Credit & Receivables: Terms, Risks & Optimization

TAKEAWAYS:

• Credit policy (terms, period, discounts) directly impacts sales volume, collection risk, and working capital needs—measured via average collection period (ACP) and accounts receivable turnover.
• Trade credit cost (e.g., "2/10 net 30") can be converted to an annual percentage rate (APR) to compare with bank loans or other financing options.
• Cash conversion cycle (CCC) = inventory period + receivables period – payables period; optimizing receivables shortens CCC and frees up cash for growth.
• Credit scoring models (e.g., 5C analysis: Character, Capacity, Capital, Collateral, Conditions) help businesses like Ncell or Daraz assess customer risk before extending credit.
• Factoring (selling receivables to a third party like Nepal Investment Bank) improves liquidity but at a cost—always compare the factor’s fee to the opportunity cost of capital.
• Bad debt expense is recorded via the allowance method (contra-asset account) to match revenue with expenses, not when defaults occur.

1. Credit Policy: The Levers of Sales and Risk

Credit policy is the rulebook a business sets for selling goods/services on credit. It includes:

• Credit terms (e.g., "2/10 net 30" = 2% discount if paid in 10 days, else full amount due in 30 days).
• Credit period (how long customers get to pay).
• Credit standards (who qualifies for credit).
• Collection policy (how aggressively to chase overdue payments).

Why It Matters

• Too lenient? → High bad debts, tied-up cash, lower profitability.
• Too strict? → Lost sales, competitive disadvantage.
• Example: Daraz offers "Cash on Delivery (COD)" for small orders but requires pre-payment for high-value items to manage risk.

Key Metrics to Monitor

Worked Example: Beta Company’s AR Calculation

Problem: Beta Company sells on credit terms of net 30 (no discount). Its accounts are, on average, 40 days past due. Annual credit sales = Rs 18 million. Calculate Beta’s accounts receivable (AR).

Solution:

1. Actual Collection Period (ACP) = Credit period + Average delay = 30 days + 40 days = 70 days.
2. AR = (Credit Sales × ACP) / 360 = (Rs 18,000,000 × 70) / 360 = Rs 3,500,000.

Real-World Tie-In: If Beta is a Kathmandu-based retail shop selling on credit to wholesalers, Rs 3.5 million tied up in AR could instead be used to:

• Buy more inventory (increase sales).
• Pay suppliers early for discounts.
• Expand to new locations.

2. Trade Credit: The Hidden Cost of "Free" Financing

Trade credit is when suppliers (e.g., NTC for phone bills, Daraz for inventory) let you pay later. But is it really free?

Decoding Credit Terms: "2/10 net 30"

*Calculated as: (Discount % / (100 – Discount %) × (360 / Discount Period))

Worked Example: Kathmandu Biscuits Factory

Problem: Kathmandu Biscuits Factory buys flour on terms of 2/10 net 30. If it does not take the discount, what is the annual percentage cost (APC) of the trade credit?

Solution:

1. Discount lost = 2% of invoice.
2. Effective cost = (Discount % / (100 – Discount %)) × (360 / Discount Period) = (2 / 98) × (360 / 10) = 0.0204 × 36 = 73.46% per annum.

Real-World Tie-In: If Kathmandu Biscuits forgoes the discount, it’s paying 73.46% APR—higher than most bank loans! This is why Nepal Investment Bank (which offers factoring) charges ~12–18% for financing receivables—still cheaper than missing trade discounts.

3. Optimizing Receivables: The Cash Conversion Cycle (CCC)

The CCC measures how long cash is tied up in operations. Shorter CCC = more cash available for growth.

Formula:

CCC = Inventory Period + Receivables Period – Payables Period

Where:

• Inventory Period = (Average Inventory / COGS) × 360
• Receivables Period = (AR / Credit Sales) × 360
• Payables Period = (AP / COGS) × 360

Worked Example: Kathmandu Retail Shop

Given:

• Inventory turnover = 6 times/year → Inventory Period = 360 / 6 = 60 days.
• Receivables collection period = 70 days.
• Payables deferral period = 40 days.
• Annual sales = Rs 5 million.

