Financial Management

Management of Receivables and Payables

Management of Receivables and Payables 2
 Chapter : 9

MANAGEMENT OF RECEIVABLES AND PAYABLES

INTRODUCTION
A business firm can sell goods or services on cash as well as on credit basis. In case of cash sales,
payment is immediately received, but when goods or services are sold on credit basis, the payment is
deferred for future. Receivables (debtors and bills) emerge on account of this credit facility extended by the
firm to its customers. These receivables constitute a significant portion of working capital which is an
important component of it after inventory. In India, in some business enterprises, the ratio of receivables to
total assets ranges from 16% to 20% and they form about one third of total current assets. Though, this
asset (receivables) is not financed separately from the capital market like other assets, still a substantial
portion of the capital remains blocked in receivables in large business enterprises. That is why; an effective
and efficient management of receivables is inevitable so that the investment in the receivables is kept at the
optimum level.

MEANING AND NATURE OF RECEIVABLES

Receivables arise when goods or services of a firm are sold on credit basis. Therefore, credit sales are
receivables. According to Hampton, “receivables are asset accounts representing amount owed to the
firm as a result of the credit basis sale of goods or services in the ordinary course of business.''
Thus, receivables are asset and represent claims of the firm against its customers. These are shown in
the assets side of the balance sheet under titles such as bills receivables, notes receivables, sundry debtors,
trade debtors, book debts, accounts receivables etc. These receivables are the result of extension of credit
facilities to the customers. The objective of such facility is to allow the customers a reasonable time in
which they can pay for the goods purchased by them.
CHARACTERISTICS OF RECEIVABLES
Receivables or debtors have the following characteristics :
1. It Involves Risk : Risk is involved in receivables and it should be analysed carefully. This is
because in credit sales cash payment is yet to be received, whereas, there is no such risk involved in cash
sales, as payment is made immediately.
2. Based on Present Economic Value : In the case of credit sales, the economic value in the form of
goods or services passes immediately to the customers, whereas, the seller expects an equivalent benefit i.e.
cash at a later date.
3. It Implies Futurity : The buyer makes the cash payment for goods or services received by him in
future period.
BENEFITS OF RECEIVABLES
As stated above, receivables are created because of credit sales, therefore, the creation of receivables
is directly related with the objective of making credit sales. The credit sales are required for the following
purposes or objectives :
1. Increase in Sales : Provision of facility of credit sales by a firm to its customers is a powerful
stimulant for increasing sales. While cash sales are important, more orders from customers can be had by
selling goods and services on credit, because many customers do not have sufficient cash to make cash
Management of Receivables and Payables 303

purchases. If a firm does not sell on credit, it will have fewer customers and decline in sales. Thus,
receivables help in growth of sales.
2. Increase in Profits : This is an indirect result of selling on credit. The direct result of credit sales
is growth in sales. By providing credit sales, the firm has additional sales and these additional sales result in
higher profits. Sometimes, credit sales are made at a price which is higher than usual cash selling price.
This enables the firm to make extra profit over and above the normal profit.
3. Capability to Face Competition : If competitors sell on credit, a firm would be able to face
competition only when it also sells by selling goods or services on credit. By doing so, the firm may avoid
the loss of sales from customers who would buy from elsewhere, if they did not receive the expected credit.
Therefore, the firm should adopt credit policies similar to that of the competitors so that its customers may
not attract to purchase from competitors.
4. Extra Profit : Sometimes firm make the credit sales at a price which is higher than the usual
selling price. This is Extra Profit.
COST ASSOCIATED WITH RECEIVABLES
There are several costs associated with credit extension such costs include the following :
1. Defaulting Costs : Sometimes, the firm may not collect the overdues from the customers since
they are unable to pay. These debts are treated as bad debts and are to be written off accordingly since the
amounts will not be realised in future. Such costs are termed as ‘default costs’.
2. Capital Cost of Financing : Financing resources of the firm are blocked in receivables as there is
a time lag between the sale of goods to the customers and the payment to be made by them. Hence, the firm
has to arrange additional funds to meet its own obligations towards payment to the suppliers of raw
materials, employees etc., while waiting for payments from its customers. Additional funds may either be
raised from outside sources or out of profits retained in the business. In the former case, interest has to be
paid to the outsiders while in the latter case, there is an opportunity cost to the firm. It is known as capital
cost or cost of financing the receivables.
3. Administrative Costs : A firm is also required to incur various costs in order to maintain the
record of credit customers. These costs include the salary to the staff kept for maintaining the records of
credit sales and collection thereof, cost of obtaining information regarding credit worthiness of the potential
customers etc.
4. Collection Costs : These are the costs which are to be incurred by a firm in order to collect the
amount due from customers on account of credit sales. Sometimes, additional steps may have to be taken to
recover the amount due from defaulting customers. The costs of such extra steps e.g. reminders, legal
charges etc. are known as ‘deliquency costs’.

MEANING OF RECEIVABLES MANAGEMENT

‘Credit is the soul of business in present Era’, According to this axiom and to survive in a
competitive environment, each and every firm adopts the policy of selling goods on credit. Receivables are
a direct result of credit sales which ultimately increase the profits earned by the firm. Credit sales also
result in blocking of more funds in receivables which involve extra cost in terms of interest. Moreover,
increase in receivables enhances the bad debts. Thus, receivables involve some costs (interest and bad
debts) as well as benefits (increase in profits due to credit sales) to the firm. Both the costs and the benefits
are to be looked carefully and a trade off between them should be attempted. This is, what is known as
‘Receivables Management’.
Thus, the receivables management consists of matching the cost of increasing sales (particularly
credit sales) with the benefits arising out of increased sales with the objective of maximising the return on
investment of the firm. The term ‘receivables management’ may, therefore, be defined as the process of
making decisions relating to the investment of funds in this asset which will result in maximising the
overall return on the investment of the firm. In the words of Prof. S.C. Kuchhal, “managing receivables
means making decisions relating to the investment of funds in this asset as part of short term
operating process.”
304 Financial Management

