SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 5 – Accounts Receivable Management
2
Chapter 5 Agenda
ACCOUNTS RECEIVABLE MANAGEMENT
Identify and define the components of
credit policy, describe the typical creditgranting sequence, apply net present
value analysis to credit extension
decisions, define credit scoring and
explain its limitations, and list the
elements in a credit rating report.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.
The shorter
the cash
conversion
period, the
more efficient
the firm’s
working
capital.

The firm is a system of cash flows.
 These
cash flows are unsynchronized and
uncertain.
Trade Credit
4

In most industries, it is customary to offer trade credit,
allowing customers a delay between receipt of goods
(sometimes title transfer) and the obligation to pay for it.
Also known as supplier financing, credit extension allows
deferred payment from customers and is essentially a shortterm, interest-free loan.
 It can be based on ‘standard’ terms, or can vary to attract
new customers or large orders.
 Trade credit does not have an explicit cost to the firm.



It is considered a cost of doing business or built into product pricing.
Its convenience can capture new business, trigger larger
orders, build relationships, and generate repeat sales.
Trade Credit vs. Bank Loans
5

Trade credit dwarfs short-term bank credit as a
mechanism for financing inventory.


Firms regularly use both, back-to-back.
Firms offer, and customers use, trade credit for the
following reasons:
Information Advantage – As a player in the same space,
the firm understands the other players.
 Control Advantage – Customers are motivated to pay
given the need for sound supplier relationships.
 Salvage Value Advantage – Firms can repossess and
resell inventory due to non-payment more effectively.

Trade Credit
6


Offering trade credit can have a significant impact on
top line growth; it also results in a significant balance
sheet account…accounts receivable.
The marketing strategy must strike the balance between
growing sales/capturing market share considering:

Making prudent credit decisions.

Carrying and managing the accounts receivable book

Administrative costs
Managing The Credit Function
7

Management of the credit function includes:
 Credit
Administration
 Establishing
a credit policy, along with planning, executing,
monitoring, and controlling all aspects of the credit function.
 Credit
Policy
 Includes
credit standards, credit terms, credit limits, credit
analysis and investigation, etc.
Managing Trade Credit
8

So, managing trade credit considers:
 Aggregate

Investment
 Credit
Terms
 Credit
Standards
Decisions on trade credit are influenced by the sales
and market share objectives for the firm.
Managing Trade Credit
9
Managing Trade Credit
10

Trade credit management includes the aggregate
investment.
 Overinvesting
in receivables is costly since:
 It
is often financed with short-term bank credit.
 It
reduces liquidity and limits alternative investments.
 It
could signal an ‘aging’ credit book increasing the chances
of bad debts.
Managing Trade Credit
11

Trade credit management setting credit terms.
 If
the length of time to pay is uncompetitive, orders
(and customers) are at risk to competitors selling in the
same space.
Managing Trade Credit
12

Trade credit management includes establishing
credit standards.
 What
is the credit profile of a marginally acceptable
customer?
 How
much credit should be offered?
 Too
stringent terms can lead to lost sales and customers.
 Too
lenient terms can lead to charge-offs
The Credit Administration Function
13

The Credit Administration function should:
 Control
bad debts.
 Control
the level of A/R.
 Maintain
financial flexibility.
 Optimize
the mix of company assets.
 Convert
receivables to cash.
 Analyze
customer risk.
 Minimize
administrative costs.
Credit Granting Sequence
14
Credit Policy
15

Part of Credit Administration is establishing the Credit
Policy, which includes the following decision variables:
1.
Credit Standards - Create a profile of the minimally
acceptable credit-worthy customer.
2.
Credit Terms - Define how long the customer has to pay
and/or the offering of Cash Discounts.
3.
Credit Limits - Determine the amount of cumulative credit
offered to a single customer and/or group of customer.
4.
Collection Process (Chapter 6)- Determine how and
when past-due accounts are handled.
Credit-Granting Process
16
MARKETING CONTACT
CREDIT INVESTIGATION
Time
CUSTOMER CONTACT FOR INFORMATION
FINALIZE WRITTEN DOCUMENTS
ESTABLISH CUSTOMER CREDIT FILE
FINANCIAL ANALYSIS
Credit Standards
17

Financial and non-financial data is used to establish the
profile of the minimally acceptable credit-worthy customer.

The process is similar to the underwriting process at a bank.

Marginal account might include:

Smaller amounts and/or shorter terms.

A probationary period.

