CHAPTER FOUR

RECEIVABLES MANAGEMENT
Nature and Importance of Receivables
When a firm allows customers to pay for goods and services at a later date, it creates accounts
receivable. Firms sell goods on credit to increase the volume of sales. In the present era of
intense competition, business firms, to improve their sales, offer to their customers relaxed
conditions of payment. When goods are sold on credit, finished goods get converted into
receivables, which is Trade credit. Trade credit is an informal credit arrangement. Unlike other
forms of credit, trade credit is not usually evidenced by notes, but rather is generated
spontaneously. Trade credit is a marketing tool that functions as a bridge for the movement of
goods from the firm’s ware house to its customers.
The receivables arising out of trade credit have three features.
1. It involves an element of risk. Therefore, before sanctioning credit, careful analysis of the
risk involved needs to be done;
2. It is based on economic value. Buyer gets economic value in goods immediately on sale,
while the seller will receive an equivalent value later on and
3. It has an element of futurity. The buyer makes payment in a future period.
Amounts due from customers, when goods are sold on credit, are called trade debits or
receivables. Receivables form part of current assets. They constitute a significant portion of the
total current assets of the buyers next to inventories. Receivables are asset – accounts
representing amounts owing to the firm as a result of sale of goods/services in the ordinary
course of business.
The main objective of selling goods on credit is to promote sales for increasing the profits of the
firm. Customers will always prefer to buy on credit to buying on cash basis. They always go to a
supplier who gives credit. All firms therefore grant credit to their customers to increase sales,
profits and to meet competition.
Additional funds are, therefore, required for the operating needs of the business which involve
extra costs in terms of interest. Moreover, increase in receivables also increases the chances of
bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the firm.
The financial manager needs to follow a policy of using cash funds economically to the extent
possible in extending receivables without adversely affecting the chances of increasing sales and
making more profits. Management of accounts receivables may, therefore, be defined as, the
process of making decision relating to the investment of funds in receivables which will result in
maximizing the overall return on the investment of the firm.
Thus, the objective of receivables management is to promote sales and profits until the level
where the return on investment in further finding of receivables is less than the cost of funds
raised to finance that additional credit.
Cost of Maintaining Receivables
i. Capital Cost:
Increase in the level of accounts receivables implies an investment in current assets. There is a
time gap between the sale of goods on credit and payment by the customers. During this time
gap, the firm’s funds are blocked in the form of receivables and so it will have to arrange for
additional finance for meeting its own obligations. The cost involved in financing the additional

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 capital can be in the form of interest payments in case of external finance or opportunity cost of
capital in case of internal sources that could have been put to some other use. The cost
associated with the use of additional capital to support credit sales, which could have been
profitably employed in other alternatives, is a part of the cost of extending trade credit.
ii. Administrative Costs:
These are costs related to obtaining information about the creditworthiness of the customer and
the maintenance of records. As a firm starts offering credit to customers, there happens to be an
increase in the number of debtors. As a result the firm is required to analysis and supervises a
large volume of accounts at the cost of expenses related with acquiring credit information either
through outside specialist agencies or forms its own staff.
iii. Collection Costs:
These are the costs that are incurred while collecting the receivables from the debtors. It includes
additional expenses of credit department incurred on the creation and maintenance of staff,
accounting records, stationary, postage and other related items. A firm will have to intensify its
collection efforts so as to collect the outstanding bills especially in case of customers who are
financially less sound.
iv. Default Costs:
This type of cost arises when customers fail to make payments of the receivables as and when
they fall due after the expiry of the credit period. Such debts are treated as doubtful debts and
involve:
- Blocking of firm's funds for an extended period of time.
- Additional collection costs (legal expenses and cost of initiating other collecting efforts).
If the customer does not pay after all the collection efforts, the receivables are treated as
bad-debts and have to be written-off as they cannot be realized.
Objectives of Receivable Management
From creation of receivables the firm gets a few advantages & it has to bear bad debts,
administrative expenses, financing costs etc. In the management of receivables, financial
manager should follow such policy through which cash resources of the firm can be fully
utilized. Management of receivables is a process under which decisions to maximize returns on
the investment blocked in them are taken. Thus, the main objectives of management receivable
are to maximize the returns on investment in receivables & to minimize risk of bad debts etc.
Because investment in receivables affects liquidity and profitability, it is, therefore, significant to
maintain proper level of receivables.
Thus, following are the main objectives of receivables management:

1. To optimize the amount of sales.

2. To minimize cost of credit.

3. To optimize investment in receivables

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 Receivables Management Aspects
The basic target of receivables management is to enhance the overall return on the optimum level
of investment made by the firm in receivables. The optimum investment is determined by
comparing the benefits to be derived from a particular level of investment with the cost of
maintaining that level.
Receivables management begins with the credit policy, but a monitoring system is also
important. This section discusses receivables management with respect to the following five
aspects:
 Credit Policy.
 Credit evaluation.
 Credit granting decision.
 Monitoring receivables.
Credit Policy:
The credit policy of a firm provides the framework to determine whether or not to extend the
credit to a customer and also on the amount of credit that should be extended. Credit policy
consists of the following variables:
1. Credit Standards: Credit standards are the criteria that a firm follows while choosing
customers to whom credit could be extended. A firm having very stringent credit standards
will have less credit sales granted to customers with a high credit rating and consequently it
will have lower bad debts and administrative costs and lower investment in receivables.
But this implies that the firm will not be able to expand its sales. On the other hand, if the firm
has lenient credit standards, it will have increased sales but with a high probability of bad debt
losses, administrative costs and the amount of funds locked up in receivables. Hence the
manager should decide the optimal credit standards by weighing the incremental costs
associated with credit standards against the incremental benefits.
2. Credit Period: The time given to the customers to pay the book debts is referred to as credit
period. Increasing the credit period will help in pushing up the sales but it will also lead to
increase in investment in receivables and increase in proportion of bad-debts. On the other
hand a short credit period leads to the decrease in the incidence of bad debts and reduction in
the funds locked up in receivables but at the same time it will result in reduced sales.
3. Cash Discount: A cash discount is reduction in the amount payable, offered to the customers
in order to induce them to repay the trade credit within the specified period of time which is
less than the normal credit period. Cash discount terms indicate the rate of discount and the
cash discount period and the net credit period. For example, “ 2/15 Net 30” indicates that the
customer will be granted a discount of 2% if s/he pays within 15 days, otherwise he will have
to pay the entire amount within 30 days. A firm that introduces a cash discount policy will
have benefits in the form of additional sales and reduction in the amount locked up in
receivables but the cost involved would also increase due to the cash discounts offered. Hence
a company should evaluate the incremental benefits and costs associated with introducing
cash discount policy (or liberalizing the existing cash discount policy) and should implement
it only if the incremental benefits are greater than the incremental costs. Consider the
following example:

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4. Collection Policy: A proper collection policy is needed for ensuring timely collection of
receivables so that funds are not locked up in receivables for a longer period and for reducing
the incidence of bad debt losses. Some of the activities that form a part of the collection
policy include monitoring the state of receivables– postal, telegraphic or telephonic reminders
to customers for whom the due date is nearing, threat of legal action to overdue accounts etc.
The firm should be careful about choosing the right kind of collection policy as too stringent
collection policy will decrease the incidence of bad debt losses and the average collection
period but might adversely affect the company’s relationship with the clients; whereas a
lenient collection policy will increase sales but at the same time will increase average
collection period and the proportion of bad debt losses.
CREDIT ANALYSIS
Once a firm decides to grant credit to its customers, it must then establish guidelines for
determining who will and who will not be allowed to buy on credit. Credit analysis refers to the
process of deciding whether or not to extend credit to a particular customer. It usually involves
two steps: gathering relevant information and determining creditworthiness.
Credit Information
If a firm does want credit information on customers, there are a number of sources. Information
sources commonly used to assess creditworthiness include the following:
1. Financial statements. A firm can ask a customer to supply financial statements such as
balance sheets and income statements.
2. Credit reports on the customer’s payment history with other firms. a few organizations
may sell information on the credit strength and credit history of business firms.
3. Banks. Banks will generally provide some assistance to their business customers in acquiring
information on the creditworthiness of other firms.
4. The customer’s payment history with the firm. The most obvious way to obtain information
about the likelihood of a customer’s not paying is to examine whether they have settled past
obligations (and how quickly).
EVALUATING CREDIT POLICY
In very general terms, the classic five Cs of credit are the basic factors to be evaluated:
1. Character: The customer’s willingness to meet credit obligations.
2. Capacity: The customer’s ability to meet credit obligations out of operating cash flows.
3. Capital: The customer’s financial reserves.
4. Collateral: An asset pledged in the case of default.
- Ability of creditors to collect on bad debts if the customer liquidates its assets.
5. Conditions: General economic conditions in the customer’s line of business. The sensitivity
of the customer’s ability to pay to underlying economic and market factors
COLLECTION POLICY
Collection policy involves monitoring receivables to spot trouble and obtaining payment on past-
due accounts.
Collection policies specify the procedures for collecting delinquent accounts. Collection could
start with polite reminders, continuing in progressively severe steps, and ending by placing the
account in the hands of a collection agency, a firm that specializes in collecting accounts. The
following sequence is typical:

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1. When an account is a few days overdue, a letter is sent reminding the customer of the amount
due and the credit terms.
2. When an account is a month overdue, a telephone call is made reminding the customer of the
amount due, the credit terms, and efforts to collect the account by letter.
3. When an account is two months overdue it is handed over to a collection agency.
Collection Effort
A firm usually goes through the following sequence of procedures for customers whose
payments are overdue:
1. It sends out a delinquency letter informing the customer of the past-due status of the account.
2. It makes a telephone call to the customer.
3. It employs a collection agency.
4. It takes legal action against the customer.

At times, a firm may refuse to grant additional credit to customers until arrearages are cleared up.
This may antagonize a normally good customer, which points to a potential conflict between the
collections department and the sales department.
In probably the worst case, the customer files for bankruptcy. When this happens, the credit-
granting firm is just another unsecured creditor. The firm can simply wait, or it can sell its
receivable.

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 CHAPTER 5
INVENTORY MANAGEMENT
ROLES AND TYPES OF INVENTORY
Role of Inventory in Working Capital
The term inventory refers to the stock of the products a firm is offering for sale and the
components that make up the product.
It is a part of current asset in working capital calculations. Current assets are those assets which
can be converted into cash easily within a period of one year. It is assumed that inventory can
also be sold and converted into cash within a year's time and hence categorized as current assets.
Inventories accounts large size (more than half) for a given firms current assets.
Though it is categorized as a current asset, practically, they cannot be equivalent to cash and cash
equivalents. In fact, they are not quick assets and hence not included as cash equivalent in
calculating quick ratio or acid-test ratio. The reasons are:
i. Although inventory can be sold and converted into cash or accounts receivables, it is a
blocked up fund till the accounts receivables are collected.
ii. The time it takes for the inventory to convert into sales may be longer, sometimes even
more than a year. The time depends upon the nature of the product, demand for the
product, price and market conditions.
Inventory and Operating cycle: Operating cycle has the following events:
i. Cash converted into inventory
ii. Inventory converted into accounts receivables
iii. Accounts receivables converted into cash
iv. Cash again re-converted into inventory
The above is the case of a normal wholesale or retail business. In case of manufacturing
businesses, the inventory passes through three stages and operating cycle will be as given below:
i. Cash converted into Raw materials
ii. Raw materials converted into work-in-progress
iii. Work-in-progress converted into finished goods inventory
iv. Finished goods inventory converted into accounts receivables
v. Accounts receivables converted into cash and
vi. Cash re-converted into raw materials.
In all the above cases, accounts receivables come into picture in case of credit sales. In
case of cash sales, inventory will be straight-away reconverted into cash.
Types of Inventory
In a typical manufacturing company, inventory will be in the following forms:
1. Raw Materials Inventory: Raw materials, as the name implies are in the raw stage
without any processing. They are in the stage as such purchased from the supplier. They
can also be extracted materials if not purchased from the supplier. They contain the
material or the parts required for production.
2. Work-in-Progress Inventory: Work-in-Progress inventory is in a stage between the raw
materials stage and the finished goods stage. They are partly processed (semi-
manufactured products) materials and as such direct material, labor and overheads would