FACTORS AFFECTING INVESTMENT IN RECEIVABLES

Some of the important factors which determine the amount of capital required for extending credit
and maintaining the accounts receivable are as follows :
1. The Terms of Credit Policy : The volume of accounts receivable depends upon the terms of credit
offered by the firm to the customers. These firms include the credit period and the cash discount offered
to customers for payment of dues before the expiry of credit period. A firm's investment in receivables is a
function of volume of credit sales and the collection or credit period (in terms of days). For example,if a
firm's credit sales are ` 50,000 per day and the credit period for payment of dues is 40 days, then the
average investment in accounts receivable will be 20 lakhs (50,000 ´ 40). The smaller the collection or
credit period, the smaller will be the investment in receivables.
2. Conditions of Business : The business conditions prevailing in the market also affect the size of
receivables. For instance, in highly competitive conditions or in slack periods goods may be offered on
credit to increase sales.
3. Credit Department Capability : The capability of the credit department of a firm also affects the
size of receivables. The main function of the credit department is to scrutinise the orders placed by
customers, investigating into the credit worthiness of customers and collecting the receivable in time. The
more is this department capable and effective in its activities, the quicker would be the collections and the
lesser would be the possibility of receivables turning into bad debts. In contrast to this, if credit department
is negligent in scrutinising customers orders and slow in making collections, the funds would be blocked in
receivables and that too for a long period of time.
4. Level of Sales : Generally, credit sales are a percentage of the firm's total sales. The higher the
volume or level of sales of a firm, the higher will be volume of its credit sales or accounts receivable. In
other words, a firm having a large volume of sales will be having a large volume of receivables as
compared to a firm with smaller size of total sales.
5. Credit Policy Adopted by the Firm : Credit policy means the policy adopted to extend credit
sales which include (i) the time period allowed to collect the debt; (ii) the type of discounts allowed; (iii)
the assessment of customers credit worthiness, and (iv) collection policy. The credit policy may be liberal
or rigid affects the level of investments in receivables. Pursuance of liberal credit policy will boost up the
sales of the firm as it tempts the customers to make purchases from the firm on lenient term. Consequently,
the firm will require larger amount of working capital to finance receivables. On the other hand, firms
pursuing rigid credit policy require less working capital to finance receivables. Again a firm which is
prepared to undertake higher risk is likely to invest substantial funds in receivables.
6. Nature and Tradition of Business : Customs and traditions in the trade and nature of the business
also affect the volume of accounts receivable. For example, credit sales are more common in wholesale
trade as compared to retail business. Again, the types of goods that are sold also determine the accounts
receivable. Durable and costly items like furniture, refrigerators and many other such goods are sold on
credit.
SCOPE OF RECEIVABLES MANAGEMENT
The scope of receivables management is very wide. Hence, it must be attempted by adopting a
systematic approach and considering the following aspects of receivables management :
1. Formulation of Credit Policy
● Credit Standards
● Credit Terms
● Collection Policy
2. Credit Evaluation
● Collection of Information
● Credit Analysis
● Credit Decision
3. Credit Control
● Formulation of Collection Procedure
● Monitoring and Controlling of Receivables
Management of Receivables and Payables 305

CREDIT POLICY
A business unit makes significant investment by extending credit to its customers. This requires a
suitable and effective credit policy to control the level of total investment in receivables. Credit policy
refers to decision application of those factors that influence the amount of trade credit, i.e.,
investment in receivables. Generaly economic conditions, competitions, industry norms and pace of
technology changes are the factors that affect the investment in receivables in an enterprise. But, the firm
has almost no control over these factors. Yet, it can influence the trade credit through its credit policy
within the constraints of these external factors. The credit policy of the firm will change as and when any
external factor changes. Generally, firms identify two types of credit policy viz. (a) liberal or lenient policy
(b) tight or stringent credit policy.
(a) Lenient Credit Policy, liberal sales made to those customers whose credit-worthiness is either
doubtful or even is not known at all. There will be greater sales and higher profits earned by such firms
who follow lenient credit policy. The sales will increase as the sales are made on liberal terms and
favourable incentives are granted to customers. At the same time, it increases investment in receivables and
the costs associated with it. Such a policy will also increase risk because of lower liquidity.
(b) Stringent (Tight) Credit Policy, credit sales are made only to those customers whose credit
worthiness has been tested and is proved good. Firms following such policy are very selective in granting
credit sales. In following such a policy, costs and bad debts will be minimum and no serious problem of
liquidity is posed. But, at the same time, such a policy adversely affects the sales position and margin of
profit, i.e., profitability.
From the aforesaid description, it is clear that as the firm makes its credit policy more and more
liberal, its liquidity decreases, whereas profitability increases. On the other hand, if the firm makes the
credit policy more and more stringent, the liquidity may increase but the profitability will definitely go
down. Hence, a firm should try to frame its credit policy in such a way as to attain the best possible
combination of profitability and liquidity so that the overall return of the enterprise is maximised. This has
been depicted in the graph given in Figure (1)

COMPONENTS OF CREDIT POLICY

The basic decision to be made regarding receivables is to decide how much credit be extended to the
customer and on what terms. With this view, credit policy may be defined as the set of parameters and
principles that govern the extension of credit to the customers. These parameters, also known as
components of credit policy, are as follows :
1. Credit Standards
2. Credit Terms
3. Collection Policy
306 Financial Management

I. CREDIT STANDARDS
While formulating the credit policy of a firm, the finance manager has to be ensured about the type of
customers to whom the firm will extend credit facility. This decision is taken on the basis of credit
standards. Credit standards are the basic criteria for the extension of credit to customers. The
quantitive basis of establishing credit standards are factors such as credit ratings, credit references, average
payment period, financial ratios. When the credit standards of a firm are loose, the level of sales and
receivables is likely to be high. The cost of credit administration and bad debts losses will also increase. As
against this, when credit stanards are relatively tight, the sales and receivables are likely to be low. Such
standards will result in no bad debts losses and less cost of credit administration. Thus, the choice of
optimum credit standards involve a trade off between incremental return and incremental costs. The credit
stanards of a firm are influenced by the following factors :
1. The customer's willingness to pay.
2. The customer's ability to pay.
3. The customer's financial soundness.
4. The customer's assets that may be mortgaged.
5. The conditions that are prevailing presently.
Relaxing Credit Standards : Generally, relaxation in the credit standards by a firm will result in
increased sales and margin of profit. But, at the same time administration costs in the form of supervising
additional accounts and servicing increased volume of receivables production and selling costs, bad debts
losses will increase. When a firm plans to relax or liberalise its credit standards, it should try to strike a
balance between the profits arising due to increased sales and the costs to be incurred on the increased sales
caused thereby. In other words, credit standards should be relaxed upto the point where incremental
return equals to incremental costs. In this way, when the additional net profits (profits on increased
sales-relevant increased cost) are more than the expected rate of return (cost of capital), the credit stanards
should be relaxed. This has been explained in the following illustration.
Illustration 1
Company's annual credit sales and the year-end balances of receivables are given below for three
years, i.e., 2009, 2010, 2011 :
2009 2010 2011
` ` `
Total Credit Sales 3,60,000 6,75,000 9,60,000
Receivables 60,000 75,000 80,000
On the basis of the above data you are required to calculate the average collection period (ACP) for
each of the three years and make suitable comments on the level of receivables management. Assume there
are 360 operating days in a year.
Solution :
The formula for computing average collection period is :
R´D
ACP =
S
Where, ACP = Average Collection Period
R = Receivables
D = Number of Days in the Operating Period
S = Credit Sales During the Period
Now the average collection periods for the three years can be calculated as follows :
60,000 ´ 360
2009 = = 60 days
3,60,000
75,000 ´ 360
2010 = = 40 days
6,75,000
Management of Receivables and Payables 307
80,000 ´ 360
2011 = = 30 days
9,60,000
Average collection period of the company has come down from 60 days in 2009 to only 30 days in
2011. This shows excellent performance so far credit and collection policy of the company is concerned. In
case the normal credit period allowed in the market is one month, then it can be said that there were no
defaulters, nor there were any bad debts in 2009, 2010 and 2011 respectively; because payments for credit
sales were being received promptly and regularly.
If the average collection period is within the usual credit limits, plus one-third of that credit period,
then the same is considered within reasonable credit limit. Judged on the basis of this norm, A.C.P. for
2010 (40 days) is also quite satisfactory. As already mentioned that A.C.P. for 2011 (30 days) can be taken
as a symbol of excellent credit and collection management, which is a rare occurrence in practice.
Illustration 2
The following data have been extrated from the books of accounts of a company for the year ending
31st March, 2012. `
Total Sales 10,20,000
Cash Sales 2,00,000
Sales Returns 1,00,000
Debtors (on 31.03.2012) 90,000
Bills Receivables (on 31.03.2012) 30,000
Provision for Bad-debts (31.03.2012) 20,000
You are required to calculated the average collection period for the company. Assume there are 360
days in a year.
Solution :
Receivable ´ 360
Average Collection Period =
Net Credit Sales
1,00,000 ´ 360
= = 50 days.
7,20,000
Working Notes :
(i) Receivables = (Debtors + Bills Receivables) – Bad Debts
= (` 90,000 + ` 30,000) – ` 20,000 = ` 1,00,000
(ii) Net Credit Sales = Total Sales – Cash Sales – Returns
= `10,20,000 – ` 2,00,000 – `1,00,000 = ` 7,20,000
Illustration 3
The following information of a company for the last two years are available :
F. Y. 2010 F.Y. 2011
Net Sales (`) 30,00,000 36,00,000
Receivables (`) 6,00,000 6,00,000
On the basis of the above data (i) compute the receivables turnover for the given two years and (ii) to
findout the average size of investment in receivables for an improved receivables turnover of 7.5 times on
budgeted sales volume of ` 45,00,000 for the F.Y. 2011.
Solution :
Sales
(i) Receivable Turnover =
Receivable
30,00,000
F.Y. 2010 = = 5 times
6,00,000
36,00,000
F.Y. 2011 = = 6 times
6,00,000
308 Financial Management