Calculate CCC:

CCC = 60 (Inventory) + 70 (Receivables) – 40 (Payables) = **90 days**

Interpretation:

• Kathmandu’s cash is tied up for 90 days before it’s recycled.
• Actionable insights:
  • Negotiate shorter payables (e.g., pay suppliers in 30 days instead of 40).
  • Offer discounts for early payment (e.g., "1/10 net 30") to reduce receivables to 30 days → CCC = 60 + 30 – 40 = 50 days.
  • Use factoring to sell receivables to Nepal Investment Bank and free up cash immediately.

flowchart TD
    A["Cash"] -->|"- Inventory Period"| B["Inventory"]
    B -->|"- Receivables Period"| C["Accounts Receivable"]
    C -->|"- Payables Period"| D["Accounts Payable"]
    D -->|"Cash Freed"| A

4. Managing Credit Risk: Tools and Trade-offs

A. Credit Scoring: The 5C Analysis

Businesses like Ncell or Pathao use these criteria to assess creditworthiness:

B. Collection Policies: Carrot vs. Stick

5. The Accounting Cycle: Recording Credit Transactions

A. Journal Entries for Credit Sales and Bad Debts

B. T-Accounts: Tracking AR and Allowance

6. Real-World Applications in Nepal

A. eSewa and Khalti: Credit for Digital Payments

• Idea Used: Net credit period (time between service and payment).
• How It Works:
  • eSewa lets users pay bills (e.g., NTC, Nepal Electricity Authority) after receiving the service.
  • Risk: Fraud or non-payment (mitigated by KYC and transaction limits).
  • Cost: eSewa charges a 1.5–2% fee on delayed payments (similar to trade credit cost).

B. Daraz: COD vs. Pre-Payment

• Idea Used: Credit terms optimization.
• How It Works:
  • COD (Cash on Delivery): Acts like net 0 (customer pays immediately).
  • Pre-payment: Acts like net 0 but reduces bad debts.
  • Data-Driven Decision: Daraz uses past purchase history (like the 5C analysis) to decide COD eligibility.

C. Ncell: Post-Paid Plans as Trade Credit

• Idea Used: Extended credit period with collateral.
• How It Works:
  • Ncell’s post-paid plans = 30–60 days of free credit.
  • Collateral: Customer’s credit score and device value (e.g., iPhone as security).
  • Cost: High default rates → Ncell charges higher interest (12–18% APR) on late payments.

Exam Tip: How This Unit Is Tested

1. Numerical Problems (50% of marks):

   • Calculate AR, ACP, or CCC given sales and periods.
   • Compute trade credit cost (APR) from terms like "2/10 net 30".
   • Past Question Example:

     "Delta Metal House changes credit terms from net 40 to net 50. ACP increases from 60 to 75 days. Annual sales = Rs 20M. Calculate the increase in AR." Solution: New AR = (20M × 75)/360 = Rs 4.17M; Old AR = (20M × 60)/360 = Rs 3.33M; Increase = Rs 0.84M.

2. Conceptual Questions (30% of marks):

   • Define credit policy, factoring, or allowance method.
   • Explain trade-offs (e.g., "Why might a firm prefer factoring over bank loans?").
   • Common Pitfall: Forgetting to annualize trade credit costs (e.g., giving "2%" instead of "36.7%" APR).

3. Scenario-Based (20% of marks):

   • Advise a Kathmandu retail shop on improving CCC.
   • Compare COD vs. pre-payment for a Daraz-like business.
   • Key Tip: Always tie answers to real Nepali examples (e.g., Ncell, eSewa, Daraz).

Final Mermaid Summary: The Credit Management Cycle

flowchart LR
    A["Set Credit Policy\n(Terms, Standards, Discounts)"] --> B["Grant Credit\nto Customers"]
    B --> C["Monitor ACP & AR\nvs. Policy"]
    C -->|"If ACP > Terms"| D["Tighten Policy\nor Offer Discounts"]
    C -->|"If Bad Debts Rise"| E["Use 5C Analysis\nor Factoring"]
    C -->|"If CCC Too High"| F["Negotiate Payables\nor Improve Inventory"]
    F --> A