ICAI Notes- Unit 4: Management of Working Capital | Financial Management & Strategic Management for CA Intermediate PDF Download

 Page 1


 
 
 
FINANCIAL MANAGEMENT 
 
9.70 
UNIT – IV 
MANAGEMENT OF RECEIVABLES   
15. MEANING AND OBJECTIVE 
Management of receivables refers to planning and controlling of 'debt' owed to 
the firm from customer on account of credit sales. It is also known as trade credit 
management. 
The basic objective of management of receivables (debtors) is to optimise the 
return on investment on these assets.   
When large amounts are tied up in receivables, there are chances of bad debts and 
there will be cost of collection of debts.  On the contrary, if the investment in 
receivables is low, the sales may be restricted, since the competitors may offer more 
liberal terms.  Therefore, management of receivables is an important issue and requires 
proper policies and their implementation.  
16. ASPECTS OF MANAGEMENT OF DEBTORS 
There are basically three aspects of management of receivables: 
1. Credit Policy:  A balanced credit policy should be determined for effective 
management of receivables. Decision of Credit standards, Credit terms and 
collection efforts is included in Credit policy.  It involves a trade-off between 
the profits on additional sales that arise due to credit being extended on the 
one hand and the cost of carrying those debtors and bad debt losses on the 
other.  This seeks to decide credit period, cash discount and other relevant 
matters.  The credit period is generally stated in terms of net days. For 
example, if the firm’s credit terms are “net 50”.  It is expected that customers 
will repay credit obligations not later than 50 days. 
 Further, the cash discount policy of the firm specifies: 
(a) The rate of cash discount. 
(b) The cash discount period; and 
(c) The net credit period. 
@The Institute of Chartered Accountants of India
Page 2


 
 
 
FINANCIAL MANAGEMENT 
 
9.70 
UNIT – IV 
MANAGEMENT OF RECEIVABLES   
15. MEANING AND OBJECTIVE 
Management of receivables refers to planning and controlling of 'debt' owed to 
the firm from customer on account of credit sales. It is also known as trade credit 
management. 
The basic objective of management of receivables (debtors) is to optimise the 
return on investment on these assets.   
When large amounts are tied up in receivables, there are chances of bad debts and 
there will be cost of collection of debts.  On the contrary, if the investment in 
receivables is low, the sales may be restricted, since the competitors may offer more 
liberal terms.  Therefore, management of receivables is an important issue and requires 
proper policies and their implementation.  
16. ASPECTS OF MANAGEMENT OF DEBTORS 
There are basically three aspects of management of receivables: 
1. Credit Policy:  A balanced credit policy should be determined for effective 
management of receivables. Decision of Credit standards, Credit terms and 
collection efforts is included in Credit policy.  It involves a trade-off between 
the profits on additional sales that arise due to credit being extended on the 
one hand and the cost of carrying those debtors and bad debt losses on the 
other.  This seeks to decide credit period, cash discount and other relevant 
matters.  The credit period is generally stated in terms of net days. For 
example, if the firm’s credit terms are “net 50”.  It is expected that customers 
will repay credit obligations not later than 50 days. 
 Further, the cash discount policy of the firm specifies: 
(a) The rate of cash discount. 
(b) The cash discount period; and 
(c) The net credit period. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.71 
 For example, the credit terms may be expressed as “3/15 net 60”.  This means 
that a 3% discount will be granted if the customer pays within 15 days; if he 
does not avail the offer he must make payment within 60 days. 
2. Credit Analysis:  This requires the finance manager to determine as to how 
risky it is to advance credit to a particular party. This involves due diligence 
or reputation check of the customers with respect to their credit worthiness. 
3. Control of Receivable:  This requires finance manager to follow up debtors 
and decide about a suitable credit collection policy.  It involves both laying 
down of credit policies and execution of such policies. 
 There is always cost of maintaining receivables which comprises of following 
costs: 
(i) The company requires additional funds as resources are blocked in 
receivables which involves a cost in the form of interest (loan funds) or 
opportunity cost (own funds) 
(ii) Administrative costs which include record keeping, investigation of 
credit worthiness etc. 
(iii) Collection costs. 
(iv) Defaulting costs. 
17. FACTORS DETERMINING CREDIT POLICY 
The credit policy is an important factor determining both the quantity and the 
quality of accounts receivables.  Various factors determine the size of the 
investment a company makes in accounts receivables.  They are, for instance: 
(i) The effect of credit on the volume of sales; 
(ii) Credit terms; 
(iii) Cash discount; 
(iv) Policies and practices of the firm for selecting credit customers; 
(v) Paying practices and habits of the customers; 
(vi) The firm’s policy and practice of collection; and 
@The Institute of Chartered Accountants of India
Page 3


