Management of

UNIT 4 MANAGEMENT OF RECEIVABLES Receivables

Objectives
The objectives of this unit are to:
• Highlight the need for offering credit in the operation of business
enterprises.
• Discuss and design various elements of credit policy.
• Analyse the impact of changes in the terms of credit policy.
• Discuss different credit evaluation models in evaluating the credit
worthiness of customers.
• Discuss various techniques available in monitoring receivables in order
to speed up the collection process.
• Explain options available before the credit managers in dealing with
delinquent customers.
• Analyse the strategic importance of receivables management in designing
business strategies.

Structure
4.1 Introduction
4.2 Credit Policy
4.3 Credit Evaluation Models
4.4 Monitoring Receivables
4.5 Collecting Receivables
4.6 Strategic Issues in Receivables Management
4.7 Summary
4.8 Key Words
4.9 Self-Assessment Questions
4.10 Further Readings

4.1 INTRODUCTION
“Buy now, pay later” philosophy is increasingly gaining importance in the
way of living of the Indian Families. In other words, consumer credit has
become a major selling factor. When consumers expect credit, business
units in turn expect credit form their suppliers to match their investment in
credit extended to consumers. If you ask a practicing manager why
her/his firm offers credit for the purchases, the manager is likely to be
perplexed. The use of credit in the purchase of goods and services is so
common that it is taken for granted. The granting of credit from one
business firm to another, for purchase of goods and services popularly
known as trade credit, has been part of the business scene for several
years. Trade credit provided the major means of obtaining debt financing
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Management of by businesses before the existence of banks. Though commercial banks
Current Assets
provide a significant part of requirements for working capital, trade credit
continues to be a major source of funds for firms and accounts receivables
that result from granting trade credit are major investment for the firm.
The importance of accounts receivables can be seen from Table 4 .1,
which presents investments in accounts receivables for different industries
over the years. This is expected to provide an idea of the size of investment
in receivables in the Indian Industry.

Going by the Data of the Bombay Stock Exchange (as on 07-04-2022), there
are companies having investment above Rs.10,000 crore in terms of volume.
They included companies like IRFC with total sundry debtors at Rs.1,65,569
crore, L&T with Rs.29,948 crore, TCS with Rs.25,222 crore, Infosys with
Rs.16,394 crore, NTPC with Rs.13,702 crore and IOC with Rs.13,398 crore.
The most striking fact of the trend is that there are 25 companies, whose
investment in Sundry Debtors exceeded 70 per cent of the total current assets.
These details are provided in the following Table-4.1.

Table-4.1: Select Indian Companies, whose Invest in Debtors is above 70

per cent

S. No. Name of the Company Amount (Rs. Per cent of

Crore) Current Assets
1. IRFC 165,569 99.7
2. L&T 29,948 81.9
3. TCS 25,222 88.9
4. PTC India 5836 93.3
5. NLC India 5611 73.4
6. Tech Mahindra 5153 83.1
7. Rajesh Exports 4563 81.6
8. Hind Constructions 4398 89.6
9. Indus Towers 3829 99.7
10. Kalpataru Power 3732 80.4
11. NHPC 3206 75.5
12. Bharti Airtel 3178 75.4
13. Reliance Infra 2848 95.5
14. NFL 2634 84.6
15. ITI 2552 77.5
16. HFCL 2528 80.8
17. NCC 2521 72.3
18. Glenmark 2489 76.2
19. ISGEC Heavy Engg. 2359 79.8
20. GE Power India 2213 84.0
21. Spicejet 2040 91.6
22. L&T Infotech 2021 83.4
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 Management of
23. Rattan Power 1951 79.3 Receivables
24. GET & D India 1905 74.9
25. Sterlite Techno 1376 73.6
Source: Data of the Bombay Stock Exchange:
(https://moneycontrol.com/stocks/marketinfo/sdrs/bse/index.html)

Management of Current Assets

With the increasing popularity of credit card business in India and abroad, a
new dimension got added to the credit market. As per the Report of the
Research and Markets titled ‘Credit Card Market in India-2022; the total
value of credit and transactions is expected to reach INR 51.72 trillion by the
end of Financial Year 2026-27; registering a Compounded Annual Growth
Rate (CAGR) at 39.22 per cent during 2022-27. Banks are estimated to add
about 1.2 million new credit cards, every month. Though the volume of credit
generated through credit card mechanism is short-term, it has emerged one of
the great contributors in accelerating sales volumes.
The investment in accounts receivable is an important aspect which
requires careful management. Besides the cost of investment, there are
two types of risks which are associated with the accounts receivable
management. One is the risk of OPPORTUNITY LOSS and the other
LIQUIDITY risk. The firm has to extend credit to its customers to
generate enough sales. The grant of credit is an important tool to realize
the operating plans and budgets of the company. But at the same time
management has to see that the company has not extended too much of
credit to its customers which has resulted in high degree of liquidity risk.
By liquidity risk we mean the ability to collect back the amounts due from
the customers. This would happen if the company extends the credit to
customers whose financial position is doubtful or weak and subsequently
the funds tied up with them are recovered after a long period or they are
not at all realised. If this happens it would result in the companies’ ability
to meet its own obligations and thus affecting short term and long term
solvency of the company. The decision to extend the credit to its
customers also determines the timing and amount of cash flows accruing
to the company.

At the same time minimisation of liquidity risk would imply the risk of
opportunity loss. The opportunity loss here means loss of sales by refusing
the credits to its potential customers. This would further affect the loss of
revenue and the loss of profits. Thus the objective of accounts receivable
management is to arrive at an optimum balance of these two risks and
help the company to realize its operating plans. This balancing is not a
static but a dynamic one. To arrive at the balancing of these two risk, the
company would frequently require to adjust their credit standards, credit
terms and credit policies. Management of the company would also be
required to consider general economic conditions while making such
adjustments. Covid-19 has been one such example, where every activity
came to a grinding halt due to a series of lock downs imposed across the
country.
75
Management of While high investments in accounts receivable warrant efficient management,
Current Assets
significant differences between industries call for proper structuring of credit
policy that match the industry norms. These two are essential issues in
management of receivables. The receivables management system thus
involves the following:
• Terms of credit
• Assessing customers’ credit worthiness to grant credit
• Monitoring the level of accounts receivables and improving collection
efficiency.

Setting of terms of credit is first step, in the receivables management. It is a

corporate policy and thus has a close interrelationship with other corporate
policies. For example, if a company pursues a policy of market leadership,
then it requires aggressive credit policy to achieve maximum sales volume.
Terms of credit requires management to decide period of credit, a broad
guideline on the eligibility of credit, credit limit for different customers and
discount rate offered to customers who settles the bill within a predetermined
period. Credit policy is determined by trading off risk associated with
granting credit and additional revenue available from granting credit. The
credit policy once determined is fixed in the short-run and may warrant
periodic adjustment depending on the changes in environment and
corporate policies.
Determining creditworthiness of customers, first, requires a system to
collect basic information about the customers and then fit the data into a
Model that determines the suitability of the customer in granting credit and
other credit terms. Once credit is granted, the focus is shifted to collection
of dues in time. The efficiency of receivables management is measured by
comparing the extent to which collection flows are in line with credit
terms.

The objectives that drive the above issues of receivables management are:
1) Obtain maximum (optimum) volume of sales.
2) Maintain proper control over the quantum or amount of investment in
debtors.
3) Exercise control over the cost of credit and collections.

