms. Although the cash is not
received immediately, the company manages its cash flow by scheduling its payables and expenses
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around the expected receivables. This ensures the business has sufficient cash to meet its obligations
while waiting for customer payments.

5. Building Business Relationships

• Trust and Collaboration: Extending credit can build trust and foster stronger
customer relationships. It signals confidence in the customer's ability to pay and can
lead to more collaborative business dealings.

Example: A construction company extends a line of credit to a loyal client for purchasing building
materials. This trust strengthens their business relationship, leading to repeat business and long-term
collaboration. The client appreciates the flexibility and continues to choose the construction company
for future projects.

6. Financial Leverage

• Financing Options: Accounts receivable can be used as collateral for obtaining loans.
Businesses can leverage their receivables to secure financing from banks or other
financial institutions, providing additional liquidity.

Example: A technology startup needs funding to expand its operations. It uses its accounts receivable
of ₹200,000 as collateral to secure a loan from a bank. The loan provides the necessary funds for
expansion, and the receivables will be collected within the next 60 days, ensuring the company can
repay the loan.

7. Economic Adjustments

• Market Conditions: In economic downturns, offering credit can maintain sales

volumes when customers may not have immediate cash. It helps businesses stay
resilient in fluctuating economic conditions.

Example: During an economic downturn, a clothing manufacturer offers its retailers extended credit
terms of 90 days. This helps retailers manage their cash flow better during tough times, allowing them
to continue ordering stock. As a result, the manufacturer maintains steady sales despite the challenging
economic conditions.

Cost and Benefits of Receivables

Costs:

1. Financing Costs:
o Cost of capital tied up in receivables.
o Example: If a company’s cost of capital is 10%, and it has ₹100,000 in
receivables, the annual financing cost is ₹10,000.
2. Administrative Costs:
o Costs associated with managing and collecting receivables.
o Example: Salaries of credit management staff, costs of mailing invoices, etc.
3. Bad Debt Losses:
o Risk of non-payment.

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Example: If 2% of sales typically turn into bad debts, and annual sales are
₹1,000,000, the expected bad debt loss is ₹20,000.
4. Opportunity Costs:
o Potential returns lost by not investing funds elsewhere.
o Example: Funds tied up in receivables could have been invested in a project
yielding a 15% return.

Benefits:

1. Increased Sales:
o Attracting more customers by offering credit.
o Example: Offering credit can increase sales by 20%, from ₹500,000 to
₹600,000.
2. Customer Loyalty:
o Enhanced satisfaction and repeat business.
o Example: Providing favorable credit terms to build long-term relationships.
3. Competitive Advantage:
o Differentiation through better credit policies.
o Example: More flexible terms can attract customers from competitors with
stricter policies.
4. Improved Cash Flow:
o Effective management ensures steady cash flow.
o Example: Shortening the average collection period from 45 days to 30 days
improves cash availability.

Credit Policy Variables

1. Credit Standards:
o Criteria for determining creditworthiness.
o Example: Requiring a minimum credit score of 700 and a positive payment
history with other suppliers.
2. Credit Period:
o Duration for which credit is extended.
o Example: Standard terms might be net 30 days, but special customers might
get net 60 days.
3. Cash Discounts:
o Incentives for early payment.
o Example: Offering a 2% discount for payments made within 10 days.
4. Collection Efforts:
o Strategies for collecting overdue accounts.
o Example: Automated reminders, escalating to personal calls, and legal actions.

Credit Evaluation

1. Financial Analysis:
o Reviewing financial statements to assess stability.
o Example: Calculating financial ratios like the current ratio (current
assets/current liabilities) to determine liquidity.
2. Credit Reports:
o Obtaining reports from agencies.
o Example: A report indicating a customer’s payment history and credit score.
3. Payment History:
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 o Analyzing past payment behavior.
o Example: Reviewing internal records of past transactions with the customer.

4. Trade References:
o Checking with other businesses.
o Example: Contacting other suppliers to gauge the customer’s reliability.
5. External Factors:
o Considering economic conditions.
o Example: Industry downturns may impact a customer’s ability to pay.

Credit Granting Decisions

1. Credit Limit:
o Maximum credit extended.
o Example: Setting a limit of ₹50,000 based on the customer’s financial
stability.
2. Credit Terms:
o Specific payment terms.
o Example: Net 30 days with a 2/10 discount.
3. Collateral:
o Security required for credit.
o Example: Requiring a lien on inventory for high credit amounts.
4. Credit Approval Process:
o Internal process for approval.
o Example: Multi-tiered approval where higher limits require senior
management approval.

Control of Receivables

1. Aging Analysis:
o Categorizing receivables by age.
o Example: An aging report showing ₹20,000 in 30-day receivables, ₹15,000 in
60-day receivables, and ₹5,000 in 90-day receivables.
2. Regular Monitoring:
o Continuous tracking of receivables.
o Example: Weekly reviews of accounts receivable aging reports.
3. Collection Procedures:
o Strategies for overdue accounts.
o Example: Implementing a series of actions starting with reminder emails,
escalating to phone calls, and finally legal action.
4. Bad Debt Provisioning:
o Setting aside reserves for potential bad debts.
o Example: Estimating 2% of receivables may become bad debts and
provisioning accordingly.