The investment of funds in accounts receivable involves a trade-off between profitability and risk.

Accounts receivable is the amounts of money owed to a firm by customers who have bought goods or
services on credit.
Economic conditions, product pricing, product quality, and the firm’s credit policies are the chief
influences on the level of a firm’s accounts receivable. All but the last of these influences are largely
beyond the control of the financial manager.
Lowering credit standards (The minimum quality of creditworthiness of a credit applicant that is
acceptable to the firm) may stimulate demand, which, in turn, should lead to higher sales and profits.

Objectives of Trade Credit

Trade credit exists when one firm provides goods or services to a customer with an agreement to bill
them later. It can be viewed as an essential element of capitalization in an operating business.
• To reduce capital requirements
• To improve cash flow
• To help increase business focus

Credit Policies
A firm’s credit policy is regarding its credit standards, credit period, cash discounts, and collection
procedures.
The types of Credit Policies are-
1) Lenient or
2) Stringent (tight)

1) Lenient Credit Policy

It is that policy where the seller sells goods on very liberal credit terms and standards. In other words,
goods are sold to the customers whose creditworthiness is not up to the standards or whose financial
position is doubtful.

Advantages of Lenient Credit Policy

a) Increase in Sales: Lenient credit policy expands sales because of the liberal credit terms
and favorable incentives granted to customers.
b) Higher Profits: Increase in sales leads to increase in profits, because higher level of
production and sales reduces permit cost.

Disadvantages of Lenient Credit Policy

a) Bad Debt Loss: A firm that follows lenient credit policy may suffer from bad debts losses
that arise due to the non-payment credit sales.
b) Liquidity Problem: Lenient credit policy not only increases bad debt losses but also creates
liquidity problem because when the firm is not able to receive the payment at a due date, it
may become difficult to pay currently maturing obligations.

2) Stringent Credit Policy

Stringent credit policy seller sells goods on credit on a highly selective basis only i.e., the customers
who have proven credit worthiness and financially sound.

1
 Advantages of Stringent Credit Policy
a) Less Bad Losses: A firm that adopts stringent credit policy will have minimum bad debts
losses, because it had granted credit only the customers who are creditworthy.
b) Sound Liquidity Position: The firm that follows stringent credit policy will have sound Notes
liquidity position, due to the receipt of all payments from customers on due date, the firm
can easily pay the currently maturing obligations.

Disadvantages of Stringent Credit Policy

a) Less Sales: Stringent credit policy restricts sales, because it is not extending credit to
average credit worthiness customers.
b) Less Profits: Less sales automatically reduces profits, because firm may not be able to
produce goods economically, and it may not be able to use resource efficiently that leads
increase in production cost per unit.

The policy variables we consider include-

• The quality of the trade accounts accepted,
• The length of the credit period,
• The cash discount (if any) for early payment, and
• The collection program of the firm.

Together, these elements largely determine the average collection period and the proportion of credit
sales that result in bad-debt losses.

Credit policy can have a significant influence on sales. If our competitors extend credit liberally and we
do not, our policy may have a dampening effect on our firm’s marketing effort.
Some of the costs of relaxing credit standards arise from an enlarged credit department, the clerical
work involved in checking additional accounts, and servicing the added volume of receivables. We
assume that these costs are deducted from the profitability of additional sales to give a net profitability
figure for computational purposes. Another cost comes from the increased probability of bad-debt
losses.
Finally, there is the opportunity cost of committing funds to the investment in additional receivables
instead of to some other investment. The additional receivables result from-
i. Increase sales and
ii. A longer average collection period.

To assess the profitability of a more liberal extension of credit, we must know the profitability of
additional sales, the added demand for products arising from the relaxed credit standards, the increased
length of the average collection period, and the required return on investment.

An Example of the Trade-off follows.

Suppose that a firm’s product sells for $10 a unit, of which $8 represents variable costs before taxes,
including credit department costs. The firm is operating at less than full capacity, and an increase in
sales can be accommodated without any increase in fixed costs.
Currently, annual credit sales are running at a level of $2.4 million. The firm may liberalize credit, which
will result in an average collection period of two months for new customers. Existing customers are not
expected to alter their payment habits. The relaxation in credit standards is expected to produce a 25%
increase in sales.
Assume that the firm’s opportunity cost of carrying the additional receivables is 20% before taxes.
Would the firm be advised to relax its credit standards?