Activity 4.1
i) Why companies sell/provide goods/services on credit basis?
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ii) How does the decision on granting credits affect the finance of the Management of
Receivables
company?
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iii) Analyse the impact of Covid-19 on the investment in receivables.
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4.2 CREDIT POLICY

Designing credit policy is the first step in receivables management. In
designing credit policy, the management can follow two broad approaches.
Firstly, the policy can be designed under the assumption of unlimited
production/sales and funds available for investment in receivables. If credit
policy is designed under this assumption and subsequently some
constraints are experienced on sales or funds available for receivables,
then managers have to restrict the credit at the time of implementing the
credit policy. But this may cause certain difficulties to customers because
of deviation from the announced credit policy. For example, if a company
announces that credit will be unlimited to certain categories of customers
based on unlimited funds assumption and subsequently refuse to grant
credit due to limited funds available for investment in receivables, it will
create hardship to the customer. Under the second approach, the credit
policy could be designed keeping in mind the limitations on production/
sales volume and funds available for investment in receivables. This is aimed
to achieve optimum utilisation of production capacity and funds available
for receivables. It also ensures consistency of credit policy.

The credit policy consists of the following components:

• Credit Period
• Discount
• Credit Eligibility
• Credit Limit

a) Credit Period
Decision on credit period is determined by several factors. It is important
to check the credit period given by other firms in the industry. It would be
difficult to sustain by adopting a completely different credit policy as 77
Management of compared to that of industry. For example, if the industry practice is 30
Current Assets
days of credit period, a firm which offers 120 days credit would certainly
attract more business but the cost associated with managing longer credit
period also increases simultaneously. On the other hand, if the firm
reduces the credit period to 10 days, it would certainly reduce the cost of
carrying receivables but volume would also decline because many
customers would prefer other firms, which offer 30 days credit. In other
words, granting trade credit is an aspect of price.

The time that the buyer gets before payment is due, is one of the
dimensions of the product (like quality, service, etc.) which determine the
attractiveness of the product. Like other aspects of price, the firm’s terms
of credit affect its volume. All other things being equal, longer credit
period and more liberal credit-granting policies increase sales, while shorter
credit period and more stringent credit- granting policies decrease sales.
These policies also affect the level and timing of certain costs. Evaluation
of credit policy changes must compare with the changes in sales and
additional revenues generated by the sales as a result of this policy
change and costs effects. While additional volume and revenue associated
with such additional volume are clear and measurable, the cost effects
require further analysis.

Cost of Extending Credit Period

Lengthening credit period delays the cash inflows. For example, suppose a
firm increases the credit period from 30 days to 90 days. Customers, old
as well as new, will now pay at the end of 90 days and the cash inflows
from these sales would occur further into the future. That means, the firm
has to delay in settling its dues to others or resort to short-term borrowing if
the payments cannot be delayed. The interest cost of short-term borrowing
arises mainly on account of extending the credit period.

Example 4.1
Flysafe Travels is one of the large air-ticket sellers in the city. It offers
one- month credit for the air-tickets booked through the firm. Since it also
gets one- month credit from the air-lines, the payables and receivables are by
and large matched and there is no need of additional investment. The
present annual turnover of the firm is around Rs.40 crores. The firm is
now contemplating to increase the credit period from one-month to two-
months and this is expected to increase the volume by 40% and nearly
80% of the customers (old and new) are expected to avail the new credit
facility. The firm has just concluded a credit proposal with a nationalised
bank to meet payment liability at 15%. How much more it costs for
Flysafe Travels to meet the increased credit volume.

Revised Sales Rs. 40 cr. × 1.40 = Rs. 56.00 cr.

Customers, who are expected to use additional
credit period = 80%
Sales which are likely to be collected at the end of
78 second month = Rs. 56 × 0.80 = 44.80 cr.
Total Credit Period = 2 months Management of
Receivables
Less: Credit given by Air-line operators = 1 month
Funds required for additional credit period of 1 month
Interest cost per year = 15%
Additional interest cost to sustain 1 month credit = Rs. 44.80 × 15%
= Rs. 6.72 cr.

The cost of Rs. 6.72 cr. is compared with the additional profit generated
by the new sales to decide whether it is desirable to increase the credit
period or not.

Changes in credit period also affect the cost of carrying inventory. This
arises mainly on account of increased volume attracted by the extended
credit period, which in turn requires more inventory to support increased
volume. For example, if expected additional sales is Rs. 5 cr. and the
firm’s present operating cycle requires an inventory at 20% of its sales
value, the additional inventory requirement is Rs. 1 cr. Again, inventory
is a idle investment and consumes cost in the form of cost of storage and
cost of carrying inventory. If the two costs together amount to 17%, the
changes in credit policy has caused an additional cost of Rs. 17 lakhs.
Another cost associated with extending credit term and increase in sales
volume on account of extended credit term is discount and bad debts
expenses. Increase in credit sales and period would prompt firms to
announce attractive discount policy for prompt payment. Similarly, bad
debts will also go up due to increased volume of credit sales.

The cost of collection also goes up when the credit period is increased
and more credit volume is done. The cost of collection includes cost of
maintaining records of credit sales, telephone calls, letters, personal visits
to customers, etc. These costs tend to show an uptrend with increased
volume and credit sales.

Example 4.2
Suppose the cost of collection for the Flysafe Travels is 1% and bad
debts are likely to increase from 0.50% to 0.75% due to increased credit
period. These costs are to be added along with interest cost on additional
investments in receivables arising out of changes in credit period. These two
costs are computed as follows:

Cost of Collection

Case Sales (Rs.) Cost of Collection (Rs.)

Present 56.00 cr. 0.56 cr.
Previous 40.00 cr. 0.40 cr.
Difference 16.00 cr. 0.16 cr.

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Management of Cost of Bad Debts
Current Assets
If we follow the methodology adopted earlier in computing cost of
collection, then the additional bad debts works out to Rs. 0.22 cr. (i.e.,
0.75% of Rs. 56 cr. less 0.50% of Rs. 40 cr.). However, the entire value
of additional bad debts is not on account of change in credit period. A
part of it is on account of increase in sales. The actual impact of increase
in bad debts can be computed in two stages as follows:

Increased cost of bad debts for existing sales of Rs. 40 cr.

Bad debts as per revised percentage of bad debts, 0.75% of
Rs. 40 cr. = 0.30 cr.

Bad debts as per earlier percentage of bad debts, 0.50% of

Rs. 40 cr. = 0.20 cr.

Increased value of bad debts attributable to new credit policy

= 0.10 cr.
Increased cost of bad debts for additional sales of Rs. 16 cr.
Bad debts as per revised percentage of bad debts, 0.75% of
Rs. 16 cr. = 0.12 cr.
Bad debts as per existing percentage of bad debts, 0.50% of
Rs. 16 cr. = 0.08 cr.
Increased value of bad debts attributable to new credit policy = 0.04 cr.

Total value of bad debts attributable to new credit policy (0.10+0.04) =

Rs. 0.14 cr.
The balance of Rs. 0.08 cr. is on account of increase in sales.

b) Discount
When a firm pursues aggressive credit policy, it affects cash flows in the
form of delayed collection and bad debts. Discounts are offered to the
customers, who purchased the goods on credit, as an incentive to give up
the credit period and pay much earlier. For example, suppose the terms of
credit is “3/10 net 60”. It means if the customer, who gets 60 days credit
period can pay within 10 days from the date of purchase and get a
discount of 3% on the value of order.

Since the customer uses the opportunity cost of funds and availability of cash
in taking decision, the cash discount should be set attractive. The discount
quantum should be greater than interest rate of short-term borrowings.

Example 4.3
Excel Industries is presently offering a credit period of 60 days to some of
their customers. It now intends to introduce a discount policy of “3/10 net
60”. We will now see how a customer would evaluate the discount policy
here. If a customer bought goods worth of Rs. 1 lakh, the amount due at
80 the end of 60 days is Rs. 1 lakh and if he pays within 10 days, it costs Rs.
97,000. The customer evaluates the interest cost of Rs.97,000 for 50 days Management of
Receivables
to take a decision on availing the discount and advancing the payment.
Suppose the interest cost is 15%, then cost of interest for 50 days on
Rs.97,000 is Rs. 97,000 × 0.15 × (50/365), which works out to Rs.
1,993.15. Since the discount value is greater than the cost, it is profitable
for the customer to pay the money earlier within 10 days and avail the
discount. In other words, if the customer borrows money for 50 days at
15% interest cost in the short-term market or bank and uses the money to
settle the account within 10 days, the loan amount due at the end of two
months is Rs.98,993.15, which is lower than Rs. 1,00,000 due at the end
of the period in the normal course. If the cost of borrowing is 24%, the
customer would take a different decision. The interest cost of borrowing for
50 days in this case is Rs.3189, which is greater than the discount benefit.
Of course, the customer will look into the availability of funds and other
options available to the firm before deciding whether to accept the offer or
not.