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 have been incurred to bring the raw materials into the work-in-progress state. They
cannot be called finished goods until they are fully processed or produced.
3. Finished goods Inventory: Finished goods inventory is the final stage of inventory. All
the processes are over and the product fully manufactured and ready for sale. Sometimes,
companies also procure short-term finance pledging the finished goods inventory as
security. Finished goods inventory will be then distributed to wholesalers, distributors or
retailers as the case may be.
Levels of inventories in firms differ depending upon the type of firms and their sizes.
Manufacturing firm hold all types of inventories at high level while, retail and wholesalers holds
only finished goods inventory.
Motive for holding inventories
Like, motives of holding cash, there are three general motives for holding inventories.
Transaction motive: emphasizes the need to maintain inventories to facilitate smooth
production and sales operation.
Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
Speculative motives: influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.
Other factors, which may lead firms to hold inventory includes; quantity discounts and
anticipated price increase.
Having either of these motives, a firm should maintain adequate stock of materials for a
continuous supply; otherwise mismatch will exist between demand and supply of inventories.
Objective of inventory management
An effective inventory management should:
 Ensure a continuous supply of raw materials to facilitate uninterrupted production,
 Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes,
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service,
 Minimize the carrying cost and time and
 Control investment in inventories and keep it at an optimum.
Inventory management techniques and Cost of Holding Inventory
To manage inventories efficiency, answers should be sought to the following two questions. (a)
How much should be ordered? (b) When should be ordered?
The first question, how much to order, relates to the problem of determining Economic Order
Quantity (EOQ), and is answered with analysis of costs of maintaining certain level of
inventories. The second question, when to order, arises because of uncertainty and is a problem
of determining the Re-Order Point.
Economic Order Quantity (EOQ) Model
Economic Order Quantity model is the inventory management technique for determining the
optimum order quantity which is the one that minimizes the total of its ordering and carrying
costs. It also balances the fixed ordering costs against variable ordering costs. The EOQ is the
optimum amount of goods to order each time to minimize total inventory costs. EOQ analysis
should be applied to every product that represents a significant proportion of sales.

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Thus, inventory costs includes, ordering cost and carrying costs.
a. Ordering costs: it is used in case of raw materials (supplies) and includes the entire cost
of acquiring raw materials. Ordering cost is the cost associated with placing an order to
the supplier. Apart from placing orders, the other costs related to ordering also form part
of ordering costs. The cost included in ordering costs are costs incurred in; requisitioning,
purchase ordering, transporting, receiving, inspecting, and storing and clerical costs and
costs of stationery (set up cost). Ordering costs increase in proportion to the number of
orders placed. The clerical costs and staff costs, however, do not have to vary in
proportion to the number of orders placed. But the ordering costs reduces as the size of
inventory increases, because there will be few orders placed.
The set up costs are generally fixed per order placed, irrespective of the amount of order. To
minimize the ordering costs, a firm should place minimum number of orders possible. In case of
produced items, ordering cost also includes scheduling cost.
Ordering cost = T/Q x F
Where: T = Total Usage/consumption
Q = Quantity Per Order
F = Cost of Placing an Order
Example: Say, a company needs a lot of 2400 units per year. The cost of placing one order is
$50. At different lot sizes, the ordering costs would be:
Order Size No. of orders Cost per order Total ordering cost
1200 2 $50 $100
800 3 $50 $150
600 4 $50 $200
400 6 $50 $300
The acquisition costs are inversely related to the size of inventory; they decline with the level of
inventory. But a large order may decrease ordering costs while increasing carrying costs.
In the above example, the first case of 1200 units will attract more carrying cost, although the
ordering cost is the least.
b. Carrying Costs: is cost incurred for maintaining a given level of inventory. The costs
involved in stocking the inventory like maintenance and holding inventory come under
carrying costs. Carrying costs can be further sub-divided into:
I. Costs associated with storing of Inventory: This type of costs consists of
i. Storage cost like tax, depreciation, and insurance, maintenance of the building,
utilities and janitorial services.
ii. Insurance of inventory against fire and theft.
iii. Deterioration in inventory because of pilferage, fire or technical, fashion
obsolescence and price decline.
iv. Serving costs like labor for handling inventory, accounting and clerical costs.
II. Opportunity cost of funds: Opportunity costs refer to the interest lost which otherwise
could have been earned if funds blocked in inventory are invested in interest-bearing
securities.
The carrying cost and the inventory size are positively related and move in the same direction. If
the level of inventory decreases, the carrying costs will also decrease and vice versa. This is
opposite to that of order costs which decline as inventory size increases.