(ii) Average investment in receivables for a turnover of 7.5 times on budgeted sales volume of `
45,00,000 in the year 2011.
Budgeted Sales
Receivables =
Recievables Turnover
45,00,000
= = ` 6,00,000
7.5
Increase in receivables turnover always shows improvement in the level of receivables management.
In case the management wants to improve this ratio then funds tied up in receivables are to be kept within
limits in relations to the volume of sales. This can be done by appropriate modification in terms of credit
and also by gearing up collection machinery.
Illustration 4
The following information has been taken from the books of accounts of three companies A, B
and C :
COMPANIES
Details
A B C
Recievables (year-end) 5,00,000 12,00,000 6,75,000
Credit Sales (for year) 45,00,000 72,00,000 27,00,000
All the three companies sell goods on 30 days credit. Find out average collection period of each of
the three companies and make suitable comments.
Assume 360 days in a year.
Solution :
Receivables ´ 360
ACP =
Credit Sales
5,00,000 ´ 360
Company A = = 40 days
45,00,000
12,00,000 ´ 360
Company B = = 60 days
72,00,000
6,75,000 ´ 360
Company C = = 90 days
27,00,000
Receivables management of company ‘A’ is satisfactory as its average collection period is within
usual limits (i.e., 30 days + 1/3rd of 30 days = 40 days). Credit and collection management of companies B
and C cannot be considered efficient, as payments are overdue 60 days (twice the normal credit period) in
the case of company B, and 90 days (thrice the normal credit period) in the case of company C. Such a
situation may be due to very liberal or lenient credit terms and standards. It may also be the result of a very
lenient collection policy.
Illustration 5
The following particulars in respect of a business firm are given for the year ending on 31st March,
2012
Credit Sales ` 20,00,000
Average Collection Period 36 days
The opening balance of debtors was lower by ` 40,000 than the closing balance of debtors.
From the above particulars, you are required to calculate the following :
(a) Average Debtors
(b) Debtors Turnover
(c) Closing Balance of Debtors
Assume there are 360 days in a year.
Management of Receivables and Payables 309

Solution :
(a) Average Debtors
Average Debtors
Average Collection Period = ´ 360
Net Credit Sales
Average Debtors
36 = ´ 360
20,00,000
36 ´ 20,00,000 = 360 ´ Average Debtors
7,20,00,000 = Average Debtors ´ 360
Average Debtors = 7,20,00,000 ¸ 360 = ` 2,00,000
(b) Debtors Turnover
Net Credit Sales
Debtors Turnover =
Average Debtors
20,00,000
= = 10 times
2,00,000
(c) Closing balance of Debtors
Opening Debtors + Closing Debtors
= 2,00,000
2
Closing Debtors – Opening Debtors = 40,000
Closing Debtors + Opening Debtors = 2,00,000 ´ 2 = 4,00,000
\ 2 Closing Debtors = 4,40,000
Closing Debtors = 4,40,000 / 2 = ` 2,20,000
Verification : Opening Debtors = 2,20,000 - 40,000 = ` 1,80,000
Illustration 6
A new batch of customers with 10% risk of non-payment desires to establish business connection
with you. This group would require 1.5 month of credit and is likely to increase your sales by ` 1,30,000
p.a. cost of sales amounted to 80% of sales. Income Tax rate is 50%.
Should you accept the offer if the required rate of return is 45% (after tax).
Solution :
Evaluation for Credit Extension to New Customers
A. Profitability on Additional Sales `
Increase in Sales p.a. 1,30,000
Less : Cost of Sales (80% of Sales) 1,04,000
26,000
Less : Bad Debts (10% of Sales) i.e., (10% of 1,30,000) 13,000
Net Profit Before Tax 13,000
Less : Income Tax @ 50% 6,500
Net Profit After Tax 6,500
B. Return on Additional Investment on Receivables
45
13,000 ´ 5,850
100
Working Notes :
Working Days or Months in a Year 12
(i) Receivable Turnover = = = 8 months
Credit Period 1.5
Cost of Sales 1,04,000
(ii) Average Investment in Additional Receivables = = = ` 13,000
Receivable Turnover 8
Decision : Net profit after tax (` 6,500) on additional sales is more than the expected return (` 5,850)
on additonal investments in receivables. Hence, proposal of new customer should be accepted.
310 Financial Management

II. CREDIT TERMS

After determining credit standards and capability of the customer, the management has to determine
those terms on which credit will be extended. The credit terms refer to the set of stipulations or
conditions under which the credit is extended to the customers. These relate to the payment of goods
sold. The credit terms specify, how the credit will be offered including the length of the period, the interest
on the credit and the cost of default. The credit terms relate to (i) credit period, (ii) cash discount, and (iii)
discount period.
(i) Credit period : Credit period is the time duration for which the credit is extended to the
customers. Credit period is generally given as a net date. For example, when the terms of trade credit
allowed by a firm indicate ‘net 30’ it specifies that the payment is expected to be made by the 30th day
from the date of credit sale. There is no hard and fast rule regarding the credit period and it may differ from
one market to another. Normally, credit period is governed by industry norms and customs of the trade, but
individual firms can extend credit for larger durations provided in the industry norms. Credit period
affects demand of the products, average collections period and bad debt losses.
Effect of Change : Lengthening the credit period increases the sale by attracting more and more
customers, whereas squeezing the credit period has the reverse effect. The effect of changing the credit
period is similar to that of changing the credit standards and hence requires careful analysis. The firm must
consider the costs involved in increasing the credit period which will result in an increase in the investment
in receivables. This has been explained in the following illustration :
Illustration 7
A company X Ltd. is extending one months credit to its customers. It sells product at ` 100 each and
has annual sales volume of 70,000 units. At current level of production, which matches with sales, the
product has total cost of ` 90 per unit and a variable cost of ` 80 per unit.
The company is considering a plan to grant more liberal terms by extending the duration of credit
from one month to two months and expects the sales to the customers to go up by 35%. The normal
expected rate of return on investment is 30%.
Is relaxation in credit period is justified ?
Solution : Evaluation of the Relaxation in the Credit Period
Profit from Additional Sales Due to Increase in Credit Period `
[Additional Sales in units ´ (SP – VC)] 4,90,000
24,500 i.e., (70,000 ´ 35%) ´ ( 100 – 80)
= 24,500 units ´ 20 2,55,500
Less : Increased Cost of Additional Investment in Receivables (` 8,51,667 ´ 30%)
Net Increase in Profits 2,34,500
Decision : The credit periods should be extended from one month to two months as the net profits of
the company will increase by ` 2,34,500.
Working Notes :
12 Months 12
(i) Receivable Turnover = = = 6 months
Credit Period in Months 6
Cost of Sales
(ii) Average Investment in Proposed Credit Period =
Receivables Turnover
Total Cost + Variable Cost (70,000 units ´ ` 90) + (24,500 units ´ ` 80)
= = ` 1,376,667
Receivable Turnover 6
Less : Average Investment in Credit Period
Unit Sold ´ Cost per Unit
Month in a Year Credit Period
70,000 units ´ 290
5,25,000
(12 months + 1 months)
Additional Investment in Receivables 8,51,667
Management of Receivables and Payables 311