How do we evaluate the discount terms of the company? Cost of funds is an

important factor but it is not the only factor in evaluating the discount
term. For instance, if the cost of borrowing is 15% of this firm also, then
the discount value of Rs. 3000 is to be compared to the interest cost of
Rs.97000 at 15% for 50 days, which works out to Rs.1993.15. In other
words, if the company is in a position to raise a loan of Rs. 97,000 for 50
days at 15% cost, there is no need to raise Rs. 97000 in the form of
offering discount to the customers, where the cost of offering discount
works out to Rs. 3000. But, there are other issues in deciding the discount
policy. Cash discount reduces the probabilities of delayed collection as well
as bad debts. In the above example, we have assumed that the customer,
who has not availed the discount, promptly pays up the dues at the end of
50 days. The interest cost of Rs.1993.15 will undergo a change if the
customer fails to pay at the end of 50 days. Further, the value of bad
debts will go up if more credit sales are made and period of credit
increases.

Example 4.4
Royal Textiles is contemplating to increase the credit period from 30 days
to 60 days. This is expected to increase the sales from Rs. 20 cr. to Rs.
23 cr. but the bad debts is also expected to go up from 0.5% on sales to
1% on sales. Marketing Director felt that by giving 3% discount for
payment within 10 days would prompt several customers to avail the
facility and thus would bring back the bad debts value to 0.5% on sales.
The interest cost of short-term borrowing is 15% and nearly 40% worth of
sales are expected to be collected at the end of 10 days. Is it desirable to
introduce the discount policy?
As far as interest cost component is concerned, our earlier working on Excel
Industries shows the interest cost of 15% is higher than the discount value
of 3%. We will work out the interest cost and discount value again. The
40% sales, which is expected to be collected at the end of 10 days works
out to Rs. 9.20 cr. (23 × 0.4). The discount to be given on this value at
81
Management of 3% is Rs.0.276 cr. or Rs. 27,60,000 (i.e. 9.2 × 0.03). The net collection is
Current Assets
Rs. 8.924 cr. (i.e. 9.2 - 0.276). If the company is in a position to borrow
this money at 15%, the interest cost for 50 days would be Rs. 18,33,700
(i.e. 8.924 × .15 × (50/365). Since the discount value is greater than cost
of borrowing, 3% discount is not economical if interest cost alone is
considered. However, it is not correct to ignore the impact of discount
policy on bad debts.

The discount policy will bring down the value of bad debts from 1% to
0.50%. The savings in terms of values is Rs. 11,50,000 i.e. 23,00,00,000 ×
(1% – 0.50%). If this saving is deducted from the discount value of Rs.
27,60,000, the net discount cost is Rs. 16,10,000. When the net discount
cost of Rs. 16,10,000 is compared with the interest cost of Rs. 18,33,700,
then offering 3% discount for payment within 10 days is economical.
(However, before implementing this new credit policy, the overall impact
of the policy on profit is to be assessed and this will be discussed later).

The above analysis also highlights the factors that are involved in
evaluating the discount policy. The discount policy is judged on the basis
of discount percent (3%), discount period (10 days), percentage of
customers expected to avail the discount term (40%), and interest cost
(15%). For example, if 80% of the customers are likely to avail this
facility, then the discount value and interest cost will double to Rs.
55,20,000 and Rs. 36,67,400 respectively. If there is no change in
reduction of bad debts value, then the cost (Rs.55.20 – 11.50 lakhs)
exceeds benefit (Rs.36.674 lakhs) and thus, the discount policy is
uneconomical. To make the policy economical, the company has to reduce
the discount rate from 3% to lower level, which will cut down the discount
cost as well as percentage of customers using the discount offer.

Example 4.5: Cost-Benefit Analysis

American Pharma is a multinational pharmaceutical company selling certain
premium tablets in the domestic market for the last three years. The
company has not offered any credit on sales and the annual turnover for
the year was Rs. 10 cr. Due to increased competition, the company is now
evaluating new credit policy, which it intends to introduce. As per the
policy, the company will offer 30 days credit and a discount of 2% if the
amount is paid within a day (i.e., 2/1 net 30). Without this new credit
policy, the sales are expected to increase to Rs. 12 crore and with the new
policy, the sales will be Rs. 15 cr. It is estimated that 40% of the
customers would avail the discount. The contribution margin for its sales is
30% and the company is operating above break-even point. The new
credit policy will cause additional costs in terms of collection charges at
1% and bad debts at 0.5%. The interest cost is 16%. Evaluate the credit
policy and its implication on profit.

Increase in sales on account of credit policy (Rs.15 cr. less Rs. 12 cr.): Rs.
3.00 cr.

82
 Management of
Contribution from increased sales (30% on : Rs. 0.90 cr. Receivables
cr.) Rs. 3
Cost associated with credit policy
1. Collection charges @ 1% on Rs. 15 cr. Rs. 0.150 cr.
2. Bad debts at 0.5% on Rs. 15 cr. Rs. 0.075 cr.
3. Discount at 2% on 40% of Rs. 15 cr. Rs. 0.120 cr.
4. Interest cost on receivables @ 16%
Sales not likely to take discount: Rs. 9 cr.
Investments on 30 days receivable
Rs. 9 cr. x (30/365) = Rs. 0.74 cr.
Interest on Rs. 0.74 cr. at 16% Rs. 0.118 cr. Rs. 0.463 cr.
Net benefit before tax Rs. 0.437 cr.

c) Credit Eligibility
Having designed credit period and discount rate, the next logical step is to
define the customers, who are eligible for the credit terms. The credit-
granting decision is critical for the seller since credit-granting has
economic value to buyers and buyers decision on purchase is directly
affected by this policy. For instance, if the credit eligibility terms reject a
particular customer and requires the customer to make cash purchase, the
customer may not buy the product from the company and may look
forward to someone who is agreeable to grant credit. Nevertheless, it may
not be desirable to grant credit to all customers. It may instead analyse
each potential buyer before deciding whether to grant credit or not based
on the attributes of that particular buyer. While the earlier two terms of
credit policy viz. credit period and discount rate are not changed frequently
in order to maintain consistency in the policy, credit eligibility is
periodically reviewed. For instance, an entry of new customer would
warrant a review of credit eligibility of existing customers.

The decision whether a particular customer is eligible for credit terms

generally involves a detailed analysis of some of the attributes of the
customer. Credit analysts normally group the attributes in order to assess
the credit worthiness of customers. One traditional way of organising the
information is by characterising the applicant along five dimensions namely,
Capital, Character, Collateral, Capacity and Conditions. These five
dimensions are also popularly called Five Cs of credit analysis.
Capital: The term capital here refers to financial position of the applicant
firm. It requires an analysis of financial strength and weakness of the firm
in relation to other firms in the industry to assess the credit worthiness of
the firm. Financial information is normally derived from the financial
statements of the firm and analysed through ratio analysis. The liquidity
ratios like current ratio, debt- service coverage ratio, etc. are often used to
get a preliminary idea on the financial strength of the firm. Further
analysis includes trend analysis and comparison with the other industry
norm or other firms in the industry.
83
Management of Character: A prospective customer may have high liquidity but delay
Current Assets
payment to their suppliers. The character thus relates to willingness to pay
the debts.

Some relevant questions relating to character are:

• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honour
debts as they become due?

Information on these areas are useful to assess the applicant’s character.

