RECEIVABLES

MANAGEMENT
AND
FACTORING

Credit Sales

1)
2)
3)
4)

Collection Costs
Capital Costs
Delinquency Costs
Default Costs

Investment in
receivables =
volume of credit
sales*collection
period.

Why Credit ?

Variables of credit policy:?Credit Standards

Credit terms
Collection Efforts

Marketing tool
Sales Maximization.

Lenient
Credit policy
& Stringent
Credit policy

Evaluation of change in a firms

credit policy involves:a) Opportunity cost of lost
contribution
b) Credit- administration cost and
bad-debt losses.

Increase in sales volume= increase in profits

Increase in ACP= Decrease in profits
Increase in bad debts = decrease in profits

4 steps to determine the Optimum Credit

Policy:1)

Estimation of incremental profit

2) Estimation of incremental investment in receivable

3) Estimation of incremental rate of return (IRR)
4) Comparison of incremental rate of return with
required rate of return (RRR)

Optimum credit policy: IRR = RRR

Example:-1
Sales- 100 lakhs
After-tax profit 2.5 lakhs. (Declining trend for last 3
years)
10% of total sales to weak customers.
Variable Cost 94%
Bad debt losses and collection cost entirely attributed to
weak customers accounting to .06%.
ACP-60 days, 90% credit sales.
Required rate of return -25%.
Should the company change its credit policy of giving
to weak customers.?

Step:-1
Tightening of credit policy- 10%
Total Sales- 100 lakhs
Weak Customers- 10%
Sales lost- 100 lakhs *10%= 10
lakhs.

Step-2
Contribution Lost:Sales lost- 10 lakhs
Variable cost- 94%
Contribution= 10 lakhs *6%=
60,000/-

Step-3
Change in the operating profit
Change in contribution
Additional Cost
i.e. .{(60000)-[-10
lakhs*.06%)]}
= (60,000)+600= (59400)

Step-6
Compare IRR with RRR
RRR=25%
IRR-42.127%
Net benefit = (.42127-.25)*141000
= 24149/Company should not change the
policy.

Step-4
Incremental investment in AR
[(10,00,000)*.90/360]*60
150000.
To calculate in Variable cost:150000*.94= 141000

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
59400/141000*100 = 42.127%

Example:-2
Sales- 250 lakhs
After-tax profit 25 lakhs. (Declining trend for last 3 years)
10% of total sales to weak customers.
Variable Cost 95%
Bad debt losses and collection cost entirely attributed to weak customers accounting to .10%.
ACP-45 days, 75% credit sales.
Required rate of return -25%.
Should the company change its credit policy of giving to weak customers.?

Step:-1
Tightening of credit policy- 10%
Total Sales- 250 lakhs
Weak Customers- 10%
Sales lost- 250 lakhs *10%= 25
lakhs.

Step-2
Contribution Lost:Sales lost- 25 lakhs
Variable cost- 95%
Contribution= 25 lakhs *5%=
125000

Step-3
Change in the operating profit
Change in contribution
Additional Cost
i.e. .{(125000)-[-25
lakhs*.10%)]}
= (125000)+2500= (122500)

Step-6
Compare IRR with RRR
RRR=25%
IRR-55.01%
Net benefit = (.5501-.25)*222656.25
= 66819.14/Company should not change the
policy.

Step-4
Incremental investment in AR
[(25,00,000)*.75/360]*45
234375
To calculate in Variable cost:234375*.95= 222656.25

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
122500/222656.25*100 = 55.01%

Credit Policies determination of credit standards and credit analysis.

Minimum requirements for extending

credit to a customer.

ACP (Investment in receivables)

Bad debt expenses
Sales Volume

Example 2.1
A firm is currently selling a product @ INR 10/- unit. The recent credit sales were
30,000 units per annum.The variable cost is INR 6/- unit and the average cost per
unit is INR 8/-.The total fixed cost is INR 60,000/- Currently the firms average
collection period is 30 days and the firm planning to increase the credit period to
45 days.
By this, the firm is expecting a 15% increase in their sales with no bad debt
expense. This in turn may call for an additional working capital of INR 10,000/-.
The firms expects a minimum of 10% return on investments.
Should the firm change its credit terms?

Example 2.1
A firm is currently selling a product @ INR 10/- unit. The recent credit sales were
30,000 units per annum.The variable cost is INR 6/- unit and the average cost per
unit is INR 8/-.The total fixed cost is INR 60,000/- Currently the firms average
collection period is 30 days and the firm planning to increase the credit period to
45 days.
By this, the firm is expecting a 20% increase in their sales with no bad debt
expense. This in turn may call for an additional working capital of INR 40,000/-.
The firms expects a minimum of 15% return on investments.
Should the firm change its credit terms?

