RECEIVABLES MANAGEMENT THEORY
Q.1. Outline the importance of proper management of Sundry Debtors
If large amounts are tied up in sundry debtors, working capital requirements and consequently interest charges will be high. Also, bad debts and cost of collection of debts would be high.
If the investment in sundry debtors is low, the sales may be restricted, since the competitors may offer more liberal credit terms.
Hence, management of sundry debtors is in important issue and required proper policies and efficient execution of such policies.
Q.2. What are the aspects of management of debtors ?
The three basic aspects of management of sundry debtors are:
(1) Credit Policy -decisions on credit period to be allowed, early payment discount rates etc.
(2) Credit Analysis -decision on whether credit can be extended to a particular customer
Control over Receivables -steps for debtors follow-up, faster collection of debtors
Q.3. What are the costs of maintaining receivables ?
The cost of maintaining receivables comprises the following:
(1) Interest on Investment: Additional funds are blocked in receivables. This involves cost in the form of interest (in case of loan funds) or opportunity cost of capital (in case of own funds).
(2) Administrative Costs: Costs of record keeping, investigation of credit worthiness etc.
(3) Collection Costs: Cost of contacting customers, collecting cheques in person, outstation collection charges, etc.
(4) Defaulting Costs: Bad debts, legal charges in respect of suits pending against debtors etc.
Note: These costs are compared with benefits, i.e. Additional Contribution, in the evaluation of credit period or credit policy.
Q.4. What do you mean by credit policy? Outline its roie.
This involves decisions relating on the following aspects of credit:
(1) Length of the credit period;
(2) Discount Policy
(3) Other special items.
The credit policy determines the investment in sundry debtors, average collection period and bad debt losses. Hence, credit policy of a firm should enable it to achieve the following objectives:
(i) Increasing sales and market share
(ii) Increasing profits due to higher sale and higher margins on credit sales.
(i) Meeting competition.
Q.5. Write a brief note on Credit period.
Credit Period denotes the period allowed for payment by customers, in the normal course of business.
Credit period depends on a number of factors, for example :
(1) Nature of product i.e. if demand is inelastic, credit period may be small.
(2) Quantum of Sales -Credit may not be allowed if small quantities are purchased.
(3) Customs and Practices -normal trade practices and those followed by competitors
(4) Funds available with the Company
(5) Credit Risk i.e. possibility of bad debts
The credit period is generally stated in terms of net days. For example, if the credit terms are "net 45", it means that customers will repay credit obligations not later than 45 days.
Q.6. Write a brief note on Discount Policy.
In the context of Debtors Management, Discount Policy involves decisions relating to:
• Percentage of Cash Discount to be offered as incentive for early settlement of invoice.
• Period within which cash discount can be availed.
Discounts are given to speed up the collection of debts.. Hence, it improves the liquidity of the seller.
Normally, credit terms are expressed in this order: (a) the rate of cash discount, (b) the cash discount period and (c) the net credit period. For example, credit terms of "2/10 net 60" means that a cash discount of 2% will be granted if customer pays within 10 days; if he does not avail the offer he must pay within 60 days, being the credit period.
Q.7. Before credit is granted to a customer, a number of factors must be analysed. Discuss.
A firm selling on credit terms cannot extend credit to all customers. Credit granting decision is taken on a case-to-case basis, based on the following illustrative factors :
(a) Nature of Product: Generally perishable items are sold on "cash and carry" basis, while durable / non-perishable items may be sold on credit.
(b) Nature of customer: A Valued customer, who has long and favourable past dealings (c) with the firm may be given credit immediately, than a new customer. However, credit may also be offered for attracting new customer.
(d) Quantity purchased: Firms may decide to grant credit only beyond a certain lot size. For example, sale upto 5 kg per invoice is made on cash basis only, while orders beyond 5 kg may be supplied on credit.
(e) Value of sale: Sometimes, the invoice value (instead of quantity) may be the determinant in a credit decision. For example, credit may be granted for amounts exceeding Rs. 15,000/-.
(f) Credit worthiness of the customer: The credit-worthiness of the customer is the most crucial factor in deciding whether credit should be granted or not. This is based on past experience (for existing customers) and credit analysis (for existing and new customers).
(g) Risk of Bad Debts: The extent of risk of bad debts that a firm can bear should be determined. For example, if there is a 1% chance of bad debts, the firm may take the risk of credit supply, but when the chance of bad debts is 55%, credit should not be granted.
Credit granting is a two-phase decision making process :
Phase I - Whether Credit should be granted at all ? -Decision to be based on Credit Rating.
Phase II - Upto what limits and how long credit be granted ? -Decision to be based on Cost- Benefit Analysis.
Q.8. Write short note on decision tree analysis of credit granting.
Decision Tree Analysis is one of the techniques of Cost - Benefit Analysis as to whether credit can be granted or not.
PROBABILITY Under this technique, future uncertain events (like payment by customer, non-payment by customer) are assigned probabilities, based on the chance estimated by the firm. For example, if the chances of recovering the dues are 9 out of 10, the probability of recovery is 0.9 or 90% and that of default is 0.1 or 10%.
Expectations: Based on the probabilities, the net expected earnings of each event is determined as under:
• Expected Profit in case of payment - [Sale Less Costs] x Probability of Payment
• Expected Loss in case of default = Costs x Probability of Default
This is because, when a customer pays, the seller makes profit but when he fails to pay the amount the cost of the product is also lost.
Decisions are based on the expected profits / losses. If there is net expected profit, credit may be granted. However in case of net expected loss, credit should not he granted.
Q.9. Write short notes on Collection Policy.
ROLE OF COLLECTION POLICY
Average Collection Period and Bad Debt losses are reduced by efficient and timely collection of debtors. Hence, a proper collection policy should be laid down.
ASPECTS OF COLLECTION
Policy: The following aspects should be covered in Collection Policy and procedures.
• Timing of the collection process -when to start reminding-etc.
• Despatch of reminder letters to customers.
• Personal follow-up by Company's representatives and telephonic calls.,
• Appointment of agents for collection or follow-up.
• Dealing with default accounts, legal action to be initiated, notice to defaulting customer etc.
COST BENEFIT ANALYSIS
There are certain routine costs associated with collection from customers e.g. contacting customers, collecting cheques in person, collection agency fees etc. If a firm spends more on collection of debts, it is likely to have smaller bad debts. Hence the amount of
collection costs to be incurred should be determined by Cost-Benefit Analysis i.e. level of expenditure on one hand and decrease in bad debt losses and investment in debtors on the other.