Collateral or a Bank Letter of Credit.
Credit Standards
18

Unique customer data is gathered to assess creditworthiness and is compared to the benchmark, including:

Client-provided data, such as financial statements and
receivable agings (next slide) from which ratio and trend
analysis and industry comparisons can be performed.

Subscriber-based credit reporting agencies, such as D&B, which
provide company history and family, business registration,
operations, SIC and NAICS, payment records, maximum credit
lines, financial statements, banking, public filings (suits, liens,
judgments, UCC), and other credit and financial information.

Information from banks, industry and trade associations, and
other suppliers, including publicly-available information.
Credit-Scoring Models
19


Firms regularly model a firms likelihood to pay.
Credit-scoring Models are predictive models that use
collective, historical borrower data to assess the likelihood of
future default of a potential, single borrower.
Sample Credit Scoring Model
20

A model could be based on company and credit
attributes, such as those below. These attributes are
weighted based on predictive importance:
Credit History of Principals / Business
 Unused Credit
 Industry Type
 Available Liquid Assets
 Net Worth of Principals

Credit Terms
21

Once a customer is approved for credit, the firm must
define how long the customer has to pay (Credit
Period) and/or any Cash Discounts offered.

The Credit Period must be defined, but usually begins with
the invoice date and ends when the payment is received at
the remittance address.

Some firms use the date the goods are shipped or received.
Credit Terms
22

Factors affecting Credit Terms include:
Competition (standard terms exist within industries)
 Customer’s operating cycle
 Type of goods (raw materials, finished goods, perishables,
etc.)
 Seasonality of demand
 Consumer acceptance
 Cost and pricing
 Customer type
 Product profit margin

Credit Terms
23

Cash Discounts provide a financial incentive to
encourage early customer payments.

“2/10, net 30”


“2/10, prox net 30”


The customer may deduct 2% of the entire invoice amount if paid
within 10 days; if the discount is not taken, the invoice is due in 30
days (the customer pays $98 per $100 invoiced amount).
The customer may deduct 2% of the entire invoice amount if paid
within 10 days; if the discount is not taken, the invoice is due on
the 30th day of the following month.
60% of firms offer cash discounts, but they are offered
only to select customers.
Credit Terms
24


Earlier receipt of A/R from offering Cash Discounts
reduces short-term borrowing (increases short-term
investing).
The optimal cash discount is based on:





The level of variable costs (the lower are variable costs, the
higher the feasible discount).
The firm’s cost of funds.
The portion of customers likely to take the discount.
The elasticity of the product’s price.
The level of charge-offs (the higher are bad debts, the higher
the optimal discount).
Credit Terms
25

Firms must decide whether to impose (and/or
enforce) late penalties.
 If
a firm is too aggressive, it could drive customers to
the competition.
Credit Limits
26

Credit Limits are the amount of cumulative credit
offered to a single customer or group of customers and
is determined by:
 Percentage
of the customer’s net worth.
 Percentage
of the high credit amount reported by other
suppliers.
 Judgment
(gut call).
Calculating NPV of Potential Sale
27


Once the customer has been approved for credit, the NPV of
the potential sale is calculated to ensure the deal makes money.
Consider the following sales opportunity:


$1,000 order from new customer.

Eligible for firm’s standard 30-day credit terms.

S ($1,000) = Dollar amount of credit sale

VCR (0.70 of Sales) = Variable cost ratio

EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio

i (0.13/365) = Daily interest rate

CP (30 days) = Collection period for sale
The firm will spend variable costs (labor plus raw materials)
associated with the sale today, but will not receive the invoice
amount for 30 days.
Calculating NPV of Potential Sale
28

$1,000 order, 30-day credit terms

VCR (0.70 of Sales) = Variable cost ratio

S ($1,000) = Dollar amount of credit sale

EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio

i (0.13/365) = Daily interest rate

CP (30 days) = Collection period for sale
Variable Costs
0
$1,000 х 70% = $700
$949.85 - $700 = $249.85
A/R Collected
30 Days
$1,000 – 4%($1,000) = $960
$960
PV =
= $949.85
.13
1 + (30 х /365)
Calculating NPV of Potential Sale
29

The following formula can be used:
S  EXPS 
NPV 
 VCRS 
1  iCP

NPV > 0  Extend Credit
NPV = 0  Probably Extend Credit
NPV < 0  Do Not Extend Credit
Where:






NPV
VCR
S
EXP
i
CP
= Net present value of the credit sale
= Variable cost ratio
= Dollar amount of credit sale
= Credit administration/collection expense ratio (end-of-period)
= Daily interest rate
= Collection period for sale (days)
Calculating NPV of Potential Sale
30

$1,000 order, 30-day credit terms

VCR (0.70 of Sales) = Variable cost ratio

S ($1,000) = Dollar amount of credit sale

EXP (0.04 of Sales/CP) = Credit administration/collection expense ratio

i (0.13/365) = Daily interest rate

CP (30 days) = Collection period for sale
S  EXPS 
NPV 
 VCRS 
1  iCP
Positive, so
make sale
$1,000 - $40
= ----------------------- - $700 = $249.85
1 + (.13/365 х 30)
Calculating NPV
31

How is NPV affected if the new client does not pay
exactly on time (or pays early or does not pay at all)?