(ii) Cash Discount : The second aspect of credit terms is cash discount. Such a discount is offered by
business firms to motivate customers for making early payments of their bills. The rate of discount and the
period for which it is granted is indicated in the terms of cash discount. In the event of a customer not
availing this opportunity of cash discount, he is required to make the payment by the net date specified as
credit period. For example, if credit terms are given as ‘3/15 net 45’, it indicates rate of discount 3%, period
of discount 15 days and credit period of 45 days. If payment is made within 15 days, cash discount at the
rate of 3% will be granted, otherwise payment is to be made by 45th day if the offer of discount is not
availed. Cash discount also affects cost of capital, average collection period and bad debt losses.
Increase in Discount Rates : Sometimes, the rate of discount is increased with the object to
accelerate the payment of receivables. This results in the reduction of average collection period and
consequently the investment in receivables is also decreased. It also reduces the cost of capital. But, on the
other hand, cash discount which is itself a loss to the firm, also increases. Therefore, if the income earned
due to accelerated recovery of receivables is more than the increased cost on account of discount, the
increase in the rate of discount will be in the interest of the firm. Hence, any change in discount terms
(rate or period) be evaluated in terms of costs and benefits of such change as explained in the following
illustration :
Illustration 8
HUL Ltd. currently sells 30,000 units at ` 40 each. The average collection period is 40 days. The
present average cost per unit is ` 30 and variable cost per unit is ` 24.
The company is considering to allow 3% discount for payment prior to the 15th day after a credit
sale. It is expected that if cash discount is allowed, then expected sales will be 36,000 units and the average
collection period will come down to 25 days. Assume bad debts expenses will not be affected. The
company expects a rate of 16%. 70% of the total sales will be collected on cash discount.
Should the company implement the proposal ? Assume 360 days in a year for your calculation.
Solution :
Evaluation of Cash Discount Proposal
Profit on Additional Sales : `
(36,000 – 30,000) = 6,000 units ´ (` 40 – 24) 96,000
Add : Saving Due to Reduction in Cost of
16 ö
Average Investment in Receivables æç 27,500 ´ ÷ 4,400
è 100 ø
1,00,400
Less : Cost Involved in Cash Discount @ 3% of ` 10,08,000
(70% of 36,000 units @ ` 40) 30,240
Net Benefit from Cash Discount Proposal 70,160
Decision : It is clear that accepting cash discount proposal results in the increase of ` 70,160 in
profits, hence, the proposal should be accepted.
Working Notes :
Calculation of Average Investment in Receivables :
Cost of Sales
=
Receivables Turnover
Units Sold ´ Cost per Unit
or
Days in a Year / Credit Period
30,000 Units ´ ` 30
Present Plan (without Discount) =
360 ¸ 40
9,00,000
= ` 1,00,000
9
312 Financial Management

Less : Proposed Plan (without Discount)

(30,000 units ´ ` 30) + (6,000 units ´ ` 24)
=
360 ¸ 25
9,00,000 + 1,44,000 10,44,000
= = 72,500
14.4 14.4
Reduction in Investment in Receivables 27,500

III. COLLECTION POLICY

Proper management of receivables requires an appropriate collection policy of the firm. Collection
policy refers to the procedure adopted by a firm to collect payments due on past accounts. The basic
objective of formulating a collection policy is to ensure the timely payment on receivables without losing
any customer. It helps the finance manager to tighten the credit policy for slow paying customers. A strict
or lenient, both types of collection policies have adverse effects on business. A strict collection policy can
affect the goodwill and damage the growth prospectus of sales, while in a lenient collection policy the
customers with natural tendency towards slow payments will become even more slower to settle their
accounts. Therefore, a collection policy should be such that it may reduce the proportion of bad debt losses
and shorten the average collection period. An important variable in collection policy is expenditure on
collection. The greater the amount spent on collection efforts, the lower the proportion of bad debt losses
and the shorter is the average collection period. Therefore, an optimum collection policy should be
framed by the firm in such a way that the costs (collection expenditure) and benefits (reduction in
bad debt losses and the cost of investment in receivables) arising from collections are in equilibrium
and it should be pursued till benefits exceed costs. This has been explained in the illustration given
below :
Illustration 9
Zenith Ltd. company sells 50,000 units of its products per annum @ ` 35 per unit. The cost per unit
is ` 31 and the variable cost per unit is ` 28. The average collection period is 60 days. Bad debt losses are
3% of sales and the collection charges amount to ` 20,000.
The company is considering a proposal to follow a stricter collection policy which would reduce bad
debt losses to 1% of sales and the average collection period to 45 days. It would, however, reduce sales
volume by 1,000 units and increase the collection expenses to ` 25,000.
The company's required rate of return is 20%. Would you recommend the adoption of the new
collection policy. Assume 360 days in a year for your calculation.
Solution :
Evaluation of New Collection Policy `
A. Savings or Benefits under New Policy :
(i) Savings in Bad Debts Due to Decrease in Credit Period :
Present Bad Debts [3% of ` 17,50,000 i.e. (50,000 units ´ ` 35] 52,500
Less : Proposed Bad Debts :
(1% of ` 17,15,000 i.e. (49,000 units ´ 35) 17,150
35,350
(ii) Savings Due to Reduction in Cost of Investment in Reeivables (` 68,083 ´ 20%) 13,617
Total Savings/Benefits 48,967
B. Increase in Cost and Reduction of Profit under New Policy
(i) Increase in Collection Charges 5,000
(` 25,000 – ` 20,000)
(ii) Reduction in Profits Due to Decreases in Sales of 1,000 units
[1,000 units ´ (` 35 – 28)] 7,000
Total Increase in Cost and Reduction in Profit 12,000
Net Gain Arising from New Policy (A – B) 36,967
Management of Receivables and Payables 313

Decision : Hence, the company is advised to adopt the new collection policy as the net profits of the
company will increase by ` 36,967.
Working Notes :
Reduction in Cost of Average Investment in Receivables :
Cost of Sales
Average Investment in Receivables =
Receivables Turnover
Working Days / Months in a Year
Receivable Turnover = `
Credit Period
50,000 units ´ ` 31 ` 15,50,000
Average Investment under Present Policy = = 2,58,333
360 ¸ 60 6
Less : Average Investment under New Policy
Unit Sold ´ Cost per Unit
Days in a Year Credit Period
(50,000 units ´ ` 31) – (1,000 units ´ ` 28)
=
360 / 45
15,50,000 – 28,000 15,22,000
= = 1,90,250
8 8
Reduction in Investment in Receivables 68,083

