Accounts Receivable & Credit Management: Policies, Trade-offs & Control

TAKEAWAYS:

• Credit policy (terms, standards, collection) directly affects sales volume, bad-debt costs, and cash flow—measured via accounts receivable turnover and average collection period.
• The 5 Cs of credit (Capacity, Capital, Collateral, Conditions, Character) form the foundation for evaluating customer creditworthiness before granting trade credit.
• Trade discounts (e.g., 2/10 net 30) incentivize early payment but require balancing discount costs against lost interest income.
• Aging schedules reveal credit risk concentration—e.g., if 60% of receivables are >90 days overdue, the firm faces liquidity or bad-debt crises.
• Factoring (selling receivables to a bank) improves cash flow but erodes gross margins by 2–5% and cedes control over collections.
• Optimal credit terms must align with industry norms (e.g., retail: net 30; wholesale: 2/10 net 60) and the firm’s cash conversion cycle.

Core Concepts: What Is Accounts Receivable and Why Does It Matter?

Accounts receivable (AR) represents money owed to a firm by customers for goods/services sold on credit. Unlike cash sales, AR ties up working capital until collected, creating a liquidity-risk trade-off:

• Opportunity cost: Funds tied in AR could earn interest if invested elsewhere.
• Bad-debt risk: If customers default, the firm loses revenue and may need to write off debts.
• Operational cost: Maintaining a credit department, tracking payments, and enforcing collections adds overhead.

Visual 1: The AR-Cash Flow Link

flowchart TD
    A["Sales on Credit\n(Revenue recognized)"] -->|"AR Recorded"| B["Accounts Receivable\n(Liability on customer)"]
    B -->|"Customer Pays"| C["Cash Received\n(Working Capital freed)"]
    B -->|"Default"| D["Bad Debt Expense\n(Write-off)"]
    C -->|"Reinvested"| E["Operating Cycle\n(Inventory → Sales → AR → Cash)"]

Real-world tie-in:

• eSewa uses AR when it processes utility bill payments on behalf of NTC or Ncell before deducting its fee. The delay between service provision and fee collection is its floating AR.
• Daraz sellers face AR risks when they ship goods to buyers who later request refunds or claim "not received"—Daraz’s credit policy (e.g., 7-day return window) directly impacts seller cash flow.

Credit Policy: The 4 Key Levers

A firm’s credit policy consists of four interdependent components, each requiring trade-offs:

Visual 2: Credit Policy Trade-offs

pie
    title Credit Policy Impact on Firm
    "Sales Volume ↑" : 30
    "Bad Debt Cost ↓" : 20
    "Cash Flow ↑" : 25
    "Operating Cost ↑" : 15
    "Profit Margin ↓" : 10

Worked Example: Credit Terms Decoding A supplier offers 2/10 net 30. What does this mean for a Kathmandu spice trader?

• 2: 2% discount if paid within 10 days.
• 10: Discount period (10 days).
• net 30: Full payment due in 30 days if discount is not taken. Decision:
• If the trader’s cost of capital is 18% annually, the annualized cost of not taking the discount is: \text{Cost} = \frac{2\%}{98\% \times (30-10)/365} = 46.7\% \quad (\text{vs. 18% borrowing cost}) → Take the discount to save money.

Evaluating Creditworthiness: The 5 Cs Framework

Before granting credit, firms assess customers using the 5 Cs (visualized below). Use this to evaluate a Pathao driver’s credit request for a bulk fuel purchase:

(Note: The image will show a table with columns for each C, rows for Pathao driver’s profile, and risk ratings.)

Decision: Offer Rs 20,000 credit (vs. Rs 30,000 requested) with net 15 terms and monitor payments weekly.

Tools to Monitor and Control AR

1. Aging Schedule

Reveals how long receivables remain outstanding. Example for Bhutanese Curry House (month-end data):

Formula: $$\text{ACP}=\frac{\text{Average AR}}{\text{Credit Sales}}\times 365=\frac{1,600,000}{3,200,000}\times 365=182.5\text{ days}$$ Problem: ACP > industry norm (15–30 days for restaurants). Solution: Tighten credit terms to net 15 or offer 1% discount for cash.