2
Solution:
Profitability versus required return in evaluating a credit standard change.
• Profitability of additional sales = (Contribution margin per unit) x (Additional units sold)
= $2 x 60,000 units = $1,20,000
• Additional receivables = (Additional sales revenue)/(Receivable turnover for new customers)
= $6,00,000/6 = $1,00,000
• Investment in additional receivables = (Variable cost per unit/Sales price per unit) x (Additional
receivables) = 0.80 × $1,00,000 = $80,000
• Required return before - tax return on additional investment = (Opportunity cost) x (Investment
in additional receivables) = 0.20 × $80,000 = $16,000

The firm can be suggested to allow credit relaxed because additional profitability is greater than the
required return on additional investment.
However, as we take on poorer credit risks, we also increase the risk of the firm, as reflected in the
variance of the firm’s expected cash-flow stream. This increase in risk also manifests itself in additional
bad-debt losses.

Credit Terms
Credit terms specify the length of time over which credit is extended to a customer and the discount, if
any, given for early payment.

For example, one firm’s credit terms might be expressed as

“2/10, net 30.” The term “2/10” means that a 2% discount is given if the bill is paid within 10 days of the
invoice date. The term “net 30” implies that if a discount is not taken, the full payment is due by the 30th
day from invoice date. Thus, the credit period is 30 days.
Although the customs of the industry frequently dictate the credit terms given, the credit period is
another means by which a firm may be able to increase product demand. As before, the trade-off is
between the profitability of additional sales and the required return on the additional investment in
receivables.

Let us say that the firm in our example changes its credit terms from “net 30” to “net 60” – thus
increasing its credit period from 30 to 60 days. The average collection period for existing customers
goes from one month to two months. The more liberal credit period results in increased sales of
$3,60,000, and these new customers also pay, on average, in two months. The total additional
receivables are composed of two parts.
✓ The first part represents the receivables associated with the increased sales. With a new
receivable turnover of six times a year, the additional receivables associated with the new sales
are $3,60,000/6 = $60,000. For these additional receivables, the investment by the firm consists
of the variable costs tied up in them.
✓ The second part of the total additional receivables is caused by the slowing in collections
associated with sales to original customers. Receivables due from original customers are now
collected in a slower manner resulting in a higher receivable level. With $2.4 million in original
sales, the level of receivables with a turnover of 12 times a year is $24,00,000/12 = $2,00,000.

The new level with a turnover of 6 times a year is $24,00,000/6 = $4,00,000. Thus, there are $2,00,000 in
additional receivables associated with sales to original customers. For this addition, the relevant
investment using marginal analysis is the full $2,00,000.

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Profitability Versus Required Return in Evaluating a Credit Period Change-
Profitability of additional sales = (Contribution margin per unit) x (Additional units sold)
= $2 x 36,000 units = $72,000

Additional receivables associated with new sales = (New sales revenue)/(New receivable turnover)
= $3,60,000/6 = $60,000

Investment in additional receivables associated with new sales

= (Variable cost per unit/Sales price per unit) x (Additional receivables)
= 0.80 x $60,000 = $48,000

Level of receivables before credit period change = (Annual credit sales)/(Old receivable turnover)
= $24,00,000/12 = $2,00,000

New level of receivables associated with original sales = (Annual credit sales)/(New receivable turnover)
= $24,00,000/6 = $4,00,000

Investment in additional receivables associated with original sales

= $4,00,000 − $2,00,000 = $2,00,000

Total investment in additional receivables = $48,000 + $2,00,000 = $2,48,000

Required return before-tax return on additional investment

= (Opportunity cost) x (Total investment in additional receivables)
= 0.20 x $2,48,000 = $49,600

Cash Discount Period and Cash Discount

The cash discount period represents the period of time during which a cash discount can be taken for
early payment. Though technically a credit policy variable, like the credit period, it usually stays at some
standard length. For many firms, 10 days is about the minimum time they could expect between when an
invoice is mailed to the customer and when the customer could put a check in the mail.
The cash discount is a percent (%) reduction in sales or purchase price allowed for early payment of
invoices. It is an incentive for credit customers to pay invoices in a timely fashion. Varying the cash
discount involves an attempt to speed up the payment of receivables.