 
 
 
FINANCIAL MANAGEMENT 
 
9.70 
UNIT – IV 
MANAGEMENT OF RECEIVABLES   
15. MEANING AND OBJECTIVE 
Management of receivables refers to planning and controlling of 'debt' owed to 
the firm from customer on account of credit sales. It is also known as trade credit 
management. 
The basic objective of management of receivables (debtors) is to optimise the 
return on investment on these assets.   
When large amounts are tied up in receivables, there are chances of bad debts and 
there will be cost of collection of debts.  On the contrary, if the investment in 
receivables is low, the sales may be restricted, since the competitors may offer more 
liberal terms.  Therefore, management of receivables is an important issue and requires 
proper policies and their implementation.  
16. ASPECTS OF MANAGEMENT OF DEBTORS 
There are basically three aspects of management of receivables: 
1. Credit Policy:  A balanced credit policy should be determined for effective 
management of receivables. Decision of Credit standards, Credit terms and 
collection efforts is included in Credit policy.  It involves a trade-off between 
the profits on additional sales that arise due to credit being extended on the 
one hand and the cost of carrying those debtors and bad debt losses on the 
other.  This seeks to decide credit period, cash discount and other relevant 
matters.  The credit period is generally stated in terms of net days. For 
example, if the firm’s credit terms are “net 50”.  It is expected that customers 
will repay credit obligations not later than 50 days. 
 Further, the cash discount policy of the firm specifies: 
(a) The rate of cash discount. 
(b) The cash discount period; and 
(c) The net credit period. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.71 
 For example, the credit terms may be expressed as “3/15 net 60”.  This means 
that a 3% discount will be granted if the customer pays within 15 days; if he 
does not avail the offer he must make payment within 60 days. 
2. Credit Analysis:  This requires the finance manager to determine as to how 
risky it is to advance credit to a particular party. This involves due diligence 
or reputation check of the customers with respect to their credit worthiness. 
3. Control of Receivable:  This requires finance manager to follow up debtors 
and decide about a suitable credit collection policy.  It involves both laying 
down of credit policies and execution of such policies. 
 There is always cost of maintaining receivables which comprises of following 
costs: 
(i) The company requires additional funds as resources are blocked in 
receivables which involves a cost in the form of interest (loan funds) or 
opportunity cost (own funds) 
(ii) Administrative costs which include record keeping, investigation of 
credit worthiness etc. 
(iii) Collection costs. 
(iv) Defaulting costs. 
17. FACTORS DETERMINING CREDIT POLICY 
The credit policy is an important factor determining both the quantity and the 
quality of accounts receivables.  Various factors determine the size of the 
investment a company makes in accounts receivables.  They are, for instance: 
(i) The effect of credit on the volume of sales; 
(ii) Credit terms; 
(iii) Cash discount; 
(iv) Policies and practices of the firm for selecting credit customers; 
(v) Paying practices and habits of the customers; 
(vi) The firm’s policy and practice of collection; and 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.72 
(vii) The degree of operating efficiency in the billing, record keeping and 
adjustment function, other costs such as interest, collection costs and bad 
debts etc., would also have an impact on the size of the investment in 
receivables.  The rising trend in these costs would depress the size of 
investment in receivables. 
The firm may follow a lenient or a stringent credit policy.  The firm which follows a 
lenient credit policy sells on credit to customers on very liberal terms and standards.  
On the contrary a firm following a stringent credit policy sells on credit on a highly 
selective basis only to those customers who have proper credit worthiness and who 
are financially sound. 
Any increase in accounts receivables that is, additional extension of trade credit not 
only results in higher sales but also requires additional financing to support the 
increased investment in accounts receivables.  The costs of credit investigations 
and collection efforts and the chances of bad debts are also increased. On the 
contrary, a decrease in accounts receivable due to a stringent credit policy may be 
as a result of reduced sales with competitors offering better credit terms. 
18. FACTORS UNDER THE CONTROL OF THE 
FINANCE MANAGER 
The finance manager has operating responsibility for the management of the 
investment in receivables.  His involvement includes:- 
(a)  Supervising the administration of credit; 
(b)  Contribute to top management decisions relating to the best credit policies 
of the firm; 
(c)  Deciding the criteria for selection of credit applications; and  
(d)  Speed up the conversion of receivables into cash by aggressive collection 
policy.   
In summary the finance manager has to strike a balance between the cost of 
increased investment in receivables and profits from the higher levels of sales. 
@The Institute of Chartered Accountants of India
Page 4


