10. MANAGEMENT OF RECEIVABLES
INTRODUCTION
Selling goods on credit is the most prominent force of the modern business. The firm adopts this method of selling goods to protect it from the competitors and to attract the customers to buy its products at favorable terms. When firm sells gods or services on deferred payment basis, it is said that the firm has granted trade credit to customers.
Trade credit, in other words, is known as receivables or book – debt. The book debt has three characteristics –
(i) it involves an element of risk,
(ii) it is based on economic value. It – means, goods or services passed on to the buyer have economic value and the seller will receive the equivalent in future,
(iii) the cash payment or equivalent will be made in the future. The book debts are also called debtors and represent the firm’s claim or asset.
The financial management, in managing the receivable is concerned with maintaining the receivables at the optimum level and review the credit policy and producers accordingly.
DETERMINANTS OF THE SIZE OF INVESTMENT IN RECEIVABLES
In most of business enterprises, investments in accounts receivable form a major part of their assets. Accounts receivables are one of the major components of working capital. The financials executives, should, therefore, pay due attention to the management of receivables so that each rupee invested in accounts receivables may contribute to the network of the organization.
The problem of management of receivables is basically a problem of balancing profitability and liquidity. Soft credit terms are attraction for sales and so the longer the time a company allows to pay to its customers, the greater the sales and higher the profits. However, on the other hand, the longer the period of credit the greater the risk, the greater the level of debt and greater the strains on the liquidity of the company. Hence it is a very vital issue for the financial management.
The Level of investment in receivables is determined by the following factors:
(i) Volume of Credit Sale. Volume of credit sale is the main determinant of the level of receivables. Other things being equal, accounts receivables vary directly with the volume of sales. If sales increase, receivables expand. As sales decline, investment in receivables also decline.
(ii) Terms of Sales. It is the most important variable in determining the level of investment in receivables. If a firm takes a decision not to sell goods on credit in order to avoid blocking up of funds in receivables and risk of bad debts, this item shall not appear in the balance sheet and al. Some large retail stores such as departmental stores, chain stores or super bazaars may take such decisions. But some decisions cannot be enforced by a business enterprise. Trade customs, competitions, and business practices force the company to sell goods on credit otherwise their existence will be threatened. The company, therefore, should establish a sound credit policy to suit it needs.
(iii) Policy of Credit Sales. Policy of credit sales also determines the size of investment in receivables. If credit is allowed only for the short term, its ratio with sale shall remain at lower ebb. If long – term credit is allowed, its ratio with sales may be higher. Moreover, the present value of money will always be higher hence; every businessman likes to collect the money as early as possible.
(iv) Stability of sales. In the business of seasonal character, total sales and the credit sales will go up in the season and therefore volume of receivables will also be large. On the other hand, if a firm supplies goods on installment basis, its balances in receivables will be high.
(v) Size and Policy of Cash Discount. It is also an important variable in deciding the level of investment in receivables. Cash discount affects the cost of capital and the investment in receivables. If cost of capital of the firm is lower in comparison to the cash discount to be allowed, investment in receivables will be less. If both are equal, it will not affect the investment at all. If cost of capital is higher than cash discount, the investment in receivables will be larger.
(vi) Credit and Collection Policy. Credit and collection policy of the firm affects to a large extent the amount of investment in receivables. The sales department of the concern to whom credit should be granted should decide it. If credit policy of the concern is liberal, the investment in receivables will be larger because credit will be extended even to those customers whose credit worthiness is not known or doubtful. If credit policy is stringent the credit will be extended only on selective basis to those whose credit worthiness is proven hence the size of receivables in this account will be lower. Moreover, if collection is made within stipulated time or a sound collection policy is enforced, the investment in receivables will naturally be lower.
(vii) Bill Discounting and Endorsement. If firm has any arrangement with the banks to get the bills discounted or if they are endorsed to third parties, the level of investment in this asset will be automatically low. If bills are not honored on due date, the investment will be larger.
SYSTEM OF CONTROL OF RECEIVABLES
It is in the interest of the enterprise to keep the investment in receivables in a controllable limit. The financial management should consider the following four factors, which control the receivables management cost at a minimum point.
(1) Deciding acceptable level of Risk. The first consideration in this regard is to decide to whom goods are top be sold bearing in mind the risk involved price credit extension involves costs like bad – debt loses, production and selling costs, administrative costs, cash discounts and opportunity cost. Because every sales transaction carries risk element, the financial management should consider the credit capacity of every customer before allowing any credit to him. Capacity is a subjective but five C’s of credit [character, capacity, capital, collateral (security) and conditions (terms of asset sale) represent a fair estimate of it. There are a number of sources to get the information regarding the credit – worthiness of potential buyers, such as trade references, bank references, and credit Bureau reports. Salesman’s opinion and published information, and the company must decide, relying upon the information collected, whether customers fails within an acceptable risk class or not.
(2) Terms of Credit Sales. Having decided to sell to a customer, the company has next to decide on the credit terms and the level of discount. The credit problem is just like an investment problem. The extension of credit represents an investment having resulting in larger profits. In deciding upon the credit terms to be offered to its customers, the enterprise should think over certain basic issues involved in it such as cost of capital, cash discounts, sale volume, potentially of sale, period of credit sale, liquidity of funds most important factors which affects the cost of capital of the firm. The financial manager costs and benefits of alternate credit terms to find out the most desirable credit terms. In deciding the credit terms, the firm should take care of the competitor’s reactions to the firm credit terms.
(3) Credit Collection Policy. Having completed for sale, the company will like to get the amount collected from its customers as early as possible to avoid bad – debt losses It needs following a sound and strict collection policy to keep the bad – debt losses at the minimum. A certain proportion of debts will run into bad inspite of the best efforts. So the company must provide for reserves for bad debts. Usually the companies provide 5% or 7% of sundry debtors for this purpose. The company should follow a collection procedure in a clear – cut sequence i.e. polite letter, progressively strong – worded reminders, personal visits and then legal action. Through the collection procedure should be firmly adhered to but individual cases should be considered in its merit.
Other important tool to control the credit collection is the record of age of outstanding debts. The management should stress to collect the oldest debt first.
(4) Analyzing the Investment in Receivables. The last but not the least important step in the process of management of receivables is to analyze their size form time to time with the help of certain rations such as calculation of average collection period, debtors turnover ration, ratio of receivables to current assets etc. A periodic analysis of receivables will help the management in keeping the amount of receivable within reasonable limits and is assessing the effectiveness of the management of receivables.
