Page 288 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 13: Receivables Management

the optimum level of receivables, the costs and benefits to be compared are marginal costs and Notes
benefits i.e., the firm should only consider the incremental benefits and costs that result from a
change in the receivables or trade policy. Obviously, it can go on extending credit facility till the
incremental benefits are more than the incremental costs.

Notes Credit sales are generally made on open account that means, there is no formal
acknowledgement of debt obligation through any financial instrument. However,
extension of credit involves risk and cost. The benefits as well as cost to determine the goal
of receivable management.

Self Assessment

Fill in the blanks:
1. …………………. cost arises when the customers fail to meet their obligations on due date
after the expiry of the credit period.
2. …………………. are administrative costs incurred in collecting the receivables from the
customers to whom credit sales are made.

3. Costs will be higher with liberal policies than with …………………. measures.
4. While determining the optimum level of receivables, the costs and benefits to be compared
are …………………. costs and benefits.

13.2 Three Crucial Decision Areas in Receivables Management

The three crucial decision areas in receivable management are (a) credit policies (b) credit terms
and (c) collection policies.

13.2.1 Credit Policies

It involves a trade-off between profits on additional sales that arise due to credit being extended
on the one hand and cost of carrying the receivables and bad debt losses on the other. The credit
policy of a firm provides the framework to determine (1) whether or not to extend credit to a
customer and (2) how much credit to extend. The credit policy decision has two dimensions
(1) credit standards and (2) credit analysis.
Credit standards: The term ‘credit standards’ represents the basic criteria for the extension of
credit to customers. The quantitative bases of establishing credit standards are factors such as
credit ratings, credit references, average payment period, and certain financial ratio. We are
interested in illustrating the trade-off between benefit and cost to the firm as a whole and
therefore not considering the individual components of credit standards. The trade-off with
reference to credit standards covers the collection cost, the average collection period, level of
bad debt losses, and level of sales. These factors should be considered while considering whether
to relax credit standards or not.
The implication of relaxed credit standards is more credit, a larger credit department to service
accounts and related matters and increase in collection costs.
A relaxation in credit standard implies an increase in sales, which in turn, leads to higher
average accounts receivables. Further, relaxed standards would enable credit to get extended to

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