Credit Analysis

Obtaining credit information and analysis of

information.

Internal

Quantitative and qualitative

External

credit

Example -3
APC Ltd is planning to alter its credit standards. The company has divided its
customer base into four sections on the basis of the probabilities of
default.(Refer Table 1).The bad debt ratio is nil for first two categories, where
as it is 2 & 5% for third and fourth category. Currently, the company extends
credit for the first three categories, and none to the last. The companys the
variable cost ratio is 80%, and an after-tax return of 15% is expected. The
corporate tax is 35%. The proposal has come from marketing department to
extend the sales to all the four categories. In this connection, it is expected that
5 % collection cost will have to be entirely spent for this category of
customers.
Should the company change their credit standards.

Categor
y

Potentia
l Sales
(in
Crores)

ACP

No Risk

1.2

30

Low
Risk

1.0

35

Medium
Risk

.55

45

High
Risk

.40

60

Table :1

Step:-1
Incremental Sales expected from
Category four:Sales- 40,00,000

Step-2
Incremental Contribution :Sales - 40 lakhs
Variable cost- 80%
Contribution= 40 lakhs *20%=
8,00,000

Step-3
Change in the operating profit after tax:[Change in contribution Additional Cost]*
(1-.35%)
i.e. .{8,00,000-[40,00,000*.10%)]}* (1-.35)
= 8,00,000-4,00,000= 4,00,000
=4,00,000*.65 = 2,60,000.

Step-6
Compare IRR with RRR
RRR=15%
IRR-48.75%
Net benefit = (.4875-.15)*5,33,333 =
179999.89/Company should change its credit
standards by offering credit to high
risk category as incremental benefit is
outweighing the incremental cost .

Step-4
Incremental investment in AR
[(40,00,000)/360]*60
6,66,6667
To calculate in Variable cost:6,66,667*.80= 5,33,333

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
2,60,000/5,33,333*100 = 48.75%

Example-4
ACCEL Ltd is planning to alter its credit standards. The company has divided
its customer base into three sections on the basis of the probabilities of
default.(Refer Table 1).The bad debt ratio is nil for first two categories, where
as it is 6% for third category. Currently, the company extends credit for the
first two categories, and none to the last. The companys the variable cost ratio
is 75%, and an after-tax return of 25% is expected. The corporate tax is 35%.
The proposal has come from marketing department to extend the sales to all
the categories. In this connection, it is expected that 7 % collection cost will
have to be entirely spent for this category of customers.
Should the company change their credit standards.

Category

Potential
Sales (in
Crores)

ACP

Low
Risk

2.2

35

Medium
Risk

52

High
Risk

.75

70

Table :1

Step:-1
Incremental Sales expected from
Risky Category :Sales- 75,00,000

Step-2
Incremental Contribution :Sales - 75 lakhs
Variable cost- 75%
Contribution= 75 lakhs *25%=
18,75,000

Step-3
Change in the operating profit after tax:[Change in contribution Additional Cost]*
(1-.35%)
i.e. .{18,75,000-[75,00,000*.13%)]}* (1-.35)
= 18,75,000-9,75,000= 9,00,000
=4,00,000*.65 = 5,85,000.

Step-6
Compare IRR with RRR
RRR=25%
IRR-53.49%
Net benefit = (.5349-.25)*10,93,750 =
311609.37/Company should change its credit
standards by offering credit to high
risk category as incremental benefit is
outweighing the incremental cost .

Step-4
Incremental investment in AR
[(75,00,000)/360]*70
14,58,333
To calculate in Variable cost:14,58,333*.75= 10,93,750

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
5,85,000/10,93,750*100 = 53.49%

Credit terms

Specify the repayment terms required of credit

receivables.

Credit Period

Cash discount

Cash discount period

Credit Period
Sales Volume (I)
= (+) effect on profits
ACP (I)
= (-) effect on profits
Bad debt expense (I) = (-) effect on profits

Example 4.1
A firm is currently selling a product @ INR 10/- unit. The recent credit sales were
30,000 units per annum. The variable cost is INR 6/- unit and the average cost per unit is
INR 8/-.The total fixed cost is INR 60,000/- The firm is planning to increase their credit
period from 30 to 60 days. This in turn will increase the firms average collection period
which is at present 45 days to 75 days. It is also likely that the bad debt expenses will
increase from the current level of 1 per cent to 3 per cent of sales. An increase of 15% is
expected in sales also.
The firm expects a minimum of 15 per cent return on investment. Should the firm extent
the credit?