Suppose that the firm has annual credit sales of $3 million and an average collection period of two
months. Also, assume that sales terms are “net 45,” with no cash discount given. By initiating terms of
“2/10, net 45,” the average collection period can be reduced to one month, as 60% of the customers (in
dollar volume) take advantage of the 2% discount.

Cost versus Savings in evaluating a cash discount change-

Level of receivables before cash discount change = (Annual credit sales)/(Old receivable turnover)
= $30,00,000/6 = $5,00,000

New level of receivables associated with cash discount change

= (Annual credit sales)/(New receivable turnover)
= $30,00,000/12 = $2,50,000

Before-tax cost of cash discount change

= (Cash discount) x (Percentage taking discount) x (Annual credit sales)
= 0.02 x 0.60 × $30,00,000 = $36,000

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Reduction of investment in accounts receivable = (Old receivable level) − (New receivable level)
= $5,00,000 − $2,50,000 = $2,50,000

Before-tax opportunity savings on reduction in receivables

= (Opportunity cost) x (Reduction in receivables)
= 0.20 x $2,50,000 = $50,000

Seasonal Dating
Seasonal dating is the credit terms that encourage the buyer of seasonal products to take delivery
before the peak sales period and to defer payment until after the peak sales period.
We should compare the profitability of additional sales with the required return on the additional
investment in receivables to determine whether dating are appropriate terms by which to stimulate
demand.
Seasonal dating can also be used to avoid inventory-carrying costs. If sales are seasonal and production
is steady throughout the year, there will be buildups in finished-goods inventory during certain times of
the year.
Storage involves warehousing costs that might be avoided by giving dating. If warehousing costs plus
the required return on investment in inventory exceed the required return on the additional receivables,
dating is worthwhile.

Default Risk
Our concern in this section is not only with the slowness of collection but also with the portion of the
receivables in default.
Different credit standard policies will involve both of these factors. The optimum credit standard policy,
as we shall see, will not necessarily be the one that minimizes bad-debt losses.
Suppose that we are considering the present credit standard policy (resulting in sales of $2.4 million)
together with two, increasingly more liberal, new ones. These alternative policies are expected to
produce the following results-
Present Policy Policy A Policy B
Demand (credit sales) $24,00,000 $30,00,000 $33,00,000
Incremental sales 6,00,000 3,00,000
Default losses:
Original sales 2%
Incremental sales 10% 18%
Average collection period:
Original sales 1 month
Incremental sales 2 months 3 months

We assume that after six months an account is turned over to a collection agency, and, on average, 2%
of the original sales of $2.4 million is never received by the firm, 10% is never received on the $6,00,000
in additional sales under Policy A, and 18% on the $3,00,000 in additional sales under Policy B is never
received.
Similarly, the one-month average collection period pertains to the original sales, two months to the
$6,00,000 in additional sales under Policy A, and three months to the $3,00,000 in additional sales under
Policy B. These numbers of months correspond to annual receivable turnovers of 12 times, 6 times, and
4 times, respectively.

5
The incremental profitability calculations associated with these two new credit standard policies are
shown in the following table:

Profitability versus required return in evaluating credit policy changes

Policy A Policy B
1) Additional sales $6,00,000 $3,00,000
2) Profitability of additional sales = (20% contribution 1,20,000 60,000
margin) x (Additional sales)
3) Additional bad-debt losses = (Additional sales) x 60,000 54,000
(Bad-debt percentage)
4) Additional receivables = (Additional sales/New 1,00,000 75,000
receivable turnover)
5) Investment in additional receivables = (0.80) x 80,000 60,000
(Additional receivables)
6) Required return before-tax return on additional 16,000 12,000
investment = (20%)
7) Additional bad-debt losses + additional required 76,000 66,000
return (3 + 6)
8) Incremental profitability (2 - 7) 44,000 (6,000)

Collection Policy and Procedures

The firm determines its overall collection policy by the combination of collection procedures it
undertakes. The procedures include such things as letters, faxes, phone calls, personal visits, and legal
action.
One of the principal policy variables is the amount of money spent on collection procedures. Within a
range, the greater the relative amount expended, the lower the proportion of bad-debt losses, and the
shorter the average collection period, all other things being the same.