CREDIT EVALUATION
An efficient credit management requires that a firm should formulate clear cut guidelines and
procedure for granting credit to individual customers. In other words, all the customers should not be
treated equally while extending credit facilities to them. So, at the time of extending credit to the
customers, the firm must know the credit worthiness of the customer i.e. whether a particular customer be
extended any credit or not, and if yes, how much and on what conditions. The objective of such evaluation
is to select those customers who satisfy the pre-determined norms of credit. The following steps are
involved in this process :
● Collection of Information
● Credit Analysis
● Credit decision or Credit Limit
I. COLLECTION OF INFORMATION
Credit facilities should be provided to those customers only who possess the ability to make
payments on due dates. This requires the firm to collect enough credit information from different sources
regarding credit worthiness of each customer. But, the collection of credit information involves cost which
should normally be less than the expected profits from the transactions. In case of small accounts, detailed
information may not be collected and the decision regarding extending credit facility may be taken on the
basis of limited available information. Besides, cost effects of credit information, time factor is also
involved in it. The time involved in the collection of credit information also affects the decision regarding
grant of credit and such a decision cannot be delayed for long. Thus, keeping in view the cost factor and
time factor, it is suggested that information may be collected through the following sources as given in the
figure :

Sources of Credit
Information

Financial Trade Bank Firm's Own Credit Rating

Statements References Experiences Experiences Agencies

1. Financial Statements : The financial statements of an individual prospective customer can be

scrutinised very easily by going through his profit and loss account and balance sheet. The balance sheet
provides information whether the customer has adequate assets to earn desired income to pay back the loan.
314 Financial Management

Similarly, the profit and loss account gives information regarding sources of income, production cost,
working expenses, etc. In case of joint stock companies, there is no difficulty in obtaining financial
statements as they are statutorily published. But, there is difficulty in obtaining the same from the
individual proprietorship and partnership firms. Regarding such customers, it should be presumed that their
financial position must be weak. It should be insisted that the financial statements supplied are duly
audited.
2. Trade References : The prospective customer may be asked to give the names of some of the
businessman with whom he is having dealings currently. After obtaining the names, these references can be
contacted for providing the relevant credit information. If required the references should be personally
collected for the desired information. The honesty and seriousness of the referees should also be examined
as the customer can, sometimes, furnish misleading references.
3. Bank References : Information about the customer regarding his average balance, loans
sanctioned, experience about his behaviour etc. can be obtained from different banks with whom the
customer deals. Most commercial banks maintain separate credit department to perform credit
investigations for their customers. They do not generally provide such information directly, but it can be
collected through his own bank.
4. Firm's Own Experience : If the customer is not a new and he has old relations with the firm, then
information about his credit worthiness can be obtained from the credit department of the firm. The credit
department of the firm maintains complete records of all his old customers regarding their financial
position, managerial efficiency, promptness in payments, credit limit, etc. The salesman may also supply
important information about the customers.
5. Credit Rating Institutions : When the customer insists on prompt delivery, it is not possible to
evaluate the credit worthiness of a customer from financial statements, as it takes relatively long time.
There are certain credit rating agencies who provide independent information on the credit worthiness of
different customers. These agencies gather information regarding credit history, biographies of the owners
or executive officers, nature and size of trade, financial position and behaviour of loan payments etc. of
different firms and sell it to the firms. From these agencies, a special report in respect of a particular
customer may also be obtained.
In India however, credit rating system is becoming popular and now two such important agencies viz.
Credit rating and Information System of India Limited (CRISIL) and Investment Information and Credit
rating Agency (IICRA) are operating. In U.S.A. Dun and Brad Street is a famous credit rating agency
which collects information for certain number of industries and publishes a reference book periodically.
Beside the above, the credit information of the business firms, especially the large one, can be
obtained from trade journals, periodicals, newspapers, trade directories, public records such as income tax
statements, wealth tax and sales tax returns, revenue and municipal records.
II. CREDIT ANALYSIS
Collection of information in respect of any customer will not serve any purpose in itself unless it is
analysed to reach at some conclusion regarding the credit worthiness of a customer. Credit analysis is the
evaluation of the borrowing capacity of the applicant and the promptness and repaying ability of a
customer according to the terms of contract. To reduce the inherent risk in the loan, the credit
worthiness of the applicant is analysed in details. The well known five C's of credit i.e. Character,
Capacity, Capital, Collateral and Conditions provide a framework for the evaluation of a customer.
These characteristics as discussed before, highlight the credit worthiness or default risk of the customer.
● ‘Character' refers to the temperament of the customer. It is to be judged whether the customer is
honest and is prompt in paying the dues that he had undertaken to pay. Credit evaluation has to
be made taking into account this factor.
● ‘Capacity' refers to the ability of the customer to pay back the purchase price. This can be
measured by conducting a detailed investigation of his dealings, his past actions his profession,
his business methods etc. This investigation reveals whether the customer is capable of managing
his business efficiently.
Management of Receivables and Payables 315

● ‘Capital' refers to the financial soundness of the customer. This can be assessed by studying the
financial statements of the firm.
● ‘Collateral' is a term used to express the additional ability of the customer. This measures the
securities held by the customer which can be offered for the credit he avails.
● ‘Condition' refers to the economic conditions which influence the activities of the firm. If the
conditions are unfavourable, the situation will not be good for extending credit to such firms.
From the aforesaid point of view, proper evaluation about the financial position of the customer
should be made very carefully with the help of liquidity and other ratios to be computed from the data
available in the published financial statements. These ratios discussed in chapter 4 will indicate the
repaying capacity of the customer. The performance can also be compared with industry average ratios. It
is suggested that credit analysis should be done more and more with the help of advanced quantitative
techniques. This is especially so, as the modern world is fast moving towards growth of trade credit in all
respect of commercial activities.
CREDIT DECISION OR CREDIT LIMIT
After determining credit worthiness of the applicant, it is to be decided whether or not credit facilities
should be provided to him. This requires matching of evaluated credit worthiness of the applicant with the
established credit standards of the firm. If the applicant is above or up to the standard, obviously credit
facilities should be provided, otherwise not.
If a decision is taken to extend the credit facilities to an applicant, the next step is to decide the
amount and duration of credit. The decision in this regard depends on (i) the amount of intended sales and
(ii) the financial strength of the customer. A line of credit can be established in case of a frequent buyer
which will avoid the need to investigate each order from him. A line of credit is the maximum amount of
credit which can be extended by the firm at a given period. The line of credit can be fixed on the basis
of customer's normal buying trend and the regularity in payments.
After determining the amount of credit, the firm has also to decide about the duration of credit. This
may be the normal collection period as decided in the light of industry norms. If some customers request
for the relaxation in the collection period, a comparison should be made between the costs for the extended
period and the additional profit earned by the increased sales. The collection period should be extended if
the profit thus earned exceeds the costs involved.
CONTROL OF RECEIVABLES
Once the credit has been extended as per the credit policy, the next important step in the management
of receivables is the control of these receivables. Merely, setting of standards and formulating a credit
policy is not sufficient. Their effective implementations and control is also essential. The main purpose of
controlling receivables is to ensure that the credit policies laid down and adopted are being adhered
to. To control the receivables, efforts are required in the following two directions :
1. Formulation of Collection Procedure
2. Monitoring and Controlling Receivables
FORMULATION OF COLLECTION PROCEDURE
There should be a well drawn and well-designed collection procedure in existence for the
implementation of collection policy. Hence, a clear-cut and effective collection procedure dealing with
delinquent of slow paying customers should be framed and adhered strictly. Collection procedure refers
to the actions which are taken up when customers delay the payments. The collection procedure should
neither be too lenient (resulting in an increase in receivables) nor too strict (resulting, sometimes loss of
customers) as both these affect the business adversely. Therefore, the collection procedure should be such
that it can minimise the bad debt losses without affecting the sales. At the same time, special considerations
should be made to some customers who are temporarily in tight financial position due to some external
factors such as slack economic conditions. The following actions may be taken for collecting receivables.
1. Reminder Letters
2. Help from Collection Agency
3. Cash Discount
316 Financial Management