 
 
 
FINANCIAL MANAGEMENT 
 
9.70 
UNIT – IV 
MANAGEMENT OF RECEIVABLES   
15. MEANING AND OBJECTIVE 
Management of receivables refers to planning and controlling of 'debt' owed to 
the firm from customer on account of credit sales. It is also known as trade credit 
management. 
The basic objective of management of receivables (debtors) is to optimise the 
return on investment on these assets.   
When large amounts are tied up in receivables, there are chances of bad debts and 
there will be cost of collection of debts.  On the contrary, if the investment in 
receivables is low, the sales may be restricted, since the competitors may offer more 
liberal terms.  Therefore, management of receivables is an important issue and requires 
proper policies and their implementation.  
16. ASPECTS OF MANAGEMENT OF DEBTORS 
There are basically three aspects of management of receivables: 
1. Credit Policy:  A balanced credit policy should be determined for effective 
management of receivables. Decision of Credit standards, Credit terms and 
collection efforts is included in Credit policy.  It involves a trade-off between 
the profits on additional sales that arise due to credit being extended on the 
one hand and the cost of carrying those debtors and bad debt losses on the 
other.  This seeks to decide credit period, cash discount and other relevant 
matters.  The credit period is generally stated in terms of net days. For 
example, if the firm’s credit terms are “net 50”.  It is expected that customers 
will repay credit obligations not later than 50 days. 
 Further, the cash discount policy of the firm specifies: 
(a) The rate of cash discount. 
(b) The cash discount period; and 
(c) The net credit period. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.71 
 For example, the credit terms may be expressed as “3/15 net 60”.  This means 
that a 3% discount will be granted if the customer pays within 15 days; if he 
does not avail the offer he must make payment within 60 days. 
2. Credit Analysis:  This requires the finance manager to determine as to how 
risky it is to advance credit to a particular party. This involves due diligence 
or reputation check of the customers with respect to their credit worthiness. 
3. Control of Receivable:  This requires finance manager to follow up debtors 
and decide about a suitable credit collection policy.  It involves both laying 
down of credit policies and execution of such policies. 
 There is always cost of maintaining receivables which comprises of following 
costs: 
(i) The company requires additional funds as resources are blocked in 
receivables which involves a cost in the form of interest (loan funds) or 
opportunity cost (own funds) 
(ii) Administrative costs which include record keeping, investigation of 
credit worthiness etc. 
(iii) Collection costs. 
(iv) Defaulting costs. 
17. FACTORS DETERMINING CREDIT POLICY 
The credit policy is an important factor determining both the quantity and the 
quality of accounts receivables.  Various factors determine the size of the 
investment a company makes in accounts receivables.  They are, for instance: 
(i) The effect of credit on the volume of sales; 
(ii) Credit terms; 
(iii) Cash discount; 
(iv) Policies and practices of the firm for selecting credit customers; 
(v) Paying practices and habits of the customers; 
(vi) The firm’s policy and practice of collection; and 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.72 
(vii) The degree of operating efficiency in the billing, record keeping and 
adjustment function, other costs such as interest, collection costs and bad 
debts etc., would also have an impact on the size of the investment in 
receivables.  The rising trend in these costs would depress the size of 
investment in receivables. 
The firm may follow a lenient or a stringent credit policy.  The firm which follows a 
lenient credit policy sells on credit to customers on very liberal terms and standards.  
On the contrary a firm following a stringent credit policy sells on credit on a highly 
selective basis only to those customers who have proper credit worthiness and who 
are financially sound. 
Any increase in accounts receivables that is, additional extension of trade credit not 
only results in higher sales but also requires additional financing to support the 
increased investment in accounts receivables.  The costs of credit investigations 
and collection efforts and the chances of bad debts are also increased. On the 
contrary, a decrease in accounts receivable due to a stringent credit policy may be 
as a result of reduced sales with competitors offering better credit terms. 
18. FACTORS UNDER THE CONTROL OF THE 
FINANCE MANAGER 
The finance manager has operating responsibility for the management of the 
investment in receivables.  His involvement includes:- 
(a)  Supervising the administration of credit; 
(b)  Contribute to top management decisions relating to the best credit policies 
of the firm; 
(c)  Deciding the criteria for selection of credit applications; and  
(d)  Speed up the conversion of receivables into cash by aggressive collection 
policy.   
In summary the finance manager has to strike a balance between the cost of 
increased investment in receivables and profits from the higher levels of sales. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.73 
19. APPROACHES TO EVALUATION OF CREDIT 
POLICIES 
There are basically two methods of evaluating the credit policies to be adopted by 
a Company – Total Approach and Incremental Approach.  The formats for the two 
approaches are given as under: 
Statement showing the Evaluation of Credit Policies (based on Total Approach) 
Particulars Present 
Policy  
Proposed 
Policy I  
Proposed 
Policy II 
Proposed 
Policy III 
 
