In ordinary course of business the firm makes sale of goods and services on cash and credit basis. The extension of credit allows the customers to pay, after reasonable period of time, for the received goods and services.
The objective of receivables management is to find the optimal trade-off between the benefits and the costs associated with the extension of credit. The extension of credit increases the sales and the profits and on the other hand, tightening of credit hampers the sales and also increases the administrative costs incurred in collecting the receivables.
Receivables management involves crucial decisions in
1. Formulation of a credit policy
2. Credit evaluation procedure and credit granting decision
3. Monitoring receivables
The credit policy of a firm determines whether to extend credit or not if so, to what period and what will be the discount and to what extent efforts are to be made for collection of receivables. So credit policy deals with:
These represent basic criteria for extension of credit. Credit standards are generally laid down based on credit worthiness, which determines the ability and willingness of the borrower to make payments, and financial ratios, which help in evaluating the performance, growth and ability of the borrower to make payments. A firm may have stiff credit standards where the firm does not extend credit or liberal credit standards where the firm extends credit liberally. These two are extreme cases. Generally, the firm will trade off between these two extreme positions.
This is the period extended to the customers to pay for purchases. It generally varies from a month to 2 months. If a firm allows credit for 15 days with no discount to induce early payment, its credit terms are stated as “net 15”.
Lengthening the credit period will lead to an increase in sales and accounts receivables and increased bad debts. A shortened credit period would have opposite influences.
In order to ensure prompt payments by customers, firms generally provide cash discount. This represents the percentage of discount available if payment is made in specified period. For example, 1/20, net 30 means that a discount of 1 percent is offered if the payment is made by the 20th day, otherwise the full payment is due by the 30th day. Liberalized credit policy involves more cash discount for a lengthened period. For example, if cash discount policy is 3 / 20, net 30 or 1 / 25, net 30 or 2 / 25, net 30 it indicates liberal credit policy compared to the earlier discussed cash discount policy. Stiff credit policy will have less cash discount and shorter period available for availing cash discount. For example, if cash discount policy is 0.5 / 20, met 30 or 1 / 10, net 30 or 0.5 / 10, net 30 it indicates tightening of credit policy as compared to the earlier discussed cash discount.
The objective of the collection policy is to achieve timely collection of receivables, thereby releasing funds locked up in receivables for a longer period than they should have been under the credit terms and to minimize bad debt losses. The collection program involves (1) letters including reminders (2) telephone calls for personal contact (3) personal visits (4) legal action (5) help of collection agencies.
After establishing credit standards a firm must establish a credit evaluation process to determine to whom the credit can be extended. In judging the credit worthiness of the applicant, the factors to be considered by the firm are of three C’s (1) character (2) capacity (3) collateral. Character refers to willingness to pay, capacity refers to ability to pay and collateral represents the security offered by the firm in the form of mortgages.
Establishing of credit evaluation process involves two stages (1) obtaining credit information (2) analysis of credit information. Credit information of a firm will be obtained through audited reports, financial statements, bank references and trade references. Analysis of credit information can be done by financial ratios and by firm’s experience because analysis of credit information includes evaluation of both qualitative and quantitative aspects of the credit receiver. The credit granting decision can also be made using decision tree analysis, the explanation of which is beyond the scope of this article.