Cash discount

Sales Volume (I)

= (+) effect on profits
ACP
(D)
= (+) effect on profit
Bad debt expense(D) = (+) effect on profits

Example 4.2
A firm is currently selling a product @ INR 10/- unit. The recent credit sales were 30,000
units per annum.The variable cost is INR 6/- unit and the average cost per unit is INR 8/.The total fixed cost is INR 60,000/- Currently the firms average collection period is 30
days and the firm planning to offer 2% discount for payment within ten days after a credit
purchase. It is expected that this strategy will increase sales by 15% and the average
collection period will reduce to 15 days.
Assume that there is no change on the bad debt expenses; expected return on investment is
15%;60 per cent of the total sales will be on discount.Should the firm implement this
proposal?

Collection Policies

Bad debt expense (D)

= (+) effect on profits
ACP (D)
= (+) effect on profits
Sales volume (D)
= (-) effect on profits
Collection expenditure (I) = (-) effect on profits

Example 4.3
Currently firm is having a lenient policy and they are planning to shift to a stringent
collection policy.
At present, the firm is selling 36000 units on credit at a price of INR 32/- each; the variable
cost per unit is INR 25/- while the average cost per unit is INR 29/-. Average collection period
is 58 days and collection expense amount to INR 10,000/- and bad debt account for 3 per cent
of sales.
If collection policies are tightened, additional charges amounting to INR 20,000/- would be
required, bad debt will be 1 per cent; the collection period will be 40 days; sales volume is
likely to decline by 500 units.
Assuming a 20% return on investments, should the firm change their collection policies?

Example -5
SRS Ltd is considering to increase its credit period from net 35 to net
50.By this , the firm expects its sales to increase from 120 lakhs to 150
lakhs. The average collection period is expected to increase from 35 to 50
days. The bad-debt losses and collection efforts are expected to remain at
5% and 6% respectively. The firms variable cost ratio is 85% and the tax
rate is 35%. The company expects an after tax return of 18%. Should the
company change its credit terms?

Step:-1
Incremental Sales expected from
Changing the credit terms:Sales- 30,00,000

Step-2
Incremental Contribution :Sales - 30 lakhs
Variable cost- 85%
Contribution= 30 lakhs *15%=
4,50,000

Step-6
Compare IRR with RRR
RRR=18%
IRR-10.01%
Net benefit = (.1001-.18)*7,79,166 =
(62,255.36)/Company should not change its credit
terms as incremental cost is
outweighing the incremental benefit .

Step-3
Change in the operating profit after tax:[Change in contribution Additional Cost]*
(1-.35%)
i.e. .{4,50,000-[30,00,000*.11%)]}* (1-.35)
= 4,50,000-3,30,000= 1,20,000
=1,20,000*.65 = 78,000.

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
78,000/7,79,166*100 = 10.01%

Step-4
Incremental investment in AR:New-Old
Old= [120,00,000/360]*35
11,66,6667
New= [150,00,000/360]*50
20,83,333
Therefore 20,83,333-11,66,667
=9,16,666
Calculation in variable cost
9,16,666*.85 =7,79,166

Example -6
Amrack Ltd is considering to increase its credit period from net 25 to net
40.By this , the firm expects its sales to increase from 135 lakhs to 180 lakhs.
The average collection period is expected to increase from 25 to 48 days. The
bad-debt losses and collection efforts are expected to remain at 6% and 5%
respectively . The firms variable cost ratio is 88% and the tax rate is 35%.
The company expects an after tax return of 10%. Should the company change
its credit terms?

Step:-1
Incremental Sales expected from
Changing the credit terms:Sales- 45,00,000

Step-2
Incremental Contribution :Sales - 45 lakhs
Variable cost- 88%
Contribution= 45 lakhs *12%=
5,40,000

Step-6
Compare IRR with RRR
RRR=10%
IRR-2.27%
Net benefit = (.227-.10)*12,87,000 =
(99,485.1)/Company should not change its credit
terms as incremental cost is
outweighing the incremental benefit .

Step-3
Change in the operating profit after tax:[Change in contribution Additional Cost]*
(1-.35%)
i.e. .{5,40,000-[45,00,000*.11%)]}* (1-.35)
= 5,40,000-4,95,000= 45,000.
45,000 *.65 =29,250/-

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
29,250/12,87,000*100 = 2.27%

Step-4
Incremental investment in AR:New-Old
Old= [135,00,000/360]*25
9,37,500
New= [180,00,000/360]*48
24,00,000
Therefore 24,00,000-9,37,500
=14,62,500/Calculation in variable cost
14,62,500*.88 =12,87,000

Example -7
Petric Polymers Ltd is considering to decrease its credit period from net 45 to
net 30 as its bad-debts losses are increasing heavily. By tightening the credit
standards, would result in a reduction in sales from 6,00,000 to 5,00,000 and the
bad debt losses would from 5% to 2% and the collection expense would
decrease from 3% to 1% of the total sales. The firms variable cost ratio is 85%,
tax rate is 35% and the after tax expected rate of return is 14%.
Should the company change its credit terms?