The relationships are not linear. However, Initial collection expenditures are likely to cause little
reduction in bad-debt losses.
Additional expenditures begin to have a significant effect up to a point – then they tend to have little
effect in further reducing these losses. The hypothesized relationship between collection expenditures
and bad-debt losses is shown in the following figure-

Relationship between number of bad-debt losses and collection expenditures

Bad-debt Losses

Saturation
Collection Expenditure Point

6
Initially, a telephone call is usually made to ask why payment has not been made.
Next, a letter is often sent and followed, perhaps, by additional letters that become more serious in tone.
A phone call or letter from the company’s attorney may then prove necessary.
Some companies have collection personnel who make visits to a customer about an overdue account.
If all else fails, the account may be turned over to a collection agency. The agency’s fees are quite
substantial – frequently one-half the amount of the receivable – but such a procedure may be the only
feasible alternative, particularly for a small account.
Direct legal action is costly, sometimes serves no real purpose, and may only force the account into
bankruptcy. When payments cannot be collected, compromise settlements may provide a higher
percentage of collection.

Analyzing the Credit Applicant

Having established the terms of sale to be offered, the firm must evaluate individual credit applicants
and consider the possibilities of a bad debt or slow payment. The credit evaluation procedure involves
three related steps-
1) Obtaining information on the applicant,
2) Analyzing this information to determine the applicant’s creditworthiness, and
3) Making the credit decision.

The credit decision, in turn, establishes whether credit should be extended and what the maximum
amount of credit should be.

Sources of Information
A number of services supply credit information on businesses, but for some accounts, especially small
ones, the cost of collecting this information may outweigh the potential profitability of the account. The
firm extending credit may have to be satisfied with a limited amount of information on which to base a
decision. The firm must consider the time it takes to investigate a credit applicant. The amount of
information collected needs to be considered in relation to the time and expense required.
Depending on these considerations, the credit analyst may use one or more of the following sources of
information:
a) Financial Statement
b) Credit Ratings & Reports
c) Bank Checking
d) Trade Checking and
e) Company’s Own Experience

Credit Analysis
Having collected credit information, the firm must make a credit analysis of the applicant. Presumably,
the expected value of the additional information will exceed the cost of acquiring it. Given the financial
statements of a credit applicant, the credit analyst should undertake a ratio analysis. The analyst will be
particularly interested in the applicant’s liquidity and ability to pay bills on time. Such ratios as the quick
ratio, receivable and inventory turnovers, the average payable period, and debt-to-equity ratio are
particularly relevant.
In addition to analyzing financial statements, the credit analyst will consider the characters of the
company and its management, the financial strength of the firm, and various other matters.

Sequential Investigation Process.

The amount of information collected should be determined in relation to the expected profit from an
order and the cost of investigation. More sophisticated analysis should be undertaken only when there is
a chance that a credit decision based on the previous stage of investigation will be changed.
The prospect of changing the reject decision, if the added cost associated with this stage of investigation
would not be worthwhile. Each incremental stage of investigation has a cost, which can be justified only
if the information obtained has value in changing a prior decision.

7
 Sequential Investigation Process

Credit-Scoring Systems
A system used to decide whether to grant credit by assigning numerical scores to various
characteristics related to creditworthiness. Quantitative approaches have been developed to estimate
the ability of businesses to service credit granted to them; however, the final decision for most
companies extending trade credit (credit granted from one business to another) rests on the credit
analyst’s judgment in evaluating available information.
Strictly numerical evaluations have been successful in determining the granting of credit to retail
customers (consumer credit), where various characteristics of an individual are quantitatively rated, and
a credit decision is made on the basis of the total score.

