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Accounts receivables

Accounts receivable is one of a series of accounting transactions dealing with the billing of customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms. Ross, Westerfield, Jaffe, and Jordan (2008) define accounts receivable as: amounts not yet collected from customers for goods or services sold to them. Weygandt, Keiso, and Kell (2005) define trade receivables as accounts and notes receivables: accounts receivables are amounts by customers on account. They result from sale of goods and services. These receivables generally are expected to be cash collected on sales collected within 30 to 60 days. They are the most significant type of claim held by a company. Notes receivable represent claim for which instruments of credit are issued as evidence of the debt. The credit instrument normally requires the debtor to pay interest and extends for time periods of 60 90 days or longer. Notes and accounts receivables result from sales transactions are often called trade receivables. Accounts receivable (hereafter, accounts receivable) are open accounts owed to the firm by trade customers. They are part of the firms working capital and constitute 14 percent of 2005 us industrial firms total assets, making them one of the largest asset groups on industrial firms balance sheet. Accounts receivable serve as a tool for firms to extend credit to their business partners and are often instrumental in facilitating sale of goods. From a creditor standpoint, the information characteristics associated with accounts receivable differ from other firms assets. While the information on firms other assets is related to the firms performance, the information on the firms accounts receivable and their value depends on other firms performance, i.e. the customers. Furthermore, accounts receivable shares many attributes of financial assets, including their reparability and relative liquidity. These attributes of accounts receivable, as well as the diversification effect of multiple customers comprising the receivable account on the balance sheet, make this asset different and potentially lower in its information asymmetry than the rest of the firms assets.

According BPP Publishers, Financial management (2009), accounts receivables represent the firms claim on the assets of customers. Receivables constitute a substantial proportion of the current assets of several organizations, thus represent investment. Kakuru (2000) defines receivables as book debts which the firm is expected to collect in the near future and those receivables is money owed to the business for a short period of time. Eskew (1989) noted that receivables are investments and should neither be too many nor too few but rather the test should be whether the level of return the firm is able to earn from receivables equals or exceeds the potential gain from other commitments. Dickerson (1995), also commented that if it is possible to sell on credit, then selling on credit becomes more profitable, for it leads to increased sales as well as profits. And helps to maintain and retain customers. Thus companies should sell on credit than on cash. However, firms potential to earn a favorable return on investment in receivables is dependent on the volume of credit sales, collection period and credit policy applied.

Justification for investment in account receivables

Trade credit is important to a firm because it helps to protect its sales from being eroded by its competitors and also attract potential customers to buy at favorable terms. In most economies, including Uganda, trade credit is significant source of working capital (Pandey, 1996). Kakuru (2000), noted that different business firms depending on their size, the nature of the business dealt in and type of industry give various justifications for investment in receivables; Firm use trade credit as marketing tool. When a firm has just launched its products, credit can be used to expand sales. In declining market, it can be used to maintain the market share. Credit is also extended so as to build long term relationships with the customer or as a reward for their loyalty i.e. building customer good will. Depending on the status of the buyer, credit is granted. Because of bulk purchases and higher bargaining power, large scale buyers demand easy credit terms. Some companies may not grant

credit to small scale retailers since it becomes hard to collect receivable from them.


extending large amounts of credit to big firms, the company extending credit will be at an advantage as it will collect the money in lump sums. Trade credit enhances a companys bargaining power. If a companys bargaining power is low, it will grant more credit so as to build and enhance its bargaining power unlike a company with a high bargaining power. Granting credit to customers may be a practice with in a given industry. Thus new entrants in the industry are left with no option but find it inevitable to offer credit. This is done so as to win customers from competitors and later on maintain them using the same incentive. Therefore, if any firm is to survive in any competitive industry, granting credit becomes inevitable.

Account receivables management policy

To ensure optimal investment in receivables, a firm requires an appropriate credit policy. Kakuru (2000) define credit policy as a set of policy actions designed to minimize costs associated with credit while maximizing benefits from it. It is aimed at having optimal

investment in receivables. Optimal investment is that level of investment where there is a trade off between the costs and the benefits associated with a particular investment. A firms credit policy should maximize the firms value. The firms value is maximized When incremental rate of return is equal to incremental costs of funds used to finance the investment (ACCA Financial management, paper F9, 2009).

