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Credit and Accounts Receivable Management Chapter 5 Strategize The objectives of credit and accounts receivable management How credit and account receivable management fit into corporate finance and treasury operations How companies develop credit policies
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Strategize • The objectives of credit and accounts receivable management • How credit and account receivable management fit into corporate finance and treasury operations • How companies develop credit policies • How companies calculate the costs and benefits of credit policies • The forms of credit extension
Strategize • The commonly used terms of sale, including credit terms • How companies make customer credit decisions • How companies measure and monitor accounts receivable • How companies finance accounts receivable • How the cash application process works • Legislation that affects credit and collection
Strategize • Learn how to calculate the following: • Annualized cost of trade credit • Days’ sales outstanding (DSO) • An aging schedule • An accounts receivable balance pattern
Differentiate #1 Differentiate among nine different types of terms of sale. cash before delivery (CBD) Buyer must make full and final payment before shipment or receipt of goods Seller ships goods and the buyer pays upon receipt Buyer has a week to ten days to make payment Seller specifies a net due date by which the buyer must pay in full cash on delivery (COD) cash terms net terms
Differentiate #1 Seller specifies a net due date, but may offer an incentive if payment is made prior to that due date Buyer must pay by a specified date the following month Associated with documentary collections; the draft enables the seller to get paid; the bill of lading enables the buyer to get the goods Seller agrees to accept payment at the end of the buyer’sselling season when the buyer has cash discount terms monthly billing draft/bill of lading seasonal dating
Differentiate #1 Seller ships the goods to the buyer with no obligation to pay until the goods have been sold or used consignment
Describe #1 • Describe seven objectives of trade credit and accounts receivable management. 1. Establish and communicate the company’s credit policies 2. Establish terms of sale consistent with overall company objectives 3. Evaluate customer creditworthiness and set customer credit lines 4. Ensure prompt and accurate customer billing in conjunction with customer service or billing departments 5. Create, preserve, collect accounts receivable 6. Maintain up-to-date records of accounts receivable 7. Follow up on overdue accounts and initiate collection procedures when necessary
Describe #2 • Describe three key policy decisions a company must make if it is going to offer credit. 1. Credit standards 2. Credit Terms 3. Collection policy
Describe #3 • Describe the five C’s of credit. 1. Character 2. Capacity 3. Capital 4. Collateral 5. Conditions
Describe #4 • Describe the four most common forms of credit extension. 1. Open Account 2. Installment credit 3. Revolving credit 4. Letter of credit
Describe #5 • Describe eightways accounts receivable can be financed. 1. Unsecured borrowing 2. Secured borrowing 3. Securitization 4. Captive finance subsidiary 5. Third-party financing 6. Credit cards 7. Factoring 8. Private label financing
Annualized Cost of Trade Credit (#1) The annualized cost to a buyer of not taking a discount can be calculated as a function of the amount of the discount and the number of additional days of credit gained by delaying payment until the net due date. If funds can be borrowed at a rate less than the cost of not taking the discount, then a buyer should borrow those funds and take the discount for early payment. If borrowed funds are more expensive (or not available), then the buyer should delay payment until the net due date.
Annualized Cost of Trade Credit (#1) • Example • Assuming terms of 2/10, net 45, the cost of not taking the discount can be determined as follows: If the company can borrow at less than 21.28%, it should do so and use the borrowed funds to pay early and take the discount.
DSO and Average Past Due (#2) The most commonly used measurement of accounts receivable is days’ sales outstanding (DSO), which is calculated by dividing accounts receivable outstanding at the end of a time period by the average daily credit sales for the period. DSO is easy to calculate and gives a single number that when compared to the stated credit terms or to a historic trend provides an indication of a company’s overall collection efficiency. It may, however, be distorted by changing trends in sales volume, payment pattern, or by a strong seasonality in sales.
DSO and Average Past Due (#2) Example Assume a company has outstanding receivables of $398,000 at the end of the first quarter and credit sales of $567,000 for the quarter. Using a 90 day averaging period, the DSO for this company can be computed as follows:
DSO and Average Past Due (#2) If the company’s credit terms are net 60, the Average Past Due is as follows: Average Past Due = DSO - Average Days of Credit Terms Average Past Due = 63.2 Days - 60 Days = 3.2 Days Info.
Aging Schedule (#3) • An aging schedule is a list of the percentages and/or amounts of outstanding accounts receivable classified as current or past due, usually in 30-day increments. • The schedule can be prepared at the aggregate level or on a customer-by-customer basis. • The primary use of these schedules is to identify past-due accounts. This is important because the older a receivable becomes, the less likely it is to be collected.
Aging Schedule (#3) Age of Accounts Accounts Receivable % of Accounts Receivable 0-30 Days $ 300,000 30% 31-60 Days $ 450,000 45% 61-90 Days $ 150,000 15% 91+ Days $ 100,000 10% Total $1,000,000 100% Example Given the aging schedule below and assuming the credit terms are Net 60, 25% of the company’s accounts receivable are past due. The percentage of past due accounts = 15% + 10% = 25%.
Differentiate #2 Differentiate among the types of bankruptcy under the Federal Bankruptcy Reform Act of 1978. Chapter 7 When a company files for liquidation When a company files for reorganization When an individual files for reorganization Chapter 11 Chapter 13