Collateral: If a debt is supported by collateral, then the debt enjoys lower
risk because in the event of default, the debt holder can liquidate the
collateral to recover the dues. The collateral causes hardship to other
debt holders. Thus, the analysts should look into both the availability of
collateral for the debt and the amount of collateral the firm has given to
others. In computing the liquidity of the firm, the analysts should remove
the assets used for collateral and take into account only the free assets.
The credit worthiness improves if the customer is willing to offer
collateral assets or the value of collateral asset backed loan is low.
Capacity: The capacity has two dimension - management’s capacity to
run the business and applicant firm’s plant capacity. The future of the firm
depends on the management’s ability to meet the challenges. Similarly, the
facility should exist to exploit the opportunity. Since the assessment of
capacity is a judgement on the part of analysts, a lot of care should be
taken in assessing this feature.

Conditions: These are the economic conditions in the applicant’s industry

and in the economy in general. Scope for failure and default is high when
the industry and economy are in contraction phase. Credit policy is
required to be modified when the conditions are not favourable. The policy
changes include liberal discount for payment within a stipulated period and
imposing lower credit limit.
Management of Current Assets
The information collected under five Cs can be analysed in general to decide
whether the customer is eligible for credit or fit into a statistical model to
get an unbiased credit rating of the customer. Discussion on credit
evaluation model is presented in the next section.
d) Credit Limit
If a customer falls within the desired limit of credit worthiness, the next
issue is fixing the credit amount. This is something similar to banks fixing
overdraft limit for the account holders. If a customer is new, normally the
credit limit is fixed at the lowest level initially and expanded over the
period based on the performance of the customer in meeting the liability.
Credit limit may undergo a change depending on the changes in the credit
worthiness of the customer and changes in the performance of customer’s
84 industry.
 Management of
Example 4.6
Receivables
Alpha Electronics is presently grouping its customers into three categories.
It offers unlimited credit to first group, a maximum credit of Rs. 1 cr. to
second group and Rs. 5 lakhs for third group. It is presently doing a
turnover of Rs. 50 cr. at 60% production capacity. One of the proposals
received to increase the capacity utilisation during the annual review
meeting is increasing the credit limit for second and third groups of
customers. Instead of relaxing credit limit to all groups, the Marketing
Chief felt it is desirable to upgrade some of the customers based on their
past performance by relaxing the review procedure. The Marketing Chief
felt this will also give a right signal to their customers. After completing
the upgrading exercise, the marketing manager projected that the sales will
go up by another Rs. 10 cr. Based on the average collection period of 40
days, the Finance Manager estimated the revised investments in
receivables at Rs. 6.58 cr. against the earlier figure of Rs. 5.48 cr. The
interest cost on short-term borrowing is 14%. No major change is
expected in collection and bad debts values on account of this regrouping.
The firm presently has a contribution margin of 20% and operating above
break-even level.
The additional contribution on account of increase in sales works out to
Rs. 2 cr. (20% of Rs. 10 cr.). The investment in receivables has gone up
by Rs. 1.10 cr. and it costs additional interest burden of Rs. 0.154 cr. per
year. Since additional contribution of Rs. 2 cr. is higher than the additional
cost of Rs. 0.154 cr., the revision is profitable to the firm.
There are several reasons for limiting the credit facility to the customers.
Some of the important reasons are:
• reduce the impact of deficiencies in credit-granting decision;
• reduce the scope for over buying by the customers;
• rationally allocate the limited funds available for investment in bills
receivable; and
• mitigate agency problem

The last reason, mitigating agency problem, requires further discussion.

Agency problem arises on account of conflict of interest between the
managers (agents) and equity shareholders (owners or principal). Agents will
always try to maximise their return even if it is at the cost of principal.
Two types of agency problems arise in credit-granting decision. Firstly,
managers may collude with some of the customers and grant credit even to
undesirable customers. Credit limit puts a cap on the potential loss.
Secondly, managers may hesitate to give credit to even creditworthy
customers when the performance of the managers is assessed on the basis
of collection efficiency. Recently, many public sector banks were criticised
for not granting fresh loan despite comfortable monetary position and
funds are simply used to buy government securities. The fear of default
and delay in collection would prevent in granting credit even to good
customers and thus, take away the opportunity to maximise the profit.
Credit limit would to some extent take away this fear of managers since
85
Management of default is restricted and thus would encourage them to accept credit
Current Assets
proposals. The situation will improve further if credit limits are built into
the system of performance evaluation and managers are not penalised as
long as they have restricted the credit.

Activity 4.2
i) What are the major components of credit policy?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
ii) List out important factors that are used in assessing credit worthiness.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
iii) How do you evaluate alternative credit policies? Identify the principles
to be used in evaluating credit policies.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

4.3 CREDIT EVALUATION MODELS

In the previous section, how the credit analysts collect the information
required for processing credit application under five C’s was discussed.
Credit evaluation models are useful for the analysts to process the
information to decide credit worthiness of the customer. It is possible to
structure credit evaluation model in different ways. An experienced credit
analyst can evaluate the credit worthiness by simply scanning the
information received or collected for the credit proposal. When the credit
transactions increase or number of customer increases, it may be difficult
to apply this methodology.

It will also cause delay in processing credit proposals and lead to

inconsistent decision. Thus, it is always useful to create a credit evaluation
system and standardise the appraisal. Decision-tree model and multivariate
statistical model are generally used to create credit evaluation system
86
Decision Tree Model: Under decision-tree model, credit applications are Management of
Receivables
rated under different parameters. For instance, if a company uses five C’s
factors, the analysts rate the credit applicant under each of the five Cs.
Decision-tree is initially created for all possible routes and decisions at the
end of each route are indicated. Figure 4.1 illustrates decision-tree model
using three credit information namely capital, character and collateral. If a
character, capital and collateral are strong, then the applicant firm is
granted large amount of credit.

Should
Credit
be
granted?

Character

Strong Weak

Capital
Capital

Strong Weak Strong

Weak
Collateral Collateral
Collateral

Collateral

Strong Strong/ Strong/

Strong
Weak Weak
Weak

Excellent Risk Fair Risk Fair Risk Dangerous

Risk

Large Credit Limited Limited to No Credit

Limit Credit Collateral Limit

Fig. 4.1: Decision Tree Credit Evaluation Model

On the other hand, if the first two are strong but the collateral is weak, a
limited credit could be granted.
If character is weak but capital and collateral are strong, then credit is
limited to collateral value. On the other hand, if all the three are weak, it
is a dangerous credit proposal and hence to be rejected. In Figure 4 .1, we
87
Management of have taken two broad ratings, which can be further divided into three or
Current Assets
five scale rating. Increasing the credit variable and rating scale will lead to
more branches and credit limit can be prescribed for each branch
separately.

It is also possible to use the above decision-tree to decide whether a

detailed credit evaluation has to be conducted. For example, if character,
capacity and conditions are good but capacity and collateral are weak, it
may require a detailed credit evaluation. That means, the information
collected is inadequate and a rigorous analysis is required.
Multivariate Statistical Model: Many firms have started using sophisticated
statistical techniques in conducting their credit analysis. Multiple
Discriminant Analysis (MDA) employs a series of variables to categorise
people or objects into two or more distinct groups. A credit scoring system
utilises multiple discriminant analysis to categorise potential credit
customers into two groups: good credit risk and bad credit risk. An
important advantage of credit scoring system is that all of the variables are
considered simultaneously, rather than individually as in the decision tree
analysis. The model is capable of handling both numerical measures such
as debt-equity ratio, current ratio, profit margin, etc., as well as non-
numerical measures like character of the customer as good, bad, average.
When a credit scoring model is constructed with historical data of a few
customers, the model would produce a equation as given below:
MDA Score Y = b1X1 + b2X2 + b3X3 + ……. + bnXn
where, b1, b2, b3, .... bn are co-efficient values of variables X1, X2, X3 … Xn.
X1, X2, etc. are variables such as debt-equity, current ratio, etc.