1. Reminder Letters : The collection procedure should be followed in a clear cut sequence to ensure
the collection from slow payers. This requires that reminder letters should be sent to those customers who
fail to pay on due dates. A politely worded letter should be sent first. If the receivables remain uncollected
strongly worded additional letters should be sent progressively. If still payment is not made, he should be
reminded by telephone or telegram and then a personal visit by the company representative should be
made for collection. If the payment is not still made, legal action may be taken against the customer.
Since, legal action is costly and time consuming, therefore, it is better if a compromise is made and the
account is settled on some payment.
2. Help from Collection Agency : If aforesaid methods fail to bring any response, the next course of
action is to deliver the overall accounts to a collection agency. It is also known as ‘factoring’. It is a debt
collection service where the factor purchases book debts of the client at a discount either with or without
some recourse. In recovering from debtors, he undertakes the responsibility of debt collection and
maintenance of the client's sales ledger in return for a service fee. Thus, finance is made available and the
risk inherent is borne by these agencies. The services of these collection agencies are, generally, not
preferred for collecting small overdue accounts as direct action against small customers is a costly affair.
3. Cash Discount : The Prompt payment from few customers can be facilitated by offering them
cash discount. Cash discount is a cost to the firm and such a cost can be incurred if quick collections are
bound to come. These discounts to the customers reduce the costs and if they have funds they would
certainly come forward to avail the facility. But, full payment should be recovered from those customers
who do not make payment within the specified discount period.

II. MONITORING AND CONTROLLING RECEIVABLES

In order to control the level of receivables the firm should apply regular checks. For this, there should
be a continuous monitoring system and proper control over receivables. The following methods may be
adopted for this purpose :
1. Sales Ledger Accounting : Mechanised sales ledger accounting can be introduced to have regular
checks on the debtors. This system of accounting gives the break up of each invoice and the age of each
outstanding account. This facilitates the quick collection of receivables. Majority of the firms today are
using the computers for preparation of accounts. This has actually reduced the collection period.
2. Ageing Schedule of Receivables : Preparation of ageing schedule of receivables is essential for
the purpose of reducing the bad debt losses and measured by accelerating the collection procedure. The
quality of the receivables of a firm can be measured by looking at the age of receivables. The older the
receivables, the lower is the quality and the greater the possibility of a default. An ageing schedule is a
statement in which the total outstanding receivables on a particular day are classified into different
age groups together with percentage of total receivables that fall in each age group. A specimen of
such a schedule taking a normal credit period of 60 days is given below :
Ageing Schedule of Receivables
Receivables Overdue Overdue as % of Total
Period Days ` Receivables (%)
0—60 75,000 12.25
61—120 2,25,000 37.75
121—180 3,00,000 50.00
Total 6,00,000 100.00
From the above schedule, it may be noted that the firm has a credit period of 60 days and 12.25% of
the total receivables are less than 60 days old; 37.75% of the receivables are overdue by 60 days; 50% of
receivables are overdue by 120 days. Thus, such type of ageing schedule can provide a kind of early
warning suggesting deterioration quality of receivables and the stage where to take the appropriate
corrective action. This ageing schedule can be compared with the part ageing schedule of the same firm or
by other comparable firms or the ageing schedules of different periods may also be compared. This will
Management of Receivables and Payables 317

give an idea of any required change in the collection procedure and point out those customers who require
special attention.
The preparation of an ageing schedule is explained with the help of the following illustration.
3. Efficient Billing System : In most of the firms, invoicing of goods takes place after the delivery of
goods to the customers. Much time is also taken to prepare invoices. In order to control debt collection, the
invoice has to be prepared quickly and should be sent along with the goods. This minimises debt collection
period.
4. Average Collection Period : A common method to control the receivables is the average
collection period. This period refers to the time taken in collecting debts from customers or the number of
day's outstanding receivables. The average collection period may be found by dividing the average
receivables by the amount of credit sales per day i.e.,
Average Receivables
Average Collection Period =
Credit Sales per day
The managerial efficiency or trend can be ascertained by comparing it with the past year's period of
the firm. The actual average collection period may also be compared with the standard collection period to
evaluate the efficiency of collection. If variations are found, necessary corrective action can be taken. For
example, if standard average collection period is 30 days. Whereas actual collection period comes to 40
days, then this is clearly an indication of deterioration in the collection procedure and the credit evaluation
process.
5. Accounting Ratios : Accounting information may be usefull in controlling the receivables.
Though, several ratios may be calculated for this purpose, two accounting ratio in particular may be
calculated to find out the changing pattern of receivables. These are : (i) Receivables Turnover ratio; and
(ii) Average Collection Period.
To monitor the receivables, both these ratios should be calculated on continuous basis. These ratios so
calculated for the firm must be compared with the standard ratios for that industry or with the past ratios of
the same firm. For example, if the receivables turnover for the firm is 5 as compared to standard turnover
ratio of the industry i.e. 8, then there is something to worry about.
Illustration 10
The following particulars relate to Z Ltd. for the financial year ending 31st March, 2017.
Net Credit Sales ` 3,50,000
Debtors Turnover 10 times
Debtors at the end were ` 14,000 more in value than debtors at the beginning of the year.
From the above information you are required to calculate the opening and closing balance of Debtors.
Solution :
Suppose Opening Balance of Debtors was x
\ Closing Balance of Debtors = x + 14,000
Net Credit Sales
Debtors Turnover Ratio =
Average Debtors
10 3,50,000
=
1 x + ( x + 14,000)
2
10x + 10x + 1,40,000
or = 3,50,000
2
or 20x + 1,40,000 = (3,50,000 ´ 2)
20x + 1,40,000 = 7,00,000
20x = 7,00,000 - 1,40,000
5,60,000
x=
20
318 Financial Management

Opening Debtors = ` 28,000

Closing Debtors = ` 28,000 + 14,000 = ` 42,000

MISCELLANEOUS ILLUSTRATION
Illustration 11
A firm sells goods of ` 10,000 on ‘2/10, Net 30 days basis’. The customer has two options : (i) either
to avail of cash-discount by making payment on or before 10th day; or (ii) to keep the credit open and pay
full amount by the 30th day.
Assuming that bank finance is available on 18% per annum, suggest which option would be more
beneficial to the customer to exercise.
Solution :
In case, the first option is exercised, the customer saves ` 200 and has to pay only ` 9,800.
If the customer does not avail of the facility of 2% cash-discount and pays ` 10,000 on the 30th day,
then it would imply that he is paying interest of ` 200 on ` 9,800 (10,000 – 200) for getting the facility of
keeping ` 9,800 for a duration of 20 days. This by implication would mean that ` 200 is the interest on `
9,800 for 20 days. On this basis the interest for 12 months can be calculated as follows :
200 ´ 30 ´ 12
Interest for 12 Months = = ` 3,600
20
3,600
Annual Rate of Interest = ´ 100 = 36.74% (approx.)
9,800
As the rate of bank credit is only 18%, there is no point in exercising the second option (not availing
of the facility of 2% discount) and paying 36.74% interest.
Therefore the customer must make the payment by the 10th day and take advantage of 2% cash
discount. In case cash is not readily available then resorting to borrowing from bank (@ 18%) and making
the payment by the 10th day (to get a discount of ` 200) will be beneficial to the customer.
Illustration 12
A firm is currently selling on ‘Net 30 days basis’. As a measure of credit liberalisation the firm is
considering to sell on 2/10 net 30' days basis. The present sales are of ` 40,00,000 and it is estimated that
the credit liberalisation, would increase sales by 25%. The firm also expects that the sales of ` 25,00,000
would attract cash discount and funds blocked in inventories would increase by ` 5,00,000.
The costs of credit relaxation will be production and selling costs 65% of increased sales,
administrative costs 5% of increased sales, bad-debts 2% of increased sales, cash discount 2% of the sales
availing of discount facility, and opportunity costs 15% of additional funds, tied up in inventories.
On the basis of the above information, suggest whether the proposed credit relaxation would prove
profitable to the firm.
Solution :
Cost Benefit Analysis `
1. Additional Sales 10,00,000
(25% of ` 40,00,000)
2. Less : Costs (additional)
(i) Production and Selling Costs (65% of ` 10,00,000) 6,50,000
(ii) Administrative Costs (5% on ` 10,00,000) 50,000
(iii) Bad-debts (2% of ` 10,00,000) 20,000
(iv) Cash Discount (2% of ` 25,00,000) 50,000
(v) Opportunity Costs (15% of ` 5,00,000) 75,000 8,45,000
Profit on Additional Sales 1,55,000
Illustration 13
A firm has ` 10,00,000 in receivables on July 1, 2016. The sales represented by this amount were
made as follows ` 4,00,000 in June, ` 3,00,000 in May, ` 2,00,000 in April and the remainder prior to
Management of Receivables and Payables 319