The longer someone owes you, the greater the chance you will
never get paid!
Risk can be incorporated into the analysis based on a
probability distribution of payment dates.
Calculating NPV – Example Cont’d
32

Continuing with this example, we can model how late
payments affect the result.
S  EXPS 
NPV 
 VCRS 
1  iCP
$1,000 - $40
= ----------------------- - $700 = $249.85
1 + (.13/365 х 30)
Before, our calculation assumed that the
customer paid exactly on-time at the 30-day
mark. We can use collective, historical customer
data to predict more realistic payment timing for
the new customer.
Calculating NPV – Example Cont’d
33

Assume the new customer is expected to mirror
the firm’s historical collection experience 

VCR (0.70 of Sales) = Variable cost ratio

S ($1,000) = Dollar amount of credit sale

EXP (0.04 of Sales/CP) = Credit
administration/collection expense ratio

INCURRED AT THIS RATE BEGINNING IN THE SECOND
CP THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE,
80% OF INVOICE ONE MONTH AFTER REFERRAL AND
CHARGES A 25% COMMISSION ON THE AMOUNT
COLLECTED.

i (0.13/365) = Daily interest rate

CREDIT TERMS (Net 30 days)

CP (Various) = Collection period for sale
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
These are four possible
outcomes. Existing
customers fall into one (and
ONLY one) of these four CP
buckets. The average DSO for
each bucket is indicated. The
weighted-average DSO is 45
days.
Calculating NPV – Example Cont’d
34

Assume the new customer is expected to mirror
the firm’s historical collection experience 

VCR (0.70 of Sales) = Variable cost ratio

S ($1,000) = Dollar amount of credit sale

EXP (0.04 of Sales/CP) = Credit
administration/collection expense ratio

INCURRED AT THIS RATE BEGINNING IN THE SECOND
CP THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE,
80% OF INVOICE ONE MONTH AFTER REFERRAL AND
CHARGES A 25% COMMISSION ON THE AMOUNT
COLLECTED.

i (0.13/365) = Daily interest rate

CREDIT TERMS (Net 30 days)

CP (Various) = Collection period for sale
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
As DSO increases, the NPV
decreases since it takes longer
to receive the money. In
addition, we incur additional
EXP. Assume all EXP is
recognized when the invoice is
paid.
Calculating NPV – Example Cont’d
35

Assume the new customer is expected to mirror
the firm’s historical collection experience 

VCR (0.70 of Sales) = Variable cost ratio

S ($1,000) = Dollar amount of credit sale

EXP (0.04 of Sales/CP) = Credit
administration/collection expense ratio

INCURRED AT THIS RATE BEGINNING IN THE SECOND
CP THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE,
80% OF INVOICE ONE MONTH AFTER REFERRAL AND
CHARGES A 25% COMMISSION ON THE AMOUNT
COLLECTED.

i (0.13/365) = Daily interest rate

CREDIT TERMS (Net 30 days)

CP (Various) = Collection period for sale
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
For the segment that is turned
over to the collection agency,
the AVERAGE amount
collected is 80%, which includes
some accounts for which no
receipts are made. The agency
sends the amount collected, on
average, in 152 days.
Calculating NPV – Example Cont’d
36

Timeline for EXP (0.04 of Sales/CP)

INCURRED AT THIS RATE BEGINNING IN THE SECOND CP
THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE, 80%
OF INVOICE ONE MONTH AFTER REFERRAL AND CHARGES A
25% COMMISSION ON THE AMOUNT COLLECTED.
0
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
EXP
EXP
EXP
EXP
15 DSO
45 DSO
90 DSO
152 DSO
1
2
3
4
The customer will pay in ONE of these discrete CP ranges;
with the average DSO indicated (the mid-point).
Calculating NPV – Example Cont’d
37

Timeline for EXP (0.04 of Sales/CP)

