November 27, 2014

Management of Investment in Accounts Receivable

Management of Accounts Receivable

Accounts receivable is a current asset that appears due to the extension of open-account credit
by one firm to other firms and to individuals. Credit has to be extended to generate sales.
Therefore, accounts receivable are necessary investment, but require careful analysis. Receivables can be managed efficiently so that the level of investment in them is optimal.

Credit policy involves a tradeoff between the profits on sales that give rise to receivables on one hand and the cost of carrying these receivables plus bad-debt losses on the other. Credit policy determines
the amount of credit risk  accepted. In turn, the risk accepted or taken affects the slowness of receivables as well as the amount of bad-debt losses. Collection procedures also affect these factors. Thus, proper the credit granting and collection procedures of the firm determine the success of the firm’s overall credit management and collection policies.


The policy variables include the quality of the trade accounts accepted, the length of the credit period, the cash discount given, any special terms given, such as seasonal datings, and the collection program of the firm. Together, these elements largely determine the average collection period and the proportion of bad-debt losses.

Credit Standards

Credit policy can have a significant influence upon sales. If competitors extend credit liberally and if a firm does not, the policy may have a dampening effect upon the marketing effort. Trade credit is one of many factors that influence the demand for a firm’s product.  In theory, the firm can lower its quality standard for accounts accepted as long as the expected profitability of sales generated exceeds the added costs of the receivables. What are the costs of relaxing credit standards? The incremental cost comes from the increased probability of bad-debt losses. Also a slower average collection
period will occur.

To determine 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 slowness of the average collection period; and the required return on investment.

Suppose a firm’s product sells for $ 10 a unit, of which $7 represents variable costs before taxes, including credit department costs. Current annual sales are $2.4 million, represented entirely by credit sales, and the average total cost per unit at that volume is $9 before taxes. The firm is considering a more liberal extension of credit, which will result in a slowing in the average collection period from one to two months. This relaxation in credit standards is expected to produce a 25 per cent increase in sales, to $3 million annually.  With this percentage increase, the unit sales and total costs of the firm become:

Cost of Present sales  =  240,000 units X $9 = $2,160,000
Marginal cost of Additional sales =  60,000 units X $7 = 420,000
Total cost =  $2,580,000
The average cost per unit of sale at the new level of sales is

Assume that the firm’s required return on investment is 20 per cent before taxes.

Inasmuch as the profitability on additional sales, $180,000 (60,000 * $3), exceeds the required return on the additional investment in accounts receivable, $50,000, the firm is advised to relax its credit standards. An optimal credit policy would involve extending trade credit more liberally until the marginal profitability on additional sales equals the required return on the additional investment in receivables necessary to generate those sales.

MBA Core Management Knowledge - One Year Revision Schedule

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