Page 263 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 12: Receivables Management

things being equal, a relatively liberal policy and therefore higher investments in receivable, Notes
will produce larger sales. However, costs will be higher with liberal policies than with stringent
measures. Therefore, accounts receivable management should aim at trade off between profit
(benefit) and risk (cost). That is to say, decision to loosen funds to receivables (or the decision to
grant credit) will be based on a comparison of the benefits and costs involved. While determining
the optimum level of receivables, the costs and benefits to be compared are marginal costs and
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

12.2 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.

12.2.1 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.

LOVELY PROFESSIONAL UNIVERSITY 257