Step:-1
Incremental Sales lost from

Step-2
Incremental Contribution lost :Sales - 1 lakh
Variable cost- 85%

Changing the credit terms:Contribution= 1 lakh *15%=

Sales- (1,00,000)
(15,000)

Step-6
Compare IRR with RRR
RRR=14%
IRR-49.1%
Company should change its credit
terms as incremental benefit is more
than incremental cost .

Step-3
Change in the operating profit after tax:[Change in Contribution Change in Cost]*
(1-.35%)
Change in Cost= (New Old)
i.e. (5,00,000*.03%)- (6,00,000*.08)
= 15,000-48,000= (33,000).
Therefore (15,000)- (33,000)=18,000
18,000*. (1-.35)= 11700/-.

Step-5
Incremental rate of return on
Investment:Operating profit after tax/Investments
in Receivables
Operating profit after tax=
=11700- (4667)
=16,367/16,367/33,333*100 = 49.1%

Step-4
Incremental investment in AR:New-Old
Old= [6,00,000/360]*45
75,000
New= [5,00,000/360]*30
41,667.
Therefore 41,667-75000
= (33,333)
Calculation of opportunity cost in AR
(33,333)*.14 =(4,667)

Credit Policy Variables:Credit Standards & Analysis

Credit terms
Collection Policies & Procedures.

Credit
Standards:Tight or loose

Credit Analysis:ACP
Default rate:Three Cs
Character
Capacity
Condition.

Numerical Scoring Models :Ad hoc Approach

Simple Discriminant Approach
Multiple Discriminant
Approach.

Customer
Categories:Good
Bad
Marginal

Credit Granting
Decision

Factoring provides resources to finance receivables

as well as facilitates the collection of receivables.

Functions of a factor: -

a) Financing facility/trade debts

b) Maintenance/administration of sales ledger
c) Collection Facility\of accounts receivable
d) Assumption of credit risk/credit control and
credit restrictions and
e) Provision of advisory services.

SBI
Factors
and
Commercial Services Ltd
and
Canbank Factors Ltd.

Off-balance Sheet Financing

Improved Efficiency

Reduction of Current Liabilities

More time for planning and production

Improvement in Current Ratio

Reduction of Cost and Expenses

Higher Credit Standing

Evaluation Framework

Example- 10
Aaditya Ltd has credit sales of 80 lakhs, and its average collection period is 100 days. The past
experience indicates that the bad-debt losses are around 1% of credit sales. The firm spends about
250000/- on annual sales for administering its credit sales. This cost includes salaries paid to 2 staff
members, and telephone, telex charges associated with that process. The organization has identified
a factor who is willing to buy the firms receivables, and will charge 2.5% commission. He will also
pay an advance against receivables to the firm at an interest rate of 12% withholding 10% as
reserve. Another option is to take short term financing from a bank at 4% per annum.
Which is better and why?

Step:-1
Statement showing net advances to be received from the
factor

Average level of receivables:= (80,00,000/360)*100 [A]

22,22,222.2

Factoring terms and conditions:2.5% commission (i.e. 22,22,222*.025) [B]

55,555.5

10% Reserve (i.e. 22,22,222*.10)

2,22,222.2

[C]

Advance available will be [D] = [A-(B+C)]

[i.e. 22,22,222.2- (55,555.5 + 2,22,222.2)]

19,44,444.5

Interest deducted by the factor before paying the 12%

advance for 100 days
Net advance will be
18,79,629.5
[19,44,444.5-(19,44,444.5*.12*100/360)
= 19,44,444.5 -64815

Step 2Annualized cost of Factoring.

Step 3Benefits of factoring:-

Factoring Commission
(55,555.5*360/100)
Interest charges (64815*360/100)

1,99,999.8

Cost of credit administration

2,33,334

Total

4,33,333.8

Cost
of
bad
(85,00,000*.01)
Total

debt

2,50,000
loss 85,000
3,35,000

Net cost of factoring = 4,33,333.8-3,35,000 = 98,333.8

Effective rate of annual cost = (98,333.8/18,79,629.5)*100 = 5.23%.