LG 5 15.4 Accounts Receivable Management

LG 4 LG 5 15.4 Accounts Receivable Management

The second component of the cash conversion cycle is the average collection period. This period is the average length of time from a sale on credit until the payment becomes usable funds for the firm. The average collection period has two parts. The first part is the time from the sale until the customer mails the pay- ment. The second part is the time from when the payment is mailed until the firm has the collected funds in its bank account. The first part of the average collection period involves managing the credit available to the firm’s customers, and the second part involves collecting and processing payments. This section of the chapter discusses the firm’s accounts receivable credit management.

The objective for managing accounts receivable is to collect accounts receiv- able as quickly as possible without losing sales from high-pressure collection techniques. Accomplishing this goal encompasses three topics: (1) credit selection and standards, (2) credit terms, and (3) credit monitoring.

CREDIT SELECTION AND STANDARDS Credit selection involves application of techniques for determining which cus-

tomers should receive credit. This process involves evaluating the customer’s credit standards

creditworthiness and comparing it to the firm’s credit standards, its minimum

The firm’s minimum

requirements for extending credit to a customer.

requirements for extending credit to a customer.

Five C’s of Credit

five C’s of credit One popular credit selection technique is the five C’s of credit, which provides a

The five key dimensions—

framework for in-depth credit analysis. Because of the time and expense involved,

character, capacity, capital,

this credit selection method is used for large-dollar credit requests. The five C’s are

collateral, and conditions— used by credit analysts to

1. Character: The applicant’s record of meeting past obligations.

provide a framework for in-

2. Capacity: The applicant’s ability to repay the requested credit, as judged in

depth credit analysis.

terms of financial statement analysis focused on cash flows available to repay debt obligations.

3. Capital: The applicant’s debt relative to equity.

4. Collateral: The amount of assets the applicant has available for use in securing the credit. The larger the amount of available assets, the greater the chance that a firm will recover funds if the applicant defaults.

5. Conditions: Current general and industry-specific economic conditions, and any unique conditions surrounding a specific transaction.

Analysis via the five C’s of credit does not yield a specific accept/reject deci- sion, so its use requires an analyst experienced in reviewing and granting credit requests. Application of this framework tends to ensure that the firm’s credit cus-

PART 7

Short-Term Financial Decisions

Credit Scoring Credit scoring is a method of credit selection that firms commonly use with high-

credit scoring volume/small-dollar credit requests. Credit scoring applies statistically derived

A credit selection method

weights to a credit applicant’s scores on key financial and credit characteristics to pre-

commonly used with high-

dict whether he or she will pay the requested credit in a timely fashion. Simply stated,

volume/small-dollar credit

the procedure results in a score that measures the applicant’s overall credit strength,

requests; relies on a credit score determined by applying

and the score is used to make the accept/reject decision for granting the applicant

statistically derived weights to

credit. Credit scoring is most commonly used by large credit card operations, such as

a credit applicant’s scores on

those of banks, oil companies, and department stores. The purpose of credit scoring

key financial and credit

is to make a relatively informed credit decision quickly and inexpensively, recognizing

characteristics.

that the cost of a single bad scoring decision is small. However, if bad debts from scoring decisions increase, then the scoring system must be reevaluated.

Changing Credit Standards The firm sometimes will contemplate changing its credit standards in an effort to

improve its returns and create greater value for its owners. To demonstrate, con- sider the following changes and effects on profits expected to result from the relaxation of credit standards.

Effects of Relaxation of Credit Standards

Variable

Direction of change

Effect on profits

Sales volume

Increase

Positive

Investment in accounts receivable Increase

Negative

Bad-debt expenses

Increase

Negative

If credit standards were tightened, the opposite effects would be expected.

Example 15.6 3 Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10 per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per

unit is $6. The firm’s total fixed costs are $120,000.

The firm is currently contemplating a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63,000 units; an increase in the average collection period from 30 days (the current level) to

45 days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%. The firm determines that its cost of tying up funds in receivables is 15% before taxes.

To determine whether to relax its credit standards, Dodd Tool must calculate its effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable, and the cost of marginal bad debts.

Additional Profit Contribution from Sales Because fixed costs are “sunk” and therefore are unaffected by a change in the sales level, the only cost relevant to a change in sales is variable costs. Sales are expected to increase by 5%, or 3,000 units. The profit contribution per unit will equal the difference between the sale price per unit ($10) and the variable cost per unit ($6). The profit contribution per unit therefore will be $4. The total additional profit contribution from sales

CHAPTER 15 Working Capital and Current Assets Management

Cost of the Marginal Investment in Accounts Receivable To determine the cost of the marginal investment in accounts receivable, Dodd must find the difference between the cost of carrying receivables under the two credit standards. Because its concern is only with the out-of-pocket costs, the relevant cost is the variable cost. The average investment in accounts receivable can be calculated by using the following formula:

Average investment = Total variable cost of annual sales in accounts receivable (15.9)

Turnover of accounts receivable where

365 Turnover of accounts receivable = Average collection period

The total variable cost of annual sales under the present and proposed plans can

be found as follows, using the variable cost per unit of $6.

Total variable cost of annual sales

Under present plan: ($6 * 60,000 units) = $360,000 Under proposed plan: ($6 * 63,000 units) = $378,000

The turnover of accounts receivable is the number of times each year that the firm’s accounts receivable are actually turned into cash. It is found by dividing the average collection period into 365 (the number of days assumed in a year).

Turnover of accounts receivable

Under present plan:

Under proposed plan:

By substituting the cost and turnover data just calculated into Equation 15.9 for each case, we get the following average investments in accounts receivable:

Average investment in accounts receivable

Under present plan:

Under proposed plan:

We calculate the marginal investment in accounts receivable and its cost as follows:

Cost of marginal investment in accounts receivable

Average investment under proposed plan $46,667 - Average investment under present plan

29,508 Marginal investment in accounts receivable

$17,159 * Cost of funds tied up in receivables

0.15 Cost of marginal investment in A/R

PART 7

Short-Term Financial Decisions

The resulting value of $2,574 is considered a cost because it represents the max- imum amount that could have been earned before taxes on the $17,159 had it been placed in an equally risky investment earning 15% before taxes.

Cost of Marginal Bad Debts We find the cost of marginal bad debts by taking the difference between the levels of bad debts before and after the proposed relax- ation of credit standards.