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 Carrying cost = Q/2 x CC
Where: Q/2 = Average quantity of inventory
CC = Carrying cost per unit
Total costs (TC) = Total Carrying Costs + Total Order Costs
TC= T/Q x F + Q/2 x CC
Example: If the order sizes are 1200, 800, 600 and 400 as given in the above example, if price
per unit is $10 and if the carrying costs per unit are 25% of average inventory value:
Inventory Value Average Inventory Carrying cost (25%)
1200 x $10 = $12,000 $12,000 / 2 = $6,000 $6,000 x 25% = $1,500
800 x $10 = $8,000 $8,000 / 2 = $4,000 $4,000 x 25% = $1,000
600 x $10 = $6,000 $6,000 / 2 = $3,000 $3,000 x 25% = $750
400 x $10 = $4,000 $4,000 / 2 = $2,000 $2,000 x 25% = $500

From the above example it is clear that ordering cost increases with a decrease in order size and
carrying cost increases with an increase in order size.
Thus, the EOQ analysis provides answers to the following order quantity problems:
1. How much of inventory should be bought in an order on each replenishment?
2. Should the quantity be purchased be large or small?
3. Should the requirement of materials during a given period of time be purchased in one lot
or should it be purchased in installments?
Assumptions of EOQ model:
1. Demand is known with certainty and is constant during the period.
2. Depletion of stock is linear and constant.
3. The time interval between placing an order and receiving delivery (lead time), is
constant.
4. The orders placed to replenish inventory stocks are received at exactly that point in time
when inventories reach zero.

Where:T =Annual usage in units

F =Ordering cost per order
CC=Carrying cost per unit
Example: A Company is determining its frequency of orders for Product A. Each product A
costs $20. The annual carrying cost is $400 and the cost per order is $15. The company expects
to sell 50 units of Product A each month. It has also decided to maintain an average inventory
level of 40 units. Find the EOQ.
Solution:
T (Annual usage in units) => 50 units per month x 12 = 600 units annually.
F (Ordering cost per order) => $15
C => Average inventory x carrying cost per unit. In this case, $400 is the total carrying cost
annually. Therefore, carrying cost per unit = $400 / 40 = $10 per unit.
EOQ = √2TF / CC => = √(2 x 600 x 15) / 10 => 42 units (after rounding)
Number of orders per year = T / EOQ => 600 units/42 = 14.29 or 14 orders (rounded)

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Limitations of EOQ Model:
1. The assumption of constant usage and the instantaneous or immediate replenishment of
inventories are not always practical.
2. Safety stock is always required because deliveries from suppliers may be delayed for
reasons beyond control. Also because there may be an unexpected demand for stocks.
3. EOQ assumes that the demand is constant and known with certainty which always is not
the case. Demand may rise and fall depending upon various factors leaving a certain
degree of uncertainty behind it.
4. Computational problems may arise and hence the number of orders to be placed may not
be always 100% accurate if fractions or decimals are involved.
Reorder Point System
Reorder point may be defined as the level of inventory when fresh order should be placed with
the suppliers for procuring additional inventory, equal to the economic order quantity. The
reorder point is that inventory level at which an order should be placed to replenish the
inventory. The reorder point is a signal that informs when to place an order. Calculating the
reorder point requires knowledge of the lead time between order and receipt of merchandise,
average usage and economic order quantity.
Lead time is the time normally taken in replenishing inventory after the order has been placed.
By certainty we mean that, usage and lead time do not fluctuate. Under such a situation, reorder
point is simply that inventory level which will be maintained for consumption during lead time.
Reorder point may be influenced by the months of supply or total dollar ceilings of the inventory
to be ordered or held.
Re-order Point = Lead time in days × average daily usage of inventory
Example: Average daily consumption for a firm is 10,000 units. The number of days required to
receive the delivery of inventory after placing an order is 20 days.
Reorder point = 10,000 units x 20 days => 200,000 units.
This means that the firm should place the order for replenishing the stock of inventory as soon as
the level reaches 200,000 units
Safety Stock: implies extra inventories that can be drawn down when actual lead time and/or
usage rates are greater than expected. It can be defined as the minimum additional inventory to
serve as a safety margin or buffer to meet an unanticipated increase in usage resulting from an
unusually high demand and or uncontrollable late receipt of incoming inventory.
To determine the reorder point when safety stock is maintained s as follow:
Re-order Point = Lead time in days × average daily usage of inventory + safety stock
Determination of Safety Stock : The financial manager should determine the appropriate level
of safety stock on the basis of a trade-off between the following two costs associated with it:
1. Stock-out costs: Stock-out costs refer to the cost associated with the shortage of inventory. It
is an opportunity cost of losing the benefits that would have been gained if stocks were there.
2. Carrying costs: Carrying costs are the costs associated with the maintenance of inventory.
The larger the safety stock, the larger would be the carrying costs and vice versa. The larger the
Safety stock, the smaller would be the stock-out costs. So, based on the stock-out costs and
carrying costs, safety stock will be determined attaining a trade-off between the two.

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