Credit Decision and Line of Credit

Once the credit analyst has marshaled the necessary evidence and analyzed it, a decision must be
reached about the disposition of the account. In an initial sale, the first decision to be made is whether
or not to ship the goods and extend credit. If repeat sales are likely, the company will probably want to
establish procedures so that it does not have to fully evaluate the extension of credit each time an order
is received.
One means of streamlining the procedure is to establish a line of credit (A limit to the amount of credit
extended to an account. Purchaser can buy on credit up to that limit.) for an account. A line of credit is a
maximum limit on the amount the firm will permit to be owed at any one time.

8
Factoring
Factoring is a unique innovation. It is both a financial and a management support to a client. It is a
method of converting a non-productive, inactive asset (A/C receivable) into a productive asset (Cash) by
selling receivable to a company that specializes in their collection and administration. Factoring is a
popular mechanism of managing, financing and collecting receivable in developed countries like USA
and UK.
One can define factoring as a business involving a continuing legal relationship between a financial
institution (the factor) and a business concern (the client) selling goods or providing services to trade
customers whereby the factor purchases the client’s accounts receivable and in relation thereto,
controls the credit, extended to customers and administers the sales ledger.
The factor is to perform the following functions-
• Finance for suppliers including loans and advance payments
• Maintenance of accounts (Ledgering relating to receivable)
• Collection of accounts (Ledgering relating to receivable)
• Protection against default in payment by debtor.

The agreement between the supplier and the factor specifies the factoring procedure. Usually, the firm
sends the customer’s order to the factor for evaluating the customer’s creditworthiness and approval.
Once the factor is satisfied about the customer’s creditworthiness and agrees to buy receivable, the firm
dispatches goods to the customer. The customer will be informed that his account has been sold to the
factor, and he is instructed to make payment directly to the factor.

Factoring and Short-term Financing

Although factoring provides short-term financial accommodation to the client, it differs from other types
of short-term credit in the following manners:
• Factoring involves sale of book debts. Thus, the client obtains advance cash against the
expected debt collection and does not incur a bad-debt.
• Factoring provides flexibility as regards credit facility to the client. He can obtain cash either
immediately or on due date or from time to time, as and when he needs cash. Such flexibility
is not available for formal source of credit.
• Factoring is a unique mechanism which not only provides credit to the client but also
undertakes the total management of client’s book debt.

Factoring and Bills Discounting

Factoring should be distinguished from bill discounting. Bill discounting or invoice discounting consists
of the client drawing bills of exchange for goods or services on buyers, and then discounting it with bank
for a charge. Factoring is all of bills discounting plus much more. Bills discounting has the following
limitations in comparison of factoring-
• Bills discounting is a sort of borrowing while factoring is the efficient and specialized
management of book debts along with enhancing the client’s liquidity.
• The client has to undertake the collection of book debt. Bills discounting is always with
‘recourse’ and as such the client is not protected from bad-debts.
• Bills discounting is not a convenient method for companies having large number of buyers
with small amounts since it is quite inconvenient to draw a large number of bills.

Types of Factoring
The factoring facilities available worldwide can be broadly classified into four main groups-
1. Full-service non-recourse (old line)
2. Full-service recourse factoring
3. Bulk/agency factoring
4. Non-notification factoring

9
1. Full Service Non-Recourse: Under this method, book debts are purchased by the factor, assuming
100% credit risk. The full number of invoices have to be paid to clients in the event of debt becoming
bad. He also advances cash up to 80-90% of the book debt immediately to the client.
Customers are required to make payment directly to the factor. The factor maintains sales ledger
and account and prepare age-wise reports of outstanding book debts.
Non-recourse factoring is most suited to the following situation where-
• amounts involved per customer are relatively substantial and financial failure can endanger
client’s business severely,
• there are a large number of customers of whom the client cannot have personal knowledge,
and
• the client prefers to obtain 100% cover under factoring rather than take insurance policy
which provides only 80-90% cover.

Non-recourse factoring is very popular in USA, where it is also known as ‘old-line’ factoring. Old-line
factors are true factors and they differ from those who merely finance receivables.