Credit policy
This refers to guidelines that are followed in managing credit in a business. Credit policy includes credit standards, credit terms and collection procedures. Credit sales are a function of total sales; total sales depend on such factors as the economic conditions e.t.c credit sales are also influenced by the nature of the business and industrial norms. All these factors are to a very large extent uncontrolled by a financial manager. The only way credit sales can be controlled is by making alterations in the firms credit policy. A firm therefore requires credit policy in its

operations since a proportionately large amount of sales are made on credit and credit policy variables are the ones in the control of the manger (Kakuru, 2001). Credit policy is designed to minimize costs associated with credit while maximizing the benefits from it. Credit policy is either lenient or stringent. Lenient credit policy This policy tends to give credit to customers on very liberal terms and standards. Credit is granted for period of time even to those customers whose credit worthiness is not fully known or whose financial position is doubtful. Credit is granted at high discount rates. Stringent credit policy A stringent credit policy gives credit on highly selective basis only to customers whose credit worthiness has been ascertained and is financially strong. Credit periods are shorter and discounts are lower. It involves low costs but may be detrimental to sales returns. A firm needs to formulate a credit policy which is optimum. Credit policy involves three variables. procedures (Kakuru, 2000) i.e. credit standards, credit terms and collection

Credit standards
These focus on the person who wants credit and thus determines who qualifies for the credit. Credit standards are the criteria, which the firm follows in selection of customers for credit extension. In order to analyze customers and set credit standards, the firm should consider the average collection period (ACP) and the default rate. Average collection period is the period in which the debts remain outstanding. On the other hand, default rate is the rate of uncollected receivables to total receivables. From the default ratio, the firm is able to determine that the customer will not meet his credit obligation. To estimate the probability of default, a financial manager should consider the 5cs of credit i.e. character, capacity, condition, capital and collateral.


Character. This is the willingness of a customer to settle his credit obligations. The financial manager should ascertain whether the customer would make honest efforts to honor his debt obligation.


Capacity. This is the ability of a customer to pay the credit advanced to them. The manager should look at financial statements, previous experience with the client, trade references, bank references, amount and the purpose of credit.


Condition. It involves assessment of the prevailing economic and other factors like social, political which may affect the customers ability to pay. e.g.; it is undesirable to grant credit during inflationary conditions.


Capital. This is the contribution or interest of the customer in his business. undesirable to grant credit to customers who have little capital in their business.

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Collateral. This is security against failure to pay. The person seeking credit should offer security before credit is granted. The security should easily be marketable.

Credit terms
These are stipulations under which a firm grants credit to customers. Credit terms should be more attractive to act as an incentive to clients without incurring high level of bad debt losses. Thus the terms offered should confirm to the average industrial terms.

Collection procedures
These are effort applied in order to accelerate collections from slow paying customers and to reduce bad debt losses. Collection procedures include sending reminders, use of litigation, insuring debtors, e.t.c.

Profitability is the difference between the cost of providing goods or services and the revenue derived from the sale (Mutenyo, 2007). The scholars noted that accountants define profits as the difference between costs and revenues. They further noted that in business, profit was put by the sandilands committee; is the

maximum value which the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning. According to traditional economist, profit maximization is taken as the objective of a business. Profit is the end result of an organization and a reward to entrepreneurs for undertaking risks (Mutenyo, 2007) Pandey (1996) further noted that a company should earn profits to survive and grow over a long period of time. Sufficient profits should be earned to sustain the operations of the business and to contribute towards the social overheads for the welfare of the society. Stoner (1996) defines profitability as the excess of income and expenditure that can be expressed by the rations like gross profit margin, net margin and return on equity. Besides the management of the company, creditors and shareholders are also interested in the profitability of the firm; creditors want to earn interest on repayment of the principal amount while shareholders want to get a reasonable return on their investment. This can only be possible when the firm earns profits.

Relationship between accounts receivables management and profitability

For effective management of accounts receivables, a firm must put in place an appropriate credit policy. Credit policy influences the level of book debts. A firm should be discretionary in giving debts to customers depending on the trust in them and should be prompt in collecting them (Kakuru, 2000). However with other current assets, the financial manager can vary the level of receivables in keeping with the trade off between profitability and liquidity. Lowering credit standards increases the level of sales leading to an increase in profits. But also there is an additional cost corresponding to an increase in receivables as well as greater risk of bad debt losses. Brockington (1993), argues that there is an opportunity cost of additional receivables resulting from increased sales and the slower average collection period and that, if new customers are attracted by the liberal credit standards, collections from these customers are likely to be slower

than collection from existing customers. Thus a liberal extension of credit may cause certain customers to be relaxed in the payment of debt obligations on time. Kakuru (2000) notes that a liberal credit policy may be undesirable because the firm may not attain its benefit at the least possible cost and hence a danger of higher costs. On the other hand a stringent credit policy may be advantageous in the low costs are involved. But this may slow down sales returns.

With regards to the literature used in this research, it has been observed that there is wide data about the variables under study and that it is not easy to establish a perfect system of receivables management that will guarantee maximum profitability. This is because of the conflicting interests of the firm i.e promoting profitability while maintaining a certain level of liquidity. That to achieve one, there is an opportunity cost of losing another. Thus it becomes necessary to strike a balance where investment in receivables is at optimum. The need to achieve optimal investment in receivables calls for a firm to institute a credit policy.