Copyright  1998 by Harcourt Brace &Company Chapter 5 Accounts Receivable Management A / R

Copyright  1998 by Harcourt Brace &Company The Cash Flow Timeline Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid

Copyright  1998 by Harcourt Brace &Company Learning Objectives v Define credit policy and indicate its components v Describe the typical credit-granting sequence v Apply net present value analysis to credit extension decisions v Define credit scoring and explain limitations v List the elements in a credit rating report v Describe how receivables management can benefit from EDI v Explain how an expert system can help a credit analyst

Copyright  1998 by Harcourt Brace &Company Trade Credit and Shareholder Value v Trade credit arises when goods sold under delayed payment terms v Traced to Romans due to obstacles faced in transferring money through various trading areas v Credit terms are taken for granted today v Value can be added by managing three areas: –aggregate investment in receivables –credit terms –credit standards v Over-investing in receivables can be costly v...but, if credit terms are not competitive, then lost sales can be costly

Copyright  1998 by Harcourt Brace &Company Conclusion v Minimize bad debts and outstanding receivables v Maintain financial flexibility v Optimize mix of company assets v Convert receivables to cash in a timely manner v Analyze customer risk v Respond to customer needs

Copyright  1998 by Harcourt Brace &Company A/R Management and Shareholder Value Marketing Strategy Marketing Strategy Market Share Obj. Market Share Obj. Aggregate Inv. in A/R Aggregate Inv. in A/R Credit Terms Credit Standards Total Dollar Investment Total Dollar Investment Length of Time to Pay Length of Time to Pay Acceptance of Marg Cust. Max Shareholder Value Max Shareholder Value

Copyright  1998 by Harcourt Brace &Company Trade vs. Bank Credit v Length of terms v Security v Amounts involved v Resource transferred (goods vs. money) v Extent of analysis

Copyright  1998 by Harcourt Brace &Company Why Extend Credit? v Financial Motive v Operating Motive v Contracting Motive v Pricing Motive v All reasons are related to market imperfections

Copyright  1998 by Harcourt Brace &Company Financial Motive v Potential of getting a higher price v Sellers raise capital at lower rates than customers and have cost advantages vis-a-vis banks due to: –similarity of customers –the information gathered in the selling process –lower probability of default (the goods purchased are an essential element of the buyer’s business) –seller can more easily resell product if payment is not made.

Copyright  1998 by Harcourt Brace &Company Operating Motive v Respond to variable and uncertain demand v Change credit terms rather than: –installing extra capacity, –building or depleting inventories, –or forcing customers to wait.

Copyright  1998 by Harcourt Brace &Company Contracting Cost Motive v Buyer gets to inspect goods prior to payment v Seller has less theft with separation of collection and product delivery

Copyright  1998 by Harcourt Brace &Company Pricing Motive v Change price by changing credit terms

Copyright  1998 by Harcourt Brace &Company The Credit Decision Process Marketing contact Credit investigation Customer contact for information Finalize written documents, e.g.. security agreements Establish customer credit file Financial analysis Time

Copyright  1998 by Harcourt Brace &Company Basic Credit Granting Model S - EXP(S) S - EXP(S) NPV = VCR(S) 1 + iCP 1 + iCPWhere: NPV = net present value of the credit sale VCR = variable cost ratio S = dollar amount of credit sale EXP = credit administration and collection expense ratio i = daily interest rate CP = collection period for sale

Copyright  1998 by Harcourt Brace &Company Establishing a Credit Policy v Should we extend credit? v Credit policy components v Credit-granting decision

Copyright  1998 by Harcourt Brace &Company Should We Extend Credit? v Follow industry practice v Extent and form of credit offer –in-house credit card –sell receivables to a factor –captive finance company?