INCURRED AT THIS RATE BEGINNING IN THE SECOND CP
THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE, 80%
OF INVOICE ONE MONTH AFTER REFERRAL AND CHARGES A
25% COMMISSION ON THE AMOUNT COLLECTED.
0
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
EXP
EXP
EXP
EXP
15 DSO
45 DSO
90 DSO
152 DSO
Cash Flows
Cumulative
If the new customer pays on time
like 40% of our customers (in the
first CP), there is no EXP incurred.
Calculating NPV – Example Cont’d
38

Timeline for EXP (0.04 of Sales/CP)

INCURRED AT THIS RATE BEGINNING IN THE SECOND CP
THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE, 80%
OF INVOICE ONE MONTH AFTER REFERRAL AND CHARGES A
25% COMMISSION ON THE AMOUNT COLLECTED.
0
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
EXP
EXP
EXP
EXP
15 DSO
45 DSO
90 DSO
152 DSO
Cash Flows
$1,000 х 4% = $40
Cumulative
$40
Instead, if the customer pays in the
second CP, an initial $40 EXP is
incurred, and recognized at t=45 days.
Calculating NPV – Example Cont’d
39

Timeline for EXP (0.04 of Sales/CP)

INCURRED AT THIS RATE BEGINNING IN THE SECOND CP
THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE, 80%
OF INVOICE ONE MONTH AFTER REFERRAL AND CHARGES A
25% COMMISSION ON THE AMOUNT COLLECTED.
0
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
EXP
EXP
EXP
EXP
15 DSO
45 DSO
90 DSO
152 DSO
Cash Flows
$40
$40
Cumulative
$40
$80
If the customer pays in the third CP,
another $40 EXP is incurred, for total EXP
of $80, recognized at t=90 days.
Calculating NPV – Example Cont’d
40

Timeline for EXP (0.04 of Sales/CP)

INCURRED AT THIS RATE BEGINNING IN THE SECOND CP
THROUGH THE FOURTH ,THEN TURNED OVER TO
COLLECTION AGENCY THAT COLLECTS, ON AVERAGE, 80%
OF INVOICE ONE MONTH AFTER REFERRAL AND CHARGES A
25% COMMISSION ON THE AMOUNT COLLECTED.
CP
PAYMENT TIMING
DSO
PROBABILITY
DISTRIBUTION
1
< 1 Month
15
40%
2
During Month 2
45
40%
3
3 - 4 Months
90
15%
4
> 4 Months
152
5%
100%
EXP
EXP
EXP
EXP
15 DSO
45 DSO
90 DSO
152 DSO
Cash Flows
$40
$40
$40 + ($1,000 х 80% х 25%) = $240
Cumulative
$40
$80
$ 320
0
If the customer pays in the last CP, a final $40 EXP
is incurred, for total EXP of $120 at t=152 days. At
this point, the agency commissions are also paid.
Calculating NPV – Example Cont’d
41

Analysis
Terms
Net 30 days
Projected Invoice Amount
Calculate the NPV for each, independent possible
outcome below using this formula:
$1,000
NPV 
S  EXPS 
 VCRS 
1  iCP
Variable Production Costs (0.70 of Sales)
$700
Collection/Credit Adm Exp (0.04 of Sales/CP)
$40

Weight and add the possible outcomes.
0.0003562

Remember, only one will actually occur.
Interest Rate (13% Annual)
COLLECTION PERIOD (CP)
COLLECTION
PERIOD
MIDPOINT
(months)
PAYMENT
PROBABILITY
COLLECTION
COSTS (EXP)
COLLECTION CASH
FLOW ($1,000 Column (4))
PV [PV of Column (5)
less (VCR)(S)
Expected PV
[Column (3) x
Column (6)]
< 1 Month
0.5
40%
$0
$1,000
$294.69
$117.87
During Month 2
1.5
40%
$40
$960
$244.86
$97.94
3 - 4 Months
3
15%
$80
$920
$191.43
$28.71
> 4 Months
-
5%
$320
$480
($244.65)
($12.23)
Expected NPV of Credit Extension
100%
$232.30
1
2
$320 = [25% x $800] + [3 x ($1,000 X .04)]
$480 = $800 - $320 after write-off of bad debt
NPV still
positive.
Final Thoughts
42


Our goal is to design a credit policy that combines mutuallyexclusive alternatives such that NPV is maximized.
In theory, if no credit policy alternative results in a positive
NPV, credit terms would not be offered and the firm would sell
on a cash-only basis.

Or, the pricing and/or cost structure of the sale would require
adjustment.