` ` ` ` 
A. Expected Profit:     
(a)  Credit Sales ………. …………. ……….. ………. 
(b) Total Cost other than Bad 
 Debts  
    
(i) Variable Costs ……… ………… ………. ………. 
(ii) Fixed Costs ……… ………… ………. ………. 
 ……… ………. ………. …….. 
(c) Bad Debts 
(d) Cash discount 
……… ………… ……… ………. 
(e) Expected Net Profit before 
Tax (a-b-c-d) 
.…….. ……….. ……… ………. 
(f) Less: Tax ……... ……….. ………. ……… 
(g) Expected Profit after Tax ..……. ……… ……… ……… 
B. Opportunity Cost of 
Investments in Receivables 
locked up in Collection Period 
..…… ……… ………. ……… 
Net Benefits (A – B) ……… ……… ……… ………. 
Advise: The Policy……. should be adopted since the net benefits under this policy 
are higher as compared to other policies. 
@The Institute of Chartered Accountants of India
Page 5


 
 
 
FINANCIAL MANAGEMENT 
 
9.70 
UNIT – IV 
MANAGEMENT OF RECEIVABLES   
15. MEANING AND OBJECTIVE 
Management of receivables refers to planning and controlling of 'debt' owed to 
the firm from customer on account of credit sales. It is also known as trade credit 
management. 
The basic objective of management of receivables (debtors) is to optimise the 
return on investment on these assets.   
When large amounts are tied up in receivables, there are chances of bad debts and 
there will be cost of collection of debts.  On the contrary, if the investment in 
receivables is low, the sales may be restricted, since the competitors may offer more 
liberal terms.  Therefore, management of receivables is an important issue and requires 
proper policies and their implementation.  
16. ASPECTS OF MANAGEMENT OF DEBTORS 
There are basically three aspects of management of receivables: 
1. Credit Policy:  A balanced credit policy should be determined for effective 
management of receivables. Decision of Credit standards, Credit terms and 
collection efforts is included in Credit policy.  It involves a trade-off between 
the profits on additional sales that arise due to credit being extended on the 
one hand and the cost of carrying those debtors and bad debt losses on the 
other.  This seeks to decide credit period, cash discount and other relevant 
matters.  The credit period is generally stated in terms of net days. For 
example, if the firm’s credit terms are “net 50”.  It is expected that customers 
will repay credit obligations not later than 50 days. 
 Further, the cash discount policy of the firm specifies: 
(a) The rate of cash discount. 
(b) The cash discount period; and 
(c) The net credit period. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.71 
 For example, the credit terms may be expressed as “3/15 net 60”.  This means 
that a 3% discount will be granted if the customer pays within 15 days; if he 
does not avail the offer he must make payment within 60 days. 
2. Credit Analysis:  This requires the finance manager to determine as to how 
risky it is to advance credit to a particular party. This involves due diligence 
or reputation check of the customers with respect to their credit worthiness. 
3. Control of Receivable:  This requires finance manager to follow up debtors 
and decide about a suitable credit collection policy.  It involves both laying 
down of credit policies and execution of such policies. 
 There is always cost of maintaining receivables which comprises of following 
costs: 
(i) The company requires additional funds as resources are blocked in 
receivables which involves a cost in the form of interest (loan funds) or 
opportunity cost (own funds) 
(ii) Administrative costs which include record keeping, investigation of 
credit worthiness etc. 
(iii) Collection costs. 
(iv) Defaulting costs. 
17. FACTORS DETERMINING CREDIT POLICY 
The credit policy is an important factor determining both the quantity and the 
quality of accounts receivables.  Various factors determine the size of the 
investment a company makes in accounts receivables.  They are, for instance: 
(i) The effect of credit on the volume of sales; 
(ii) Credit terms; 
(iii) Cash discount; 
(iv) Policies and practices of the firm for selecting credit customers; 
(v) Paying practices and habits of the customers; 
(vi) The firm’s policy and practice of collection; and 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.72 
(vii) The degree of operating efficiency in the billing, record keeping and 
adjustment function, other costs such as interest, collection costs and bad 
debts etc., would also have an impact on the size of the investment in 
receivables.  The rising trend in these costs would depress the size of 
investment in receivables. 
The firm may follow a lenient or a stringent credit policy.  The firm which follows a 
lenient credit policy sells on credit to customers on very liberal terms and standards.  
On the contrary a firm following a stringent credit policy sells on credit on a highly 
selective basis only to those customers who have proper credit worthiness and who 
are financially sound. 
Any increase in accounts receivables that is, additional extension of trade credit not 
only results in higher sales but also requires additional financing to support the 
increased investment in accounts receivables.  The costs of credit investigations 
and collection efforts and the chances of bad debts are also increased. On the 
contrary, a decrease in accounts receivable due to a stringent credit policy may be 
as a result of reduced sales with competitors offering better credit terms. 
18. FACTORS UNDER THE CONTROL OF THE 
FINANCE MANAGER 
The finance manager has operating responsibility for the management of the 
investment in receivables.  His involvement includes:- 
(a)  Supervising the administration of credit; 
(b)  Contribute to top management decisions relating to the best credit policies 
of the firm; 
(c)  Deciding the criteria for selection of credit applications; and  
(d)  Speed up the conversion of receivables into cash by aggressive collection 
policy.   
In summary the finance manager has to strike a balance between the cost of 
increased investment in receivables and profits from the higher levels of sales. 
@The Institute of Chartered Accountants of India
 