April. If the credit terms offered by the firm are ‘2/10 net 30’ prepare the ageing schedule keeping in view
the credit period and comment on the collection efforts of the firm.
Solution : Agening Schedule of Receivables
Receivables Overdue Overdue as % of
Period Remarks
` Total Receivables
Less than 30 days 4,00,000 40% Current Receivables
30—59 days 3,00,000 30% Overdue Receivables
60—89 days 2,00,000 20% Overdue Receivables
Over 89 days 1,00,000 10% Overdue Receivables
Total 10,00,000 100%

ACCOUNT PAYABLES MANAGEMENT

Account Payables Management refers to the set of policies, procedures and practices employed by a
company with respect to managing its trade credit purchases.
In summary, they consist of seeking trade credit lines, acquiring favorable terms of purchase and
managing the flow and timing of purchases so as to efficiently control the company's working capital.
The account payables of a company can be found in the short-term liabilities section of its balance
sheet, and they mostly consist of the short-term financings of inventory purchases, accrued expenses and
other critical short-term operations.
WHY COMPANIES FINANCE THEIR PURCHASES
Purchasing inventory, raw materials and other goods on trade credit allows a company to defer its
cash outlays, while accessing resources immediately.
When managed appropriately financing purchases can contribute to effective working capital
management.
A company that employs best practices with regards to payables management can reap the benefits of
stable operating cycles that provide a stable source of operating cash flows and place it in a good liquidity
position with respect to its competitors.
OBTAINING TRADE CREDIT
Companies seeking trade credit must demonstrate that they meet certain criteria with respect to their
credit worthiness and financial condition.
This typically entails credit analysis by the supplier.
The financial statements of the company are analyzed, paying particular attention to its working
capital, short-term liquidity and short and long-term debt to gauge its ability to meet obligations. The final
product of such analysis is usually some form of a credit risk rating.
PURCHASE AND PAYMENT TERMS
The purchase and credit terms obtained will depend on the company's risk assessment above.
Companies that are financial stable can benefit from favorable terms (e.g., lengthy repayment periods)
For example, a company might be offered a sales on credit term of 5/10 net 30 implies a 5% discount
on the purchase amount if payment is made within 10 days of billing date.
If the discount is not taken, the full invoiced amount is due in 30 day.
MANAGING PAYMENTS
After entering into purchase agreements with a supplier, the company has the responsibility of
fulfilling its payment obligations.
The Accounts Payable department is accountable for this function and performs tasks such as
communicating with suppliers, sending payments and reconciling bank records, as well as updating and
performing related accounting entries.
Managing payables also include the expense administration with respect to the company's own
employees.
320 Financial Management

Expenses such as employee travelling, meals, entertainment and other costs related to doing business
for the company are administered by the payables department and must be managed appropriately.
EVALUATING THE PERFORMANCE OF PAYABLES MANAGEMENT
Accounts payable are one of 3 main components of working capital, along with receivables and
inventory.
Understanding how these 3 accounts interact among each other and the resulting effects on working
capital levels, cash flow and the operating cycle can help in managing and evaluating payables
management.
An appropriate balance must be struck, whereby the advantage of deferring cash outlays using trade
credit is weighted against the risk of excessive short-term credit.
It is therefore important to maintain optimal utilization of credit lines and timing of payments and
create a balance between the need for cash, working capital and liquidity.
A number of metrics and short-term financial ratios can be used to evaluate the performance payables
management.
Payables Turnover Ratio (PTR)
Management can use this ratio to measure the average number of times a company pays its suppliers
in a particular period.
A higher number than the industry average indicates the company pays its suppliers at a faster rate
than its competitors and is generally conductive to short-term liquidity.
Net Credit Purchase
Payable Turnover Ratio =
Average Payables
Note : Payable = Creditors + Bills Payable
Illustration 14.
From the following information. Calculate payable turnover ratio : `
Total Purchases 1,50,000
Cash Purchases 40,000
Credit Purchase Return 10,000
Opening Creditors 10,000
Closing Creditors 6,000
Opening Bills Payable 18,000
Closing Bills Payable 12,000
Solution :
1. Calculation of Net Credit Purchase `
Total Purchase 1,50,000
Less : Cash Purchase 40,000
Total Credit Purchase 1,10,000
Less : Purchase Return 10,000
Net Credit Purchase 1,00,000
10,000 + 6,000
2. Calculation Average Creditors = = ` 8,000
2
18,000 + 12,000
3. Calculation of Average Bills Payable = = `15,000
2
Net Credit Purchase
Now, Payable Turnover Ratio =
Average Payable
1,00,000 1,00,000
= = = 4.35 Times
8,000 + 15,000 23,000
Management of Receivables and Payables 321

Illustration 15.
From the following information. Calculate opening creditors :
Credit Purchase ` 2,00,000
Closing Creditors ` 40,000
Payable Turnover Ratio 5 Times
Solution :
Credit Purchase
Payables T. O. Ratio =
Average Creditors
2,00,000
or 5 =
Average Creditors
or 5 ´ Average Creditors = 2,00,000
2,00,000
or Average Creditors =
5
or Average Creditors = 40,000
Opening Crs.+ Closing Crs.
Now, Average Creditors =
2
Opening Exp + 40,000
or 40,000 =
2
or 80,000 = Opening Crs. + 40,000
or Opening Creditors = 80,000 – 40,000
= ` 40,000
Days in Payables Outstanding (DPO)
Measuring the average length of time it takes a company to pay for its short-term purchases in a
period, the DPO can be used by management to determine an optional timing of payments for its payables.
Illustration 16.
Calculate Average Payable Periods (in days) from the following informations : `
Total Credit Purchase 2,80,750
Opening Creditors 26,000
Closing Creditors 22,000
Opening B/P 17,000
Closing B/F 13,000
Purchase Return 80,750
Solution :
Working Notes :
1. Net Credit Purchase = 2,80,750 – 80,750 = ` 2,00,000
2,80,000 + 22,000
2. Average Creditors = = ` 25,000
2
17,000 + 13,000
3. Average B/P = = `15,000
2
Average Amount Payable
\ Average Payable Period = ´ 365
Net Credit Purchase
25,000 + 15,000
= ´ 365
2,00,000
40,000
= ´ 365 = 73 days
2,00,000
322 Financial Management