The model produces the coefficient values and when a new application is
received for credit scoring, the values of X’s are to be measured and
substituted in the model equation to get the discriminant score. The
discriminant is then compared with the point of separation to place the
applicant in one of the two groups. For example, if the point of separation
is 3.80, when the applicant’s score is above 3.80, then the applicant is
placed in fair or excellent risk group. If the score is below 3.80, then it is
risky proposal. Thus, it is possible to evaluate where a particular customer
stands in terms of credit worthiness. No difficulty is felt when the scores
are much above or below the separation point but credit worthiness of
customers, whose scores are close to separation point, are difficult to
assess. In such cases, further analysis is made to understand the credit
worthiness of the customers. It is also possible to outsource credit rating
evaluation from specialised credit rating agencies.

Credit scoring models are periodically updated to take into account changes
in the environment and also reassess the credit worthiness of the customers.
An outdated model may wrongly classify the customers and lead to heavy
losses. Further, while developing the system, it is necessary to ensure good
sample for developing the model. It is equally important that the model is
validated before employing it. Many foreign banks and credit card agencies
88
extensively use credit rating schemes and found them useful in taking credit Management of
Receivables
decision.

4.3.1 Rating Methodologies of Credit Rating Institutions

Credit rating has become one of the professionalised services in the recent
past. Though rating is more common with different securities offered by
industrial units, there is also focus on the rating of individuals and
institutions as credit applicants. For instance, CRISIL's rating methodology
includes the following key factors for deciding the credit worthiness of a
borrowing company.

A. Business Analysis
• Industry Risk (nature and basis of competition, key sucess factors,
demand supply position, structure of industry, cyclical/seasonal
factors. Goverment policies etc.)
• Market position of the company within the industry (market share,
competitive advantages, selling and distribution arrangements
product and customer diversity, etc.).
• Operating efficiency of the company (locational advantages, labour
relationships, cost structure, technological advantages and
manufacturing efficiency as compared to those of competitors
etc.)
• Legal position (terms of prospectus, trustees and their
responsiblities: systems for timely payment and for protection
against forgery/fraud; etc.)

B. Financial Analysis
• Accounting quality (overstatement/understatement of profits;
auditors qualifications; method of income recognition; inventory
valuation and depreciation policies; off balance sheet liabilities;
etc.)
• Earnings protection (sources of future earnings growth;
profitability ratios; earnings in relation to fixed income charges;
etc.)
• Adequacy of cash flows (in relation to debt and fixed working
capital needs; sustainability of cash flow; capital spending
flexibility; working capital management, etc.)
• Financial flexibility (alternative financing plans in times of stress;
ability to raise funds; asset redeployment potential; etc.)

C. Management Evaluation
• Track record of the management; planning and control systems;
depth of managerial talent; succession plans.
• Evaluation of capacity to overcome adverse situations
• Goals, philosophy and strategies
89
Management of The above factors are considered for companies with manufacturing
Current Assets
activities.The assessment of finance companies lays emphasis on the
following factors in addition to the financial analysis and management
evaluation as outlined above.

D. Regulatory and Competitive Environment

• Structure and regulatory framework of the financial system
• Trends in regulation/deregulation and their impact on the company.

E. Fundamental Analysis
• Capital Adequacy (assessment of true net worth of the company, its
adequacy in relation to the volume of business and the risk profile
of the assets.)

• Asset Quality (quality of the company's credit-risk management

systems for Monitoring credit; sector risk; exposure to individual
borrowers; management of problem credits; etc.)

• Liquidity Management (capital structure; term matching of assets

and liabilities; policy on liquid assets in relation to financing
commitments and maturing deposits.)
• Profitability and Financial Position (historic profits; spreads on
fund deployment; revenues on non-fund based services; accretion
to reserves; etc.)
• Interest and Tax Sensitivity (exposure to interest rate changes; tax
law changes and hedge against interest rate; etc.)

Individual Credit Rating: As indicated earlier, credit rating has become

more popular now, with financial instruments than individuals.
Nevertheless, there are now costing institutions like the Onida Individual
Credit Rating Agency (ONICRA), developing specific methodology to help
in rating individuals as consumers. The ONICRA model considers the
following three parameters as important:

I. Individual Considerations
i) Personal strengths - Qualification Occupation.
ii) Stability - Job Tenure
Duration of stay in personal
place of residence
iii) Capability - Income
Future Job Prospects
iv) Strengths - Financial aspects, Discipline
Willingness to pay
II. Transaction Considerations
i) Risk - Security
Ownership of the asset
Control over end use of the product
90
 Collateral Management of
Receivables
Exposure
ii) Modalities of payment - Direct deduction from salary
Advance post dated cheques
Automated debiting of bank account
Payment on due date
Payment on demand
III. Environmental Considerations- Economy

Activity 4.3
i) Why do we need models to evaluate credit proposals?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) List down some of the important inputs required in evaluating credit
proposals.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iii) Briefly explain multivariate discriminant model of credit evaluation.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

4.4 MONITORING RECEIVABLES

Managing receivables does not end with granting of credit as dictated by
the credit policy. It is necessary to ensure that customers make payment
as per the credit terms and in the event of any deviation, corrective actions
are required. Thus, monitoring the payment behaviour of the customers
assumes importance. There are several possible reasons for customers to
deviate from the payment terms. Three of these possible reasons and their
implications in credit management are discussed below:
Changing Customer Business Characteristics: The customers, who
have earlier agreed to make payment within a certain period of time, may
deviate from their acceptance and delay the payment. For example,
economic slow down or slow d own in the industry of the customers
91
Management of business may force the customers to delay the payment. In fact, the bills
Current Assets
payable become discretionary cash outflow item in economic recession.
Thus, a close watch on the performance of customer’s industry is
required.

Inaccurate Policy Forecasts: A wide deviation from the credit terms and
actual flow of cash flows show inaccurate forecast and defective credit
policy. It is quiet possible that a firm uses defective credit rating model or
wrongly assesses the credit variable. For example, it is quiet possible to
overestimate the collateral value and then lend more credit. If this is the
reason for wide deviation, it requires updating the model or training the
employees.

Improper Policy Implementation: Often wide deviation is noticed in

practice while implementing credit policy. This may not be intentional but
frequently in the form of accommodating special requests of the
customers. For example, a customer may not be eligible for credit or higher
credit as per the model in force. The customer may personally see the
concerned manager and request her/him to relax the credit restriction. If
there is no policy in place to deal with these types of request and ad hoc
decisions are made, then wide deviation is possible. Often these deviations
become costly for the firm. Intervention of top officials and ad hoc
decisions are cited as major reasons for widespread defaults in many
public financial institutions. Thus, it is necessary to ensure that policies are
implemented in letter and spirit.
Monitoring provides signals of deviation from expectations. There are
several monitoring techniques available to the credit managers. The
monitoring system begins with aggregate analysis and then move down to
account-specific analysis.

Investments in Receivables: The decision to supply on credit basis leads to

investments in receivables. Credit policy is designed in such a way that
investment needs of receivables are optimized, i.e return is greater than cost
associated with investments. Credit monitoring starts with an assessment of
investment in receivables as a percentage of total assets. The investments in
receivables are then compared with the budget. Any deviation from
budgeted value shows delay in collection or managers deviating from the
credit policy. For example, if a firm based on credit policy worked out that
investments in receivables is 12%, the actual value for the last three
months is around 18%, there are two possible reasons. Firstly, some of
the customers are not paying and thus, the receivables value has gone up.
Secondly, the managers would be giving more credit than the prescribed
limit or extend the credit period. In either case, it requires an investigation
and explanation from managers for the increased investment in receivables.

