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Unformatted text preview: MANAGEMENT OF ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE There are two ways to approach the management of accounts receivable: 1) See how the "Parameters" interface with the "Variables", and 2) The development of a credit granting decision rule. y First, we will examine the relationships between the Parameters and the Variables. y ACCOUNTS RECEIVABLE The PARAMETERS are: y Cash Discount A discount from the face amount of invoice for paying before end of discount period y Cash Discount Period Period in which you can take the Cash Discount, e.g....., 10 days y Credit Period e.g...., 30 days; customer is expected to pay before this date. y Collection Effort The effort that goes into collecting the account; may not be a matter of $'s, rather "effort" in collection. ACCOUNTS RECEIVABLE The VARIABLES are: y Sales y Net Income y Rate of Return on Sales and ROA y Volume of Accounts Receivable y NOCF y Bad Debt Expense ACCOUNTS RECEIVABLE y Now let's see what the elasticity is with respect to the variables and the parameters. First, the Cash Discount. What determines the elasticity with regard to Sales? It appears that it's the relative importance of the order to the customer. If the order is relatively unimportant, then inelastic; if the order is important, then elastic every "price change" will be important. Thus: ACCOUNTS RECEIVABLE y Elasticity of Cash Discount relative to Sales: Cash Discount 3% 2 1 1/2 Elastic; Inelastic. Sales ACCOUNTS RECEIVABLE y y Now the elasticity of the Cash Discount with regard to Net Income: If inelastic, and you lowered the Cash Discount, and you then 3 Cash 2 Discount 1 Net Income $'s ACCOUNTS RECEIVABLE y And the Cash Discount relative to Rate of Return on Sales if inelastic relative to Sales 3 Cash 2 Discount 1 1 2 3 4 5 6 Rate of Return on Sales ACCOUNTS RECEIVABLE y But, while the Rate of Return on Sales may go up, what might happen to ROA? It may actually go down! If A/R's account for a large proportion of Total Assets and A/R's go up because customers have less incentive to pay early. Thus: Cash Discount 3 2 1 ROA ACCOUNTS RECEIVABLE y And what might happen to NOCF with this decrease in Cash Discount if we assume inelasticity? NOCF Cash discount 3% 2 1 IN $'S NOCF Time NOCF will be larger, but it may go down first when the A/R's increase. ACCOUNTS RECEIVABLE y y If you reduce the Cash Discount this will have a tendency to increase Bad Debt Expense. The Cash Discount is, in effect, an "early warning The system" because if a customer suddenly stops taking a cash discount when it was taking it, this may signal that customer is having liquidity problems. ACCOUNTS RECEIVABLE y With respect to the Cash Discount Period, there is little that can be done to shorten it, BUT, instead of using printed forms, and you have your invoices printed by a computer, you can specify that a Cash Discount of so much can be taken if the check is post marked by a specified date. ACCOUNTS RECEIVABLE y y What do you do if a customer takes a Cash Discount and pays LATER than the end of the Cash Discount Period? This is what might be called "Economic Bullyism" and it is to be abhorred! If you are really small relative to the customer, you may try charging an interest rate on the period over the "late date." But if you are rather big, your customer who may also be rather big may refuse to pay any interest and continue to pay slowly. The may refuse to author knows of one manufacturer in the construction field who had a profitable small "finance company" financing its own slow Receivables. ACCOUNTS RECEIVABLE y y And now for the Credit Period. This is the "bluntest instrument" in the A/R management "Tool Bag". What would happen if a firm increased its credit period from 30 to 60 days? For many items, there will be noticeable elasticity, especially from customers in the retail and mercantile distribution field until the competition responds! ACCOUNTS RECEIVABLE Credit Period versus Sales Credit Period 60 30 0 Sales Often, there will be elasticity of demand with respect to the credit period. ACCOUNTS RECEIVABLE y Credit period versus Net Income Credit Period 60 30 0 But this rise in Net Income may be misleading; what's going to happen to the Vol.of Receivables? Net Income ACCOUNTS RECEIVABLE y Credit Period versus Volume of Receivables 60 30 0 Credit Period Demand Effect Volume Of Receivables Note that the Volume of Receivables will go up because Credit Period is increased, plus a "Demand Effect" increase other customers will buy. ACCOUNTS RECEIVABLE y Credit Period versus Rate of Return on Sales & Rate of Return on Assets Credit Period 60 30 0 ROA Rate of Return on Sales ACCOUNTS RECEIVABLE y Credit period versus NOCF without retaliation. Credit Period 30 60 NOCF IN $'S 0 $'s NOCF Time ACCOUNTS RECEIVABLE y Collection Effort How hard do you try to collect Receivables? Also, what sort of screening do you do on customers? For example, re: Sales Collection Effort Sales With better screening, more sales may result at first; but pushing Collection Effort will result in declining sales. ACCOUNTS RECEIVABLE Bad Debt Expense If you were the Collection Manager and during your tenure Bad Debt Expense went up, would you think that you did a good job? y Maybe "Yes" if your Net Income went up! The object is to OPTIMIZE Bad Debt Expense, not minimize it! y ACCOUNTS RECEIVABLE Credit Granting Decision Rule How do you decide whether or not to grant credit to a customer? y Grant Credit if: Expected Gain > Expected Loss And P ( G ) > (1P)( C ), y Where : P = Probability of Collection, G = Gross Profit, and C = Cost of Goods Sold y ACCOUNTS RECEIVABLE Credit Granting Decision Rule An example of the decision rule: y Where P = .9, G = $300, and C = $700, then .9 ( 300 ) > (1 .9) ( 700 ) $270 > $70 Grant Credit y ACCOUNTS RECEIVABLE Credit Granting Decision Rule If there is a slow pay involved, we can add this to the decision rule as follows: ( S=Sales) P [ G ( i(t) S) ] >(1 P )[ C + (i(t) S) ] or y .9 [ 300 (36( 1/6 yr.) 1,000)] > .1 [ 700 + (.36(1/6yr) 1,000)] $216 > $76 Grant Credit Slow Pay Factor is "i(t)S". Assuming i = 36% and the slow pay is for 2 months. ACCOUNTS RECEIVABLE Credit Granting Decision Rule y As you can see, the probability of collection, P, is quite important in this model. Now it can be shown that : P = C/S or (S G)/ S and if you include the Slow Pay Factor, it becomes: P = [ C + ( i(t) S)] / S or P = [ S (G (i(t) S)) ] / S Where P = the probability of collection that makes left side = right side of the inequality. ACCOUNTS RECEIVABLE Credit Granting Decision Rule y y It follows from the preceding equation that the decision rule for granting credit boils down simply to: Grant Credit If : P > P So, if you have a very big Gross Profit, you should be quite liberal when granting credit (because your P will be quite small); if you have a thin Gross Profit, you must be quite careful in granting credit. ACCOUNTS RECEIVABLE Credit Granting Decision Rule y But remember, that P is " At the margin", meaning that it applies for just one more sale. The customer's probability of collection is not fixed in granite; it will be changing over time. So you must keep checking the probability over time. Furthermore, you can kill a customer with too much credit. MANAGEMENT OF ACCOUNTS RECEIVABLE END ...
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This note was uploaded on 02/11/2012 for the course BUAD 497 taught by Professor Degravel during the Spring '07 term at USC.

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