2. Full-Service Recourse Factoring: In this method of factoring, the client is not protected against the
risk of bad-debts. He has no indemnity against unsettled or uncollected debts. If the factor has
advanced funds against book debt on which a customer subsequently defaults, the client will have to
refund the money.
Most countries practice recourse factoring since it is not easy to obtain credit information, and the
cost of bad-debt protection is very high. This type of factoring is often used as a method of short-
term financing, rather than pure credit management and protection service.
The non-recourse and recourse factoring can be further classified into:
i. Advance factoring
ii. Maturity factoring

3. Bulk/Agency Factoring: This type of factoring is basically used as a method of financing book debts.
Under this, the client continues to administer credit and operates sales ledger. The factor finances
the book debt against bulk either on recourse or without recourse. Those companies which have
good systems of credit administration, but need finances, prefer this form of factoring.

4. Non-Notification Factoring: In this type of factoring, customers are not informed about the factoring
agreement. It involves the factor keeping the accounts ledger in the name of a sales company to
which the client sells his book debts. It is through this company that the factor deals with the client’s
customers. The factor performs all his usual functions without a disclosure to customers that he
owns the book debts.

Cost and Benefits of Factoring

Costs of Factoring: There are two types of costs involved in factoring-
1) The factoring commission or service fee: Factoring commission is paid for credit evaluation
and collection and other services and to cover bad-debt losses. It is usually expressed as a
percentage of full net face value of receivable factored, and in developed countries like USA,
it ranges between 1 to 3%. In fact, factoring commission will depend on the total volume of
receivables, the size of individual receivable, and the quality of receivables. The commission
is expected to be higher for ‘without recourse’ factoring since the factor assumes the entire
credit risk.

2) The interest on advance granted by the factor to the firm: The interest on advance would be
higher than the prevailing prime rate of interest or the bank overdraft rate. In USA, factors
charge a premium ranging between 2 to 5% over and above the prime rate of interest.
However, in the opinion of experts, factors should not charge more than the banks charging
since they would be in competition with them as regards the financing of receivables.

10
Benefits: There are certain benefits which result from factoring receivables, and they are more than
offset the costs of factoring.
Factoring has the following benefits-
• Factoring provides specialized service in credit management, and thus, the firm’s management
to concentrate on manufacturing and marketing.
• Factoring helps the firm to save cost of credit administration due to the scale of economies and
specialization.

Problem:
A small business has credit sales of Tk. 80 lacs and its average collection period is 80 days. The past
experience indicates that bad-debts losses are around 1% of credit sales. The firm spends about Tk.
1,20,000 per year on administering its credit sales. This cost includes salaries of one officer and two
clerks who handle credit checking, collection etc. and telephone and telex charges. These are avoidable
costs. A factor is prepared to buy the firm’s receivables. He will charge 2% commission. He will also pay
advances against receivables to the firm at an interest rate of 18% after withholding 10% as reserve.
What should be the firm do?

Solution:
8,00,000
Average Level of Receivable =
360
x 80 = Tk. 17,77,778
The advance, which the factor will pay, will be the average level of receivables less factoring
commission, reserve and interest on advance.
The factoring commission is 2% of average level of receivable
Commission = 17,77,778 x 2% = Tk. 35,556
Reserve = 17,77,778 x 10% = Tk. 1,77,778
The amount available for advance = 17,77,778 – (35,556 + 1,77,778) = Tk. 15,64,444

However, the factor will also deduct 18% interest before paying the advance for 80 days.
80
Interest on advance = 15,64,444 x 18% x = Tk. 62,578
360
Advance to be paid = 15,64,444 – 62,578 = Tk. 15,01, 866

Annual cost of factoring to the firm

Factoring Commission (35,555/80) x 360 1,60,002
Interest Charge (62,578/80) x 360 2,81,601
Total 4,41,603

The firm saves the following cost-

Cost of credit administration 1,20,000

Cost of bad-credit losses (80,00,000 x 1%) 80,000

Total 2,00,000

The net cost of factoring to the firm = 441603-200000 = 241603

2,42,603
Effective rate of interest = = 16.1%
15,01,866

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