Chapter 8: Accounts receivable management
Receivables come from sales in credit
Credit sales Increasing revenue Increasing profit
Credit sales increasing receivables Increasing
operating costs
Objective of receivables management is:
to determine whether increasing in revenue
and profit is large enough to offset increasing
in costs, or
to determine whether saving in cost is large
enough to offset decreasing in profit.
Chapter 8
Accounts receivable management
Outline of the chapter
Objective of receivable management
Credit policies
Credit standard policies
Credit term policies
Credit period
Cash discount
Credit policies with default risk
Objective of receivables
management
Receivables come from sales in credit
Credit sales Increasing revenue Increasing profit
Credit sales increasing receivables Increasing
operating costs
Objective of receivables management is:
to determine whether increasing in revenue
and profit is large enough to offset increasing
in costs, or
to determine whether saving in cost is large
enough to offset decreasing in profit.
Objective of receivables management
Sales in credit
Revenues increase Receivables increase
Profits increase Increase in costs related to receivables
Opportunity costs
Compare
Determine credit
increase in
policies
profit and in
costs
Credit policies
Credit standards
Credit terms
Credit period
Cash discount
Credit policies with influence of default risk
Credit standards
Credit standards – the minimum quality of
credit worthiness of a credit applicant that
is acceptable to the firm.
Credit standard policy may be:
Lowering – lower the standards or easier in
accepting sales in credit
Highering – Higher the standards or more
difficult in accepting sales in credit
Impact of a lower credit standard
Increasing in Increasing in
receivables opportunity
costs
Lowering
credit Increasing
standard in sales
Whether
Increasing increasing in
in profit profit is offset
increasing in
cots
Impact of a higher credit standard
Decreasing in Saving in
receivables opportunity
costs
Higher
credit Decreasing
standard in sales
Whether
Decreasing saving in
in profit costs is offset
decreasing in
profit
Suppose that ABC. Ltd’ s product sells for $10 a unit, of which $8 represents variable
costs before tax. Annual sales are presently running at level of $2.4 million and
opportunity cost of carrying the additional receivables is 20 percent before tax. The
relaxation in credit standards is expected to produce a 25 percent increase in sales
but average collection period is increased to 2 months. Should the firm relax its credit
standard?
Profitability of additional sales
Additional sales = 2.4 x 25% = $0.6 million =$600,000
Additional sales in unit = 600,000 / 10 = 60,000
Additional profit = 60,000(10 – 8) = $120,000
Opportunity cost of receivables
Receivable turnover = 12 months/Average collection
period = 12 / 2 = 6
Additional receivables = Additional sales revenue/
receivable turnover = 600,000 / 6 = $100,000
Investment in additional receivables = 100,000(8/10) =
$80,000
Required before-tax return on additional investment=
80,000 x 20% = $16,000 (opportunity cost)
Policy determination
Additional profit from relaxation of credit
standards = $120,000
Opportunity cost originated from relaxation
of credit standards = 16,000$
Additional profit > Opportunity cost
The company should lower its credit
standards
Credit terms
Credit terms include:
Credit period
Cash discount, and
Cash discount period
Example a credit term “2/10 net 30” means
Credit period = 30 days
Cash discount = 2%
Cash discount period < or = 10 days
A change in credit terms is often a change in:
Credit period, or
Cash discount
Impact of increasing credit period
Increasing
average Increasing Increasing
collection receivables opportunity
period cost
Increasing
credit Whether
period increasing
profits is
offset
Increasing Increasing increasing
sales profits costs
Impact of decreasing credit period
Decreasing
average Decreasing Saving
collection receivables opportunity
period cost
Decreasing
credit period Whether
saving costs
is offset
decreasing
Decreasing Decreasing profits
sales profits
ABC. Ltd ‘s product has selling price of $10, variable cost per unit is $8, and its annual
revenue is 2.4 million dollars. The opportunity cost of carrying receivable is 20%. If
the firm changes its credit terms from “net 30” to “net 60”, there are $360,000 in
additional sales and its average collection period increases from 30 to 60 days. Should
the firm change its credit period?
Additional profit
Additional sales: $360,000 => Additional sales in unit = 360,000 / 10 =
36,000
Additional profit = 36,000(10 – 8) = $72,000$
Opportunity cost of carrying receivables
New receivable turnover = 12 months/Average collection period
= 12 / 2 = 6
Additional receivables associated with new sales =Additional sales / New
receivable turnover = 360,000 / 6 = $60,000
Additional receivables associated with original sales = (2,400,000 / 6) –
(2,400,000 /12) = $200,000
Total receivables = 60,000 + 200,000 = $260,000
Investment in additional receivables = 260,000(8/10) = $208,000
Opportunity cost of carrying receivables = 208,000 x 20% = $41,600
Policy determination
Additional profit if credit period changed = $72,000
Opportunity cost of carrying receivables = $41,600
Additional profit > Opportunity cost
The firm should change its credit period.
Cash discount terms
Cash discount terms include:
Cash discount rate
Cash discount period
Changing cash discount terms means:
Changing cash discount rate
Changing cash discount period
In reality, cash discount period is rarely
changed.
Impact of increasing cash discount rate
Average Saving the
collection Receivables opportunity
period decreased cost of
decreased carrying
receivables
Discount
rate
increased
Whether cost
Net sales Profit saved is
decreased decreased offset profit
decreased
Impact of decreasing cash discount rate
Average Opportunity
collection Receivables cost of
period increased carrying
increased receivables
increased
Discount
rate
decreased
Whether profit
increased is
offset
Net sales Profit opportunity cost
increased increased increased.
Presently the annual sales of ABC. Ltd is 3 million dollars and its average collection
period is 2 months. Opportunity cost of carrying receivables is 20%. ABC believes if its
credit term is changed from net 45 to 2/10 net 45, its average collection period will
lower to 1 month and 60 percent of its customers will pay earlier to take discount.
Should the firm change its credit term?
Determine cost saved
Receivable turnover before changing credit term =
12months/Average collection period = 12 / 2 = 6
Receivables before changing credit term = Sales /
Receivable turnover = 3,000,000 / 6 = $500,000
Receivables after changing credit term= 3,000,000 /12 =
$250,000
Receivables decreased = 500,000 – 250,000 = $250,000
Cost saving = 250,000 x 20% = $50,000
Determine profit lost because of discount taken by customers =
3,000,000 x 0.6 x 0.02 = $36,000
Policy determination
Cost saving = $50,000
Profit loss = $36,000
Cost saving > Profit loss
The firm should change its credit term.