Answer: There are three aspects of the dimensions of receivables management and these aspects are:
1. Formulation of Credit Policies:
Quality of Trade accounts to be accepted: A firm’s credit terms influence, in the main, its volume of sales. By liberalizing credit policy, the firm can stimulate sales and so also its gross earnings. But the increased sales may be accompanied by added costs. One such cost is the enlarged credit department and the clerical expenses involved in investigating additional accounts and servicing added volume of receivables.
Length of the Credit Period: Credit terms specify the length of the credit period and size of the cash discount offered for quick payment. There is no legal restriction on a firm to set terms of sale. The firm can fashion its own terms and use them as a dynamic instrument in its bid to stimulate sales. But the freedom to determine the terms of credit is constrained by the customs of an industry. Each trade has its customary terms of credit, which frequently dictate the nature of the credit terms to be offered by a firm.
Cash Discount: Cash discount is a powerful device to speed up collections of receivables. This would result in reduction of investment in receivables. But offering cash discount involves cost. The finance manager should match the earnings resulting from investment of funds released by reducing the level of receivables with the cost of the discount to decide whether or not cash discounts should be offered.
Discount Period: Period of discount also influences average collection period of receivables. Thus, by lengthening the discount period many customers, who were not taking advantage of cash discount, may be tempted to avail of this benefit. This would, therefore, shorten the collection period. However, there may be some customers who were availing discount facility and making payment within discount period, will now postpone the payment until the expiry of lengthened discount period.
2. Execution of Credit Policies:
Once credit policies have been formulated, the finance manager should execute these policies properly. Execution of credit policies calls for evaluation of credit applicants and financing of investment in receivables.
Evaluation of Credit Applicants: Mere determination of appropriate credit policy for the firm will not help accomplish the overall objective of minimizing investment in receivables and reducing bad debt losses unless creditworthiness of applicants is evaluated to ensure that they conform to the credit standards prescribed by the firm.
Credit evaluation process involves three steps, viz., gathering credit information about the credit applicants, determining the creditworthiness of the applicants on the basis of information so collected and finally, taking decision to grant credit facilities.
The following paragraphs will deal with these aspects:
Gathering Credit Information: A finance manager gathers requisite information from different sources on which customers evaluation must necessarily be based. Two important factors that should be kept in mind while searching for credit information are: cost and time. A firm cannot afford to spend a lot of money on investigation of some credit applicant’s particularly smaller ones and in such case the finance manager should take decision on the basis of limited information about the applicant.
Financial Statements: Financial statements are, in general, the most useful source of credit information about the credit applicant. They are required from most of the applicants especially when the amount of credit involved is relatively large. In case of new customers, the firm may require the customers to supply audited balance sheet statement and profit and loss statement for several years prior to the current year. Much can be learnt from balance sheet about the liquidity of the business of the customer, its credit policy and paying habits.
Reports of Credit Rating Agencies: Where the customer insists on prompt delivery the finance manager cannot afford to devote much time in securing financial statements of the customer and interpreting them. In such cases financial reports of credit rating agencies can be relied upon to gather information about the credit-worthiness of the applicant. These agencies collect information about financial, managerial and other aspects of a large number of business concerns and keep them up-to-date.
Bazar Reports: Reports about the applicant can be obtained from the various markets, particularly from businessmen carrying on the same trade. Some of the businessmen may be his friends, others his rivals. Some may, therefore, give exaggerated figures of the applicant’s means while others may try to run him down. All such reports sometimes contradictory to each other have to be weighed independently and a balanced opinion have to be formed about credit-worthiness of the credit customer.
Reports from Banks: Information about the customer can be obtained from different banks with which the customer deals. Most commercial banks maintain credit departments of their own to perform credit investigations for their customers. Ordinarily, a firm seeking credit information on a potential customer located in another city will request his bank to collect from other banks situated in customer’s area, data relating to level of bank balance maintained by the customer and extension of bank credit to him.
Firm’s own Records: If the applicant is not a new customer the firm can depend on its own experience to study about promptness of past payments by the customer. The firm can also ask its salesman to submit report on the quality of the management of the business owned by the customer.
Credit Analysis: After assembling credit information about the potential customer, the finance manager analyses these information’s to evaluate creditworthiness of the customer and to determine whether he satisfies the standard of acceptability or not. Such an analysis is known as credit analysis. Thus, credit analysis involves the credit investigation of potential customer to determine the degree of risk associated with the account.
3. Formulation of Collection Policy and Its Execution:
Proper management of receivables calls for designing of suitable collection policy of the firm and laying down collection procedures.
Basic objective while formulating collection policy is to ensure the earliest possible payment of receivable without any customer losses through ill will. Prompt collection of accounts tends to reduce investment required to carry receivables and the costs associated with it. Percentage of bad debts is very likely to decrease.
In designing policy for the firm, finance manager faces problem of determining appropriate amount of collection expenditures to minimise bad debt losses and to shorten collection period. By matching the level of collection expenditures with the opportunity saving on reduced investment in receivables and bad debt losses, finance manager should strive for determining the appropriate level of collection expenditures.