Copyright  1998 by Harcourt Brace &Company Components of Credit Policy v Development of credit standards –profile of minimally acceptable credit worthy customer v Credit terms –credit period –cash discount v Credit limit –maximum dollar level of credit balances v Collection procedures –how long to wait past due date to initiate collection efforts –methods of contact –whether and at what point to refer account to collection agency

Copyright  1998 by Harcourt Brace &Company Credit-Granting Decision v Development of credit standards v Gathering necessary information v Credit analysis: applying credit standards v Risk analysis

Copyright  1998 by Harcourt Brace &Company Grant-Granting Sequence No Order and credit request received New/increased credit limit Material change in customer status Redo credit investigation Size of proposed credit limit Medium Medium Small Large Indepth credit invest. Indepth Moderate Minimal Check new A/R total vs credit lmt Check new A/R total vs credit lmt NoYes Yes Extend Credit No Yes Recorddisposition Set up,post A/R, ship

Copyright  1998 by Harcourt Brace &Company Credit Standards v Based on five C's of Credit –Character –Capital –Capacity –Collateral –Conditions v Determine risk classification system v Link customer evaluations to credit standards

Copyright  1998 by Harcourt Brace &Company Gathering Information v credit reporting agencies, e.g.. Dun & Bradstreet v credit interchange bureaus, NACM v bank letters v references from other suppliers v financial statements v field data gathered by sales reps

Copyright  1998 by Harcourt Brace &Company Credit Analysis: Applying the Standards v Nonfinancial –concerned with willingness to pay, character v Financial –ability to pay, financial ratios etc.. (other C’s of credit) v Credit scoring models –Example: Y = (INCOME) (PAYHIST) (EMPLOYMT)

Copyright  1998 by Harcourt Brace &Company Setting Credit Limits v Survey reasons for setting limits –Control risk exposure: 53.1% –Customer financial position: 27.9% –Experience with customer: 5.8% –Other reasons: 4.9% v Setting the limit –customer needs –10 percent of customer net worth –percentage of high credit reported by other suppliers/banks –judgement

Copyright  1998 by Harcourt Brace &Company Factors Affecting Credit Terms v Competition v Operating cycle v Type of good (raw materials vs finished goods, perishables, etc.) v Seasonality of demand v Cost v Customer type v Product profit margin

Copyright  1998 by Harcourt Brace &Company Survey Results v Two-thirds offered credit but no cash discount. Most popular credit period was net 30 v One-fourth offered cash discounts, 70% had 2/10, net 30 with 25% offering 1/10, net 30 v Industry influence: 80% of wholesalers vs 36% of service firms offered cash discounts v 80% of firms charged a late fee, usually 15-20%.

Copyright  1998 by Harcourt Brace &Company Cash Discounts v The lower the VC, the higher the feasible discount v Based on company’s cost of funds v Consider timing effect when changing discounts v Should be based on product’s price elasticity v Higher the bad debt experience, higher the optimal discount

Copyright  1998 by Harcourt Brace &Company Practice of Taking Cash Discounts v 51% of firms always took cash discount v 40% sometimes v 9% take discount and pay late v Study found that 4 or 5 companies would be more profitable if cash discount was eliminated

Copyright  1998 by Harcourt Brace &Company A/R Management in Practice v Discounts appear to be changed to match competitors, not inflation or interest rates v The higher a firm’s contribution margin, the more likely the firm should be to offer discounts. v A price cut is thought to have more impact than instituting a cash discount v Having a greater amount of receivables does not necessarily relate to use of penalty fees v The greater amount of receivables does not relate to a more active credit evaluation.

Copyright  1998 by Harcourt Brace &Company Receivables, Collections, and EDI v If credit approval is delayed... –buyers using EDI purchase orders and JIT manufacturing can encounter serious problems. –sellers can now ship within hours of receiving orders...thus seller must be able to handle electronically transmitted orders. v Seller may also issues electronic invoices and be paid electronically using an EDI-capable bank so that remittance data can be automatically read by seller’s A/R system v Trend is for use of data transmission to automate the cash application process

Copyright  1998 by Harcourt Brace &Company Emergence of Expert Systems v Example of decision rule: “If gross income is equal to or greater than $20,000 and the applicant has not been delinquent and gross income per household member is equal to or greater than $12,000 and debt/equity ratio is equal to or greater than 30% but less than 50% and personal property is equal to or greater than $50,000, then grant credit.”

Copyright  1998 by Harcourt Brace &Company Summary v Investment in A/R represents significant investment v Key aspects outlined –credit policy –credit standards –credit granting sequence –credit limits –credit terms v Management of A/R is influenced by what competitors are doing not by shareholder wealth considerations v Proper use of NPV techniques can ensure that credit decisions enhance shareholder value.