Collection Period: Receivables can be related to sales in different ways. The

simplest form of analysis is comparing sales and receivables for different
periods to know the trend. While this analysis gives a reasonable
understanding on how the receivables have moved over the period, it fails
to give an implication of the changes in the trend. For example, if sales
92
and receivables of two periods are Rs. 90 lakhs, 120 lakhs and Rs.120 Management of
Receivables
lakhs, Rs.140 lakhs respectively, the figures show (i) the sales value has
gone up during the period, and (ii) receivables have also gone up along
with sales. A shaper focus on changes in the trend can be obtained by
computing the collection period of the two periods. The collection period is
computed as follows:
Accounts Receivable
Collection Period = –––––––––––––––––––
Credit Sales per day

Credit sales per day is computed by dividing the total credit sale of the
period by the number of days of the period. If the sales value given above
are related to quarterly sales value, then sales per day for the two quarters
are Rs. 1 lakh (Rs.90 lakhs/90 days) and Rs. 1.33 lakh (Rs.120 lakhs/90
days) respectively. The collection period for the two quarters are:
Period 1: 120/1 = 120 days

Period 2: 140/1.33 =105 days

The collection period shows a decline and thus improved performance,

which was not visible earlier in simple comparison. If the sales value for
the second period is Rs.100 lakhs instead of Rs.120 lakhs, then average
credit sales per day is Rs.1.11 lakh and collection period is 126 days. The
collection performance in this case has marginally come down.

If customers are granted different credit periods, then customers of similar

nature are to be grouped separately and then sales, receivables and collection
period relating to each group of customers are to be computed separately.
Otherwise, it will give a distorted figure. In addition to comparing
collection period of one period with other periods, they are also compared
with credit terms. Any abnormal deviation warrants customer-wise
analysis. That is, all these three values for two periods can be computed for
each customer to know the trends in collection period of different customers.
Such an analysis will help to narrow down the customers who take longer
time for paying the dues.

Ageing Schedule or Age Analysis: This is one of the age-old techniques

employed to analyse the trade receivables. The receivables are categorized
into diverse slots, based on the time frame, by which they are due. The
general assumption in case of receivables is that longer the time schedules,
the more likely is the default. The other way of looking at them is to make a
comparison of the credit period allowed and the time they are collected. This
gives the firm, a picture relating to the overdue accounts. Supposing, the
company permitted one month credit to X -customer. If he is not paying after
one month and paid only after three months, the company will face the
problem of liquidity. The financial plan of the company also goes disarray.
Therefore, one must be on a continuous watch as to the time periods allowed
and the time by which the debtors were able to be collected. Generally,
companies make three to four categories and put focus on them. Ageing
Analysis will also be useful in prompting legal action, if any, to be taken on
93
Management of the overdue accounts. The general format employed by companies for
Current Assets
making Ageing Analysis would be, like as follows:
Format for Ageing Schedule
(Rs.in Lakh)
Interval Quarter-1 Quarter-2 Quarter-3 Quarter-4
(Days)
0-30
31-60
61-90
91-120
Above 120

The above two measures namely, average collection period and ageing
schedule may give misleading picture when the sales are seasonal.
Suppose the average sales per month of a quarter is Rs. 10 lakhs. The sales
figures for the three months are Rs.10 lakhs, Rs.15 lakhs and Rs. 5 lakhs.
Suppose the collection pattern shows that 50 per cent of the sales is
collected in the same month, 25% in the following month and the
remaining 25% in the third month. If there is no outstanding receivables at
the beginning of the quarter, then the receivables values at the end of
each month are Rs. 5 lakhs, Rs.10 lakhs and Rs.12.5 lakhs. The average
collection period for the last month will be very high compared to other
months though there is no change in the payment pattern of the
customers. In order to overcome this problem, particularly in a seasonal
sales pattern, the following alternatives are suggested:
• Ratio of receivables outstanding to original sales, and
• Sales-weighted Collection Period.
Both the above measures require decomposing receivable outstanding at
the end of each month to trace the receivables with original sales. Such a
decomposition will be useful even for non-seasonal firms.
Decomposing Receivables Outstanding at the End of Month: Another
way to spot changes in customer behaviour is to decompose outstanding
receivables at the end of each month. This is achieved by preparing a
schedule of the percentage portions of each month’s sales that are still
outstanding at the end of successive months. An illustrative table is given
below:
Table 4 .2: Percentage of Receivables Outstanding at the end of month
Percentage outstanding after January February March
Current Month 94 98 96
1 month 70 80 78
2 months 21 28 32
3 months 6 9 12
4 months and above 1 1 2
94
The following example will help you to understand the figures in the above Management of
Receivables
Table 4.2. Suppose Rs. 40 lakhs is outstanding receivables at the end of
January, this consists of 94% of January’s sales, 70% of December's sales,
21% of November’s sales, 6% of October's sales and 1% of September's
sales. If the credit period is 30 days, the above analysis shows that a
significant part of the debtors takes more than one month in settling dues.
While a significant part of the customers settle down their dues by the end
of second month, outstanding beyond 2 months is also high and more
importantly growing. Receivables outstanding more than two months have
gone up from 21% to 32%. The growing trend in non-collection of dues
continues for other two months too. This clearly shows the customers have
slowed down in settling their dues and thus requires more careful analysis.
If this Table 4.2 is supplemented with the names of customers along with
their dues for the second, third and fourth months, it is helpful for follow
up and for taking appropriate action.
Sales-weighted Collection Period: In the above Table 4.2, percentages of
receivables outstanding to original sales are given. To compute sales-
weighted collection period, the values are to be summed up for each month
and then multiplied by 30. The sales-weighted collection period for
January, February and March are 57.60 days (1.92 × 30), 64.80 days (2.16
× 30) and 66 days (2.20 × 30) respectively. The general equation is:
n
Sales-weighted Collection Period = AR t St 30 days
t 0

Where, ARt is Accounts Receivables of the month ‘t’ and

St is Sales of the month ‘t’

A similar table prepared for each customer will be useful to evaluate the
behaviour of each customer in settling the dues. An analysis of this
behaviour for a year can be used to assign ranks to the customers and
such ranking can be used while taking credit policy or credit decision.
Instead of using outstanding receivables values, some organisations use the
payment values. However, both should lead to same conclusion.

CIBIL Scoring: Transunion Credit Information Bureau (India) Ltd., is

India’s first Credit Information Company; which prepared and maintained
reports on the credit worthiness of borrowers, who take loans from Banks and
Financial Institutions. The general focus of the company is on the rating of
individuals; yet, it also has started generating credit reports for the
companies, having credit exposure up to Rs.50 crore. The minimum CIBIL
score for business loan is generally 750. The score ranges from 300 to 900.
Anything above 750 is considered ideal to grant loan to a borrower. Any
borrower can get his/her score by paying the subscription to the Agency. Like
the CIBIL, there are many other credit bureaus that are extending this kind of
service. Such agencies include: Equifax, Experian, CRIF High Mark. Way
back in 2004 itself, the Reserve Bank of India issued a circular dated 17-06-
2004, advising all the Banks and Financial Institutions to submit credit
information in respect of all of their borrowers to CIBIL and get reports from
the agency and take appropriate follow-up action. As at present, every bank is
95
Management of following this mandate and considering the grant of loans only when the
Current Assets
score is in the minimum range.

Conversion Matrix: This is a simple technique, whereby credit sales of

each month are patterned as per their collection. This shows how the
credit sales of a month are collected in the subsequent months. This
reveals the laxity or otherwise of the collection department. Look at the
following conversion matrix to judge whether the collection pattern is
improving, stable or deteriorating.
Conversion Matrix
Month Credit Jan Feb Mar Apr May June July Aug Sept
Sales
(Rs.)
Jan 1,00,000 10,000 40,000 30,000 20,000

(10%) (40%) (30%) (20%)

Feb 80,000 11,000 28,000 32,000 9,000
(14%) (35%) (21%) (24%)
Mar 1,20,000 18,000 48,000 25,000 29,000
(15%) (40%) (21%) (24%)
Apr 1,60,000 19,500 72,500 38,000 30,000
(12%) (45%) (24%) (19%)
May 2,00,000 20,000 72,000 60,000 48,000
(10%) (36%) (30%) (24%)
June 1,60,000 14,500 56,000 49,000 40,500
(9%) (35%) (31%) (25%)
Total Collection 10,000 51,000 76,000 1,19,500 1,26,500 1,53,500 1,46,000 97,000 40,500

It may be observed from the above data that our Hypothetical company,
making a sale of Rs. 1 lakh could collect only 10% in the same month
and around 50% after two months. The above represents a case of
deteriorating collection efficiency.