 
MANAGEMENT OF WORKING CAPITAL 
 
    
 9.73 
19. APPROACHES TO EVALUATION OF CREDIT 
POLICIES 
There are basically two methods of evaluating the credit policies to be adopted by 
a Company – Total Approach and Incremental Approach.  The formats for the two 
approaches are given as under: 
Statement showing the Evaluation of Credit Policies (based on Total Approach) 
Particulars Present 
Policy  
Proposed 
Policy I  
Proposed 
Policy II 
Proposed 
Policy III 
 
` ` ` ` 
A. Expected Profit:     
(a)  Credit Sales ………. …………. ……….. ………. 
(b) Total Cost other than Bad 
 Debts  
    
(i) Variable Costs ……… ………… ………. ………. 
(ii) Fixed Costs ……… ………… ………. ………. 
 ……… ………. ………. …….. 
(c) Bad Debts 
(d) Cash discount 
……… ………… ……… ………. 
(e) Expected Net Profit before 
Tax (a-b-c-d) 
.…….. ……….. ……… ………. 
(f) Less: Tax ……... ……….. ………. ……… 
(g) Expected Profit after Tax ..……. ……… ……… ……… 
B. Opportunity Cost of 
Investments in Receivables 
locked up in Collection Period 
..…… ……… ………. ……… 
Net Benefits (A – B) ……… ……… ……… ………. 
Advise: The Policy……. should be adopted since the net benefits under this policy 
are higher as compared to other policies. 
@The Institute of Chartered Accountants of India
 
 
 
FINANCIAL MANAGEMENT 
 
9.74 
Here  
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of  
          units sold on credit under Present Policy 
(ii) Opportunity Cost = Total Cost of Credit Sales ×      
   
Collection period (Days) Required Rate of Return
×
365 (or 360) 100
 
Statement showing the Evaluation of Credit Policies (based on Incremental 
Approach) 
Particulars Present 
Policy 
days 
Proposed 
Policy I 
days 
Proposed 
Policy II 
days 
Proposed 
Policy III 
days 
 
` ` ` ` 
A. Incremental Expected Profit:     
Credit Sales ………. …………. ……….. ………. 
(a) Incremental Credit Sales ………. …………. ……….. ………. 
(b) Less: Incremental Costs of 
Credit Sales 
    
(i) Variable Costs ………. …………. ……….. ………. 
(ii) Fixed Costs ………. …………. ……….. ………. 
(c) Incremental Bad Debt Losses ………. …………. ……….. ………. 
(d) Incremental Cash Discount ………. …………. ……….. ………. 
(e) Incremental Expected Profit 
(a-b-c-d)  
………. …………. ……….. ………. 
(f)  Less: Tax ………. …………. ……….. ………. 
(g)  Incremental Expected Profit 
after Tax 
………. …………. ……….. ………. 
 ………. …………. ……….. ………. 
B. Required Return on 
Incremental  Investments:  
    
(a) Cost of Credit Sales ………. …………. ……….. ………. 
(b) Collection Period (in days) ………. …………. ……….. ………. 
(c) Investment in Receivable (a × 
b/365 or 360) 
………. …………. ……….. ………. 
@The Institute of Chartered Accountants of India