Illustration 17.
From the following figures, calculate payable T.D. ratio and average payment period (in months) :
`
Total Purchase 1,60,000
Cash Purchases 30,000
Purchase Return 10,000
Creditors 1-4-2015 10,000
Creditors 31-3-2016 14,000
Bills Payable 1-4-2015 9,000
Bills Payables 31-3-2016 7,000
Solution :
Net Credit Purchases = 1,60,000 – 30,000 – 10,000 = `1,20,000
(10,000 + 9,000) + (14,000 + 7,000)
Average Payables =
2
19,000 + 21,000
= = ` 20,000
2
Net Credit Purchase
\ Creditors T.O. Ratio =
Average Tr. Payables
1,20,000
= = 6 Times
20,000
Average Tr. Payables
Now, Average Payable Period = ´ 12
Net Credit Purchases
20,000
= ´ 12 = 2 Month
1,20,000
Illustration 18.
From the following informations. Calcuate the average payment period :
Total Sales ` 6,00,000
Sales Return ` 1,00,000
G/P Ratio 20%
Opening Stock ` 40,000
Closing Stock 60,000
Closing Creditors 80,000
Closing B/P 20,000
Solution :
Calculation of Purchases : `
Total Sales 6,00,000
Less : Return 1,00,000
5,00,000
æ 5,00,000 ´ 20 ö
Less : Gross Profit ç ÷ 1,00,000
è 100 ø
Cost Cr. Goods Sold 4,00,000
Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
Purchases = Cost of Goods Sold + Closing Stock – Opening Stock
= 4,00,000 + 60,000 – 40,000
= ` 4,20,000
Management of Receivables and Payables 323
Closing Creditors + Creditor B / P
\ Average Payment Period = ´ 365
Credit Purchases
80,000 + 20,000
= ´ 365
4,20,000
1,00,000
= ´ 365
7,20,000
= 87 days (approx)
Cash Conversion Cycle (CCC)
An important measure of the length of time required to turn inventory purchases into sales and
subsequently into cash receipts.
Using the CCC, management can assess the interaction of payables with the 2 other working capital
accounts receivables and inventory and the resulting effects on cash flow.
A how CCC is highly desirable. A company can shorten the CCC by for example, lengthening its
terms of purchases.
Net Working Capital (NWC)
NWC is the difference between current assets and current liabilities. High levels are desirable for
short-term liquidity.
A decreasing pattern or trend in NWC can be attributed to increasing levels of payables and thus can
serve as a warning sign of excessive short-term credit.
Working Capital Ratio = Current Assets – Current Liabilities
Illustration 19.
From the following information. Calculate Current Ratio/Working Capital Ratio : `
Stock 1,50,000
Sundry Debtors 1,00,000
Cash in Hand 1,50,000
Sundry Creditors 1,60,000
Bills Payable 30,000
Outstanding Expense 10,000
Solution :
Current Ratio/Working Capital Ratio
Current Assets
=
Current Liabilities
4,00,000
= = 2 :1
2,00,000
OR
Working Capital Ratio = Current Assets Loss Current Liabilities
= 4,00,000 – 2,00,000
= ` 2,00,000 (Positive Working Capital)
Illustration 20.
From the following information calculate working capital ratio : `
Stock 1,60,000
S. Debtors 50,000
Cash in Hand 20,000
S. Creditors 1,40,000
Bills Payable 80,000
Outstanding Expenses 80,000
324 Financial Management

Solution :
Working Capital Ratio = Current Assets – Current Liabilities
= 2,30,000 – 3,10,000
= ` 80,000 (Negative W.C.)
Current and Quick Ratio
Two other equility measures the expresses the NWC equation above as a ratio between current assets
and current liabilities. Holding all else equal, rising A/P levels will reduce both the current and quick ratio.
These ratios can be used to assess the impact of increasing payables on short-term liquidity.
Liquid Assets
Quick Ratio =
Current Liabilities
Where, Liquid Assets = Current Assets – (Stock + P. P. Exp.)
Illustration 21.
Following is the balance sheet of Sumit Ltd. as on 31st March, 2017 :
Balance Sheet
EQUITY AND LIABILITIES `
1. Shareholders Fund :
Equity Share Capital 2,00,000
Reserve and Surplus 1,00,000
2. Non-Current Liabilities :
10% Debentures 1,50,000
3. Current Liabilities
Trade Payables 25,000
Provision for Taxation 5,000
Total 4,80,000
ASSETS
1. Non-Current Assets :
Fixed Assets 4,00,000
2. Current Assets :
Inventories 20,000
Trade Receivables 30,000
Cash and Cash Equivalents 20,000
P.P. Expenses 10,000
4,80,000

Calculate current ratio and liquid ratio from the above.

Solution :
1. Current Assets = Inventories + Tr. Receivables + Cash and Cash Equivalent + P. P. Exp.
= 20,000 + 30,000 + 20,000 + 10,000 = ` 80,000
Current Liabilities = Tr. Payable + Prov. for Taxation
= 25,000 + 5,000 = ` 30,000
Liquid Assets = Current Assets – (Inventories + P.P. Exp.)
= 80,000 – (20,000 + 10,000) = 2,50,000
Management of Receivables and Payables 325
Current Assets
Current Ratio =
Current Liabilities
80,000
= = 2 × 67 :1
30,000
Liquid Assets
and Liquid Ratio =
Current Liabilities
50,000
= = 1× 67 :1
30,000
CONCLUSION
The accounts payable of a company is an important working capital account. Effective payables
management can enhance a company's short-term cash flow position through the design of optimal timing
of payments to suppliers.
However, important considerations should be given to excessive financing, as that has a direct impact
on the credit risk of the company and its short-term liquidity.

☞ OBJECTIVE TYPE QUESTIONS

(A) State, whether the following statements are ‘True’ or ‘False’ :
1. Receivables management deals only with the collection of cash from the debtors.
2. Receivables management involves a trade off between costs and benefits of receivables.
3. The objective of a credit policy is to curtail the credit period allowed to customers.
4. Credit period allowed to customers must be equal to credit period allowed by the supplier to the firm.
5. Delinquiency cost refers to bad debt Losses to the firm.
6. Liberalizing the discount rate means increasing the discount rate for the same period.
7. Credit evaluation of a customer is a costly process, hence it need not be under taken by a selling firm.
8. In order to minimize the level of receivables, a firm should follow a strict and agresssive collection procedure.
9. Ageing schedule of receivables is one way of monitoring the receivables.
[Ans. : 1. (F), 2. (T), 3. (F), 4. (F), 5. (F), 6. (T), 7. (F), 8. (F), 9. (T).]
(B) Choose the correct option from the following :
1. 5 C's of the credit does not include :
(a) Collateral (b) Character
(c) Conditions (d) None of these
2. Which of the following is not an element of credit policy ?
(a) Credit Terms (b) Collection Policy
(c) Cash Discount Terms (d) Sales Price
3. Agening schedule incorporates the relationship between :
(a) Creditors and days outstandings (b) Debtors and days outstandings
(c) Average Age of Directors (d) Average Age of the Employees
4. Which of the following is not a characteristic of Receivables ?
(a) Risks (b) Based on Present Economic Value
(c) Implies Futurity (d) Useless
5. Which of the following is not a technique of receivable management ?
(a) Funds Flow Analysis (b) Agening Schedule
(c) Days Sales Outstanding (d) Collection Matrix