Receivables Variance Analysis: Receivables budget can be prepared from

sales budget and credit policy. This information is any way required to
prepare cash budget. In receivables variance analysis, the actual reason for
actual value of receivables varying with budgeted value. Actual receivables
vary with that of budget for two reasons - the level of sales and ratio of
receivable outstanding. For example, if the budgeted sales for a month is
Rs. 20 lakhs and normally 80 per cent of the sales are outstanding at the
end of month, then receivables at the end of month as per the budget
should be Rs. 16 lakhs. If the actual receivables is Rs. 18 lakhs, it could
be due to increase in the actual sales from Rs. 20 lakhs to Rs. 22.50 lakhs
or alternatively increase in the percentage of credit sales from 80 to 90 or
combination of both. In order to compute the causes for variance, three
inputs are required: budgeted receivables, revised budgeted receivables
based on actual sales and actual receivables. The revised budgeted
receivables is computed based on actual sales and credit policy. In other
96 words, it is the budgeted receivables value for the actual sales. The
difference between the first two values (budgeted receivables and revised Management of
Receivables
budgeted receivables for actual sales) explains the part of receivable
variance arising out of changes in the sales. The difference between the
second and third values (revised budgeted receivables and actual
receivables) is on account of changes in the collection efficiency. The
difference between the first and last values is the total receivables
variance.

Other simple measures of receivables management are ratio of credit sales

to total sales, Number of credit proposals rejected to total credit proposals
received and bad debt loss index.

Activity 4.4
i) Why customers often fail to adhere the credit terms?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
ii) List down various indicators used in macro-analysis of receivables.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
3) Discuss the Crucial Issues with Credit Manager/Finance Manager of any
company and Prepare a Note.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
iv) How do you set right the seasonal variation in sales affecting some of
the indicators used in receivables analysis?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

97
Management of
Current Assets
4.5 COLLECTING RECEIVABLES
The analysis explained earlier are useful to know the trend of collection and
identify customers, who are not paying on due dates. This should enable
the management to take appropriate action to collect the dues, which is the
main objective of receivables management. Collecting receivables begins
with timely mailing of invoices. There are several procedures available to
credit managers, who must judiciously decide when, where and to what
extent pressure should be applied on delinquent customers. Management of
collection activity should be based on careful comparison of likely benefits
and costs.

Inexpensive procedures include periodical mailing of duplicate bills

reminding the customers that the account is not settled or sending a formal
letter informing non- payment of bill and requesting the customer to pay
immediately. Written follow-up on an overdue account is referred to as
dunning. If a customer fails to respond to these reminders, then expensive
procedures are initiated. Personal telephone calls and reminder through
registered post are initially tried. Even if these steps fail to deliver the
desired results, a personal visit by the credit manager or representative to sort
out the issue would be useful. If the credit manager realises that the
customer is willfully defaulting or is in deep trouble and hence unlikely to
pay the dues, a formal legal action is initiated either to recover the dues or
file a liquidation petition before the court to recover the dues. It is
difficult to prescribe exactly as to which and when these collection
procedures should be adopted. If collection policy is strict, then it would
reduce the outstanding receivables but at the same time frightened many
potential customers from doing business. On the other hand, a liberal
collection policy would invite many willful defaulters to do business with
the company.
The above discussion assumes that the firm takes the responsibility of
collection. Two alternatives are available to firms in collecting the
receivables. The first one called factoring enables the firm to transfer the
receivables to factoring agent, who takes the responsibility of collection.
Some factoring agents take the credit risk (i.e. the factoring agents bear
the loss on account of bad debts) and others accept factoring without
credit risk. In India, we have factoring subsidiaries of Canara Bank, SBI,
etc. and Exim Bank does the factoring service relating to export bills. The
second one is called receivables securitisation. Securitisation is somewhat
similar to factoring but here the securitising agent sells the units of
receivables to investors in the market. Though the concept of securitisation
is popular in finance related receivables like housing loans, credit cards
receivables, lease rentals, etc., the concept is slowly spreading to other
types of receivables. A few securitisation deals have already been
completed in India and the market will witness more such transactions in
the near future.

98
 Management of
4.6 STRATEGIC ISSUES IN RECEIVABLES Receivables
MANAGEMENT
Business management today involves continuous formulation of strategies
and also, to develop and carry out tactics to implement the strategies to gain
competitive advantage. The discussion on receivables management so far
focused on operational issues such as how changes in credit policy affects
investments in receivables, how to monitor collection pattern, what are the
options available in dealing with delinquent customers, etc. Receivables
management, however, can support the strategies being pursued by the
organisation to gain certain competitive strength.
Firms pursuing strategies to acquire cost leadership need a suitable credit
policy to support their strategies. For instance, if a firm is trying to achieve
cost leadership through economies of scale of production, then it has to
generate a large volume of sales. Since credit term is an economic variable
in buying decision, the credit terms should be supportive to sell large
volume. That means, the firm may have to offer more days of credit
particularly for those who buy in large quantity. Of course, the cost of
investment in receivables will go up initially but without a liberal credit
policy, the assets created to achieve economies of scale will be idle. In
fact, the additional cost of investments in receivables need to be considered
while computing the benefit arising out of economies of scale.

Firms pursuing strategies to acquire product differentiation have limited

customer base. In order to gain access to this segment, the firm may have
to pursue liberal credit term but once the brand acquired the desired value,
credit terms can be made tight. For instance, many established
multinational firms now require the dealers and distributors to deposit the
entire amount of the consignment before lifting the delivery. Similarly,
firms pursuing market penetration may have to work with low profit margin
or selling just above the variable cost. Liberal credit terms would add cost
and increase bad debts value. Firms may be reluctant to have liberal policy
at this stage unless it is essential to achieve penetration. Firms with a large
market share in a low growth industry would not invest additional capital
in receivables since the strategy is to harvest the benefit. In other words,
instead of allowing the market to decide the credit terms of the company,
it is possible for the firm to influence the market through credit policy.

Credit policy can also be used to change the product life cycle and
investment pattern. For instance, the life cycle of a product X is 10 years,
which is worked out on the basis of existing credit terms and volume of
turnover. Assume the total sales during the period is 2,50,000 units. The
volume achieved is initially low, then it increases to reach a peak at the
end of 4th year and then declines over the remaining 6 years. Based on
different capacity options, it is found that a capacity of 20,000 units for six-
year period is optimum and offers highest net present value. The firm now
found that by increasing the credit period, it can sell more units and thus
can go for a capacity of 30,000 units and achieve same NPV in four-year
period. The second option may be suitable on account of increased
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Management of uncertainty on the product as the product moves into the latter part of the
Current Assets
life cycle and also getting economies of scale, which was not possible
with lower turnover in the first case. Shortening product life cycle has
certain advantages as well as disadvantages. The advantages are obvious.
It increases NPV and removes uncertainty. At the same time, it requires
more R&D to come out with a new and improved product and additional
investment much earlier than originally visualised. If competitors are able
to come out with better product version, the firm has to suffer higher loss
because of higher capacity. The firm has to develop various scenarios and
study their impact on the overall organizational goal.

Credit policy and its terms assume strategic importance if a firm is primarily
supplying its products or services to select firms. Suppose company R is
one of the ten customers of Company L. Company R is now going for
massive expansion and found it difficult to borrow to meet the normal
credit terms of Company R since the debt-capacity remaining is not
adequate. If Company L has reasonable borrowing capacity or internal
generation, it can extend the terms of credit. L&T had come out with a
major issue some years back to provide suppliers credit to Reliance
Industries for their expansion projects. Such kind of suppliers credit may
also be feasible when the interest cost of a domestic firm is much higher
than the interest cost of supplier firm located in a different country.