2. Bad Debt Provision

Firms estimate uncollectible debts using:

• Percentage of Sales Method: 1% of credit sales (e.g., Rs 32,000 for Rs 3.2M sales).
• Aging Method: Higher % for older receivables (e.g., 5% for >90 days).

Journal Entry:

| Date       | Description                          | Dr (Rs) | Cr (Rs) |
|------------|--------------------------------------|---------|---------|
| 31-Dec-2023| Bad Debt Expense                     | 50,000  |         |
|            | Allowance for Doubtful Accounts      |         | 50,000  |

3. Factoring Receivables

Selling AR to a factor (e.g., NMB Bank or Global IME) for immediate cash.

• Recourse: Factor can return unpaid invoices (higher fee).
• Non-recourse: Factor bears the risk (lower fee but costlier). Example: A Kathmandu textile exporter sells Rs 5M AR to a factor for Rs 4.7M (3% fee). Net cost: Rs 300K vs. potential bad debts of Rs 400K.

Pros/Cons Table:

In the Real World

1. Khalti’s AR Management:

   • When you pay a bill via Khalti, the merchant receives payment within 24 hours, but Khalti holds a float (AR) until the bank clears the transaction. This float is Khalti’s working capital, which it reinvests in merchant incentives.

2. Nepal Rastra Bank’s Credit Policy:

   • NRB requires banks to classify loans into Standard (0–30 days past due), Sub-standard (31–90 days), and Doubtful (>90 days). This aging framework mirrors how firms like NMB or Siddhartha Bank manage their corporate AR portfolios.

3. Daraz Seller Dilemma:

   • Daraz offers sellers net 7–15 payment terms for orders, but if a buyer requests a refund under "not as described," Daraz withholds payment until the dispute is resolved. This creates Daraz’s AR risk, which it mitigates by:
     • Requiring sellers to maintain minimum inventory buffers (reduces refund claims).
     • Using AI to flag high-risk buyers (like those with frequent disputes).

Cash Flow Impact: How Credit Policy Affects Working Capital

Scenario: Thapathali Electronics sells Rs 10M/year on credit with:

• Current terms: Net 60 → ACP = 60 days.
• Proposed terms: 2/10 net 30 → ACP = 15 days (if discount taken) or 30 days (if not).

Working Capital Impact:

Decision: If 60% of customers take the discount, net revenue drops by 1.2% but AR turns 6x faster, freeing up Rs 1.4M in working capital.

Exam Tip

1. Credit Terms Questions:

   • Always decode terms (e.g., "2/10 net 30") and calculate the annualized cost of not taking the discount.
   • Example: If a question asks, "Should a firm offer 3/15 net 45 if its cost of capital is 12%?", compute the cost as shown above and compare.

2. Aging Schedules:

   • Memorize the formula: ACP = (Average AR / Credit Sales) × 365.
   • Flag red flags: If ACP > industry norm, suggest tighter terms or factoring.

3. Policy Trade-offs:

   • Exams often ask: "How would loosening credit standards affect sales, bad debts, and cash flow?"
   • Answer template:

     Looser standards → ↑ Sales but ↑ Bad Debts and ↓ Cash Flow. Requires higher bad debt provision and may increase collection costs.

4. Factoring:

   • Never recommend factoring unless the question explicitly asks for short-term liquidity solutions. Instead, suggest:
     • Tighter credit terms.
     • Improved collection processes (e.g., automated reminders).
     • Collateral requirements for high-risk customers.

5. Numerical Problems:

   • Always show work: Even if the answer is simple, write out the aging schedule or trade-off analysis step-by-step.
   • Use real numbers: If given Rs 500K sales, calculate AR as Rs 500K × (ACP/365). Never assume ACP without calculating it.

Final Visual: The Accounts Receivable Cycle

flowchart LR
    A["Sales on Credit\n(Revenue Recorded)"] --> B["AR Recorded\n(Debtor Ledger)")
    B --> C["Aging Analysis\n(Identify Overdue)"]
    C -->|"Good Payments"| D["Cash Received\n(Working Capital Freed)"]
    C -->|"Bad Debts"| E["Write-off\n(Bad Debt Expense)"]
    C -->|"Factored"| F["Factor Pays\n(Minus Fee)"]
    D & F --> G["Reinvested in\nInventory/Operations"]