A firm dealing with a large number of customers may find it difficult to

manage the receivables within the existing organisational set up. If a few
other group companies also face similar problems, it may start a separate
subsidiary to manage the receivables of all group companies. Many
companies have started their subsidiary to manage share transfer jobs of
group companies. It is also equally possible to centralise the credit rating
service of the customers through subsidiaries. Instead of starting their own
subsidiaries, it is also possible to go in for factoring services and credit
rating agencies to outsource these services. Many foreign banks outsource
the services not directly related to their core activities in order to keep the
organisation lean. It is a way to convert many of the fixed costs into
variable costs. All these decisions have strategic implications and thus, it is
difficult to visualise the receivables management as a operational issues of
management in the modern business environment.

Activity 4.5
i) List down a few inexpensive and expensive methods of credit follow-
up.
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ii) A firm in high-growth industry would like to build up more market Management of
Receivables
share.What type of credit policy is suitable to be consistent with this
strategy?
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iii) How credit policy affects investment decisions?
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4.7 SUMMARY
The use of credit in the purchase of goods and services is so common that
it is taken for granted. Selling goods or providing services on credit basis
leading to accounts receivables. Though a lot of discussion is going on in
the Indian industry on how to cut down the investments in inventories
through concepts such as Just-in-Time (JIT), MRP, etc., investments in
receivables have gone up and firms are demanding more credit from banks
and specialised institutions to deal with receivables. The problem of
managing receivables has got aggravated due to uncertain business situations
arising of Covid-19 fall out. Managing in uncertain times has become the
order of the day. Since investment in receivables has a cost, managing
receivables assumes importance. Receivables management starts with
designing appropriate credit policy. Credit policy involves fixing credit
period, discount to be offered in the event of early payment, conditions to
be fulfilled to grant credit and fixing credit limit for different types of
customers. It is essential for the operating managers to strictly follow the
credit policy in evaluating credit proposals and granting credit. To evaluate
the credit proposal, it is necessary to know the credit worthiness of the
customers. Credit worthiness is assessed by collecting information about
the customers and then fitting the values into credit evaluation models.
There are number of credit evaluation models which range from simple
decision tree analysis to sophisticated multivariate statistical models. The
firm has to develop a suitable model, test the model with historical data to
validate the model and use it for credit evaluation. Models also need to be
periodically updated. Once the credit is granted, then it should be
monitored for collection. Different methodologies are available to get a
macro picture on collection efficiency. Micro analysis in the form of
individual customer analysis is done wherever there is a deviation from the
expectation. It is equally important in dealing with delinquent customers.
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Management of There are several options, simple reminders to legal action, available before
Current Assets
the credit managers in dealing with such default accounts and appropriate
method is to be selected with an objective of benefit exceeding cost. The use
of credit policy and credit analysis is not restricted to the operational
managers in dealing with day-to-day activities of the firm. In the
competitive world, credit policy and analysis provide a lot of strategic
inputs. Credit policy of an organisation is in line with the desired strategy
that the organisation wants to pursue to gain certain competitive
advantages.

4.8 KEY WORDS

Terms of Credit: These refer to eligibility conditions and payment details
for granting credit by the company to a customer.
Creditworthiness: Capacity of the customer to meet payment obligations.
Credit Policy: Decision of the firm to grant or not to grant credit. It
consists of the components such as credit period, discount, credit eligibility
and credit limit.
Credit Period: Refers to the minimum and maximum time limits for
which credit is granted.
Credit limit: Is the limit upto which credit is granted
Decision Tree: Is a model indicating decision points and chance events
for taking a decision.
Credit Scoring System: A system which attempts to rank customers as
good, bad or average by a scoring mechanism.
Business Analysis: An examination of risk factors influencing business
prospects in terms of competition, demand and supply position, structure of
industry, cost structure, labour relations, etc.
Financial Analysis: An examination of financial performance and ability
of a business unit to generate income.
Fundamental Analysis: Refers to capital adequacy asset quality, liquidity
management and interest over tax sensitivity.
Collection Period: Indicates the time taken by the collection department in
collecting its book debts. A comparison of collection period with credit
period tells us whether the debts were collected within the stipulated time
or not.
Ageing Schedule: A method of classifying debts according to the number
of days the debt remained outstanding.
Conversion matrix: Sequencing of debts in the order of their collection.
Variance Analysis: A comparison of Budgeted figures with Actuals to
note down deviations.
CIBIL Score: CIBIL Score is a score which reflects the credit worthiness of
a borrower. This is the score calculated by Credit Information Bureau (India)
102 Ltd., a credit rating agency in India.
 Management of
4.9 SELF-ASSESSMENT QUESTIONS Receivables

1. Explain important components of Receivables Management System?

2. Why do we need a credit policy? How do you evaluate credit policy?
3. How do you assess the credit worthiness of customers?
4. Discuss a few important financial ratios and analysis used in managing
receivables.
5. Assume a customer, who used to pay the dues in time earlier, has
suddenly defaulted. A couple of reminders sent to him fail to get any
response. As a credit manager, you have two issues to decide. You have
to first decide whether to continue the supply to the customer on
credit basis. The second issue is how to deal with the customer to
recover the dues. In the normal course, you have to initiate legal
process to recover the dues but this may strain your firm’s relationship
with the customer. You can’t also be silent since the money involved
is quiet high and your firm is incurring interest cost on this credit. How
do you deal with this customer and decide the two issues?
6. Hindustan Automobiles is manufacturing heavy vehicles and presently
offering a credit period of 45 days. In order to increase the sales from
its current level of Rs. 400 crore., it is contemplating to increase the
credit period to 60 days. This is expected to bring additional sales of
Rs. 40 crore. There is no change in the collection and bad debts cost.
The company is likely to earn a contribution margin of 20%. The short-
term borrowing cost is 15%. Evaluate the new credit period and its
impact on profitability.
7. Regal Industries found that a very few debtors avail the discount,
which is “1.5/10 net 60”. The firm is presently borrowing at 15%.
Since finance for receivables is limited, it is turning down many credit
proposals and thus loose the opportunity to increase the sales. The firm
now wants to revise the discount policy and make it attractive to
motivate some of the existing customers to avail the discount. The funds
released could be used for accepting new customers. The additional
details available to you are: Contribution margin is 20%; Average
collection period is 60 days; Sales could be increased to any level.
With these additional details evaluate the proposed discount policy of
“4/10 net 60”. Compute the impact of new policy on profitability of the
firm.
8. The proposed credit policy of R.K. mills would cut down the bad
debts from 4% to 2%. It will also improve the collection period from
60 days to 30 days. The firms current sale of Rs. 80 lakhs will
decline by 20% on account of this new policy. If the contribution
margin cost of borrowing are 15% and 14% respectively, how the new
credit policy affect the profit of the firm.
9. Your firm is following a credit rating model developed internally to
assess the credit worthiness of customers. The cut-off score is 4.8
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Management of points. Your analysis of historical behaviour of customers with
Current Assets
different points shows the customers, which score is between 4.80 to
5.00, are difficult to assess and nearly 60% of the overall default is
accounted by this group. You have a new customer, whose score as per
the credit rating model is 4.95. The customer wants goods worth of Rs. 5
crore for normal credit period of 60 days and the profit margin on this
sale is 20% without taking into account interest cost on receivables. Your
analysis shows that there is 60% chance that the customer pays the dues
in time, 30% chance for delay of another 60 days and 10% chance of
default. How do you assess the credit proposal?
10. Dynamic Chemicals offers a credit period of 30 days to its customers.
The budgeted sales for the period ending March, 2021 were Rs. 60 lakhs.
The company during the year has sold goods worth Rs. 72 lakhs. The
average receivables were Rs. 7 lakhs against the budgeted value of Rs. 5
lakhs. The interest cost for short-term borrowing during the period was
16%. Analyse the receivables variance and show how much the firm has
lost on the account of delayed collection.

4.10 FURTHER READINGS

Bond, Cecil J., Credit Management Handbook, Mc Graw Hill Inc. New York
Keith V. smith, Guide to Working Capital Management, Mc Graw Hill Inc.
New York.

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