TERMS OF SALE: There are three factors underlying terms of sale: Credit Period to be granted Discount Credit Instrument

CASH DISCOUNTS

For Example: Cost of Credit The sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-. If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x 2%). Look, foregoing Rs 2,000/- may look small but let’s annualize it and express it in %age: 2,000/98,000 = 0.020408 or 2.0408% Note this is for 20 days.

For computing the loss of not taking discount on annual basis: We will have 365/20 = 18.25 – 20 days period in one year. EAR = (1.020408)18.25 = 44.58% This is only for Rs 2,000 on Rs 100,000. you can well imagine the business activity that runs in million of Rupees. For seller, shorten the average collection period by offering discounts.

SHORTENING ACP A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around 50% customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30 days. Now the ACP will be as follows: 50% x 10 Days + 50% x 30 Days = 20 Days If average sales are Rs. 2 Million per month, then receivable: Rs. 2 Million x 1/3 = 666,666.00

CREDIT INSTRUMENTS There are two types of Credit Instruments INVOICE DISPATCH NOTE

ANALYZING CREDIT POLICY Following factors to be considered: Revenue effects: Granting credit period results in delayed revenue receipts. Offering discounts may or may not be Utilized by the customers. Firm may charges higher prices for longer period and may increase revenue. Cost effect: Whether firm sells on cash or credit it has to pay for the cost of sale. Payment to firm’s creditor rests on the cash to be received from debtors.

COST OF DEBT: When a firm extends credit to customers, it must finance the resulting receivable. Cost of short term borrowing is an important factor in the decision to grant credit to customers. PROBABILITY OF DEFAULT: Chances of default or bad debt are always there. DISCOUNTS: When firm offers discount to customers, there is a cost when some customers choose to pay early to seek discounts.

CONSIDERING EXTENSION OF CREDIT The increased sales that can be stimulated. Profitability of extra sales. Required Rate of Return on extra sales. Effect on Average Collection Period.

EVALUATING CREDIT WORTHINESS OF CUSTOMERS A firm who intends to grant credit to customers must seek information about the customers reputation and credit worthiness. There are several information sources commonly used. Financial statements of vendor Market reputation Banks Financial strength General economic conditions in vendors industry.

COLLECTION POLICY Monitoring of ACP Control Aging Schedule A compilation of accounts receivable by the age of each account.. Collection effort for overdue Or Delinquent accounts

DEBTORS’ MANAGEMENT Mini Case Study A firm is considering to change existing credit policy which will increase the Avg. Collection Period from one month to two months but it will ensure 20% increase in sales. Selling Price Per Unit Rs 12/- Variable Cost / Unit Rs. 10.20 Existing Annual Sales Rs. 2.00 M Required Rate of Return is 15%. 25% increase in sales will result in additional investment of Rs. 150,000 in stocks and additional creditors of Rs. 40,000/-

Advise the firm whether to change the existing policy if: The existing customers take two month credit period, and Only new customers only take two month credit.

Solution: Debtors Management Sale Price 12.00 Variable Cost 10.20 Sales 2,000,000.00 Return 15.00 Contribution Margin 1.80 Contribution /Sale Ratio Increase 1.20 Inc. In Stock 150,000.00 Inc. In Creditor 40,000.00

Solution: Debtors Management    Particulars Amount in Rs. Extra contribution 15.00 Increase in sales - 20% 400,000.00 Increase in cont. margin 60,000.00 A ALL CUSTOMERS TAKE TWO MONTHS CREDIT Total turnover after 20% increase 2,400,000.00 Avg. debtors - 2 months Existing debtors 1 month 166,666.67 Increase in debtors 233,333.33 Increase in stocks 150,000.00 Less: increase in creditors 40,000.00 Net increase in working capital 343,333.33 ROI ON EXTRA INVESTMENT 17.48

B ONLY NEW CUSTOMERS TAKE 2 MONTH CREDIT   Increase in sales 400,000.00 Increase in debtors 66,666.67 Increase in stock 150,000.00 Less: increase in creditors 40,000.00 Increase in net working capital 176,666.67 ROI ON EXTRA INVESTMENT 33.96 In both cases new policy look favorable and financially viable.

DISCOUNTS Evaluate the Discounts. More precisely, we must work out what level of discount can be offered to debtors for early payment. The other aspect would be to know the effect of this discount of the sales, ACP and Profit. This example deals a situation where early payment does not effect the sales.

EXAMPLE – DISCOUNT NOT EFFECTING VOLUME A company has decided to offer 2% discount to customers if they pay the invoice within 10 days. The current sales level is Rs. 10 million and existing terms are 2 month. This discount offering is only intended to reduce the credit terms. The company has estimated that around 75% of customers will avail this opportunity. Required: If the ROI is 18%, what will be effect of % discount?

Solution: Debtors Management   Sale 10,000,000.00 Discount offered 0.02 Discount validity days 10.00 No of customer to avail discount 0.75 Existing collection time - days 2.00 month New collection time - days 1.00 month Return on investment 0.18 A) UNDER NO DISCOUNT POLICY Existing volume of Debtors =10,000,000/12 x 2 1,666,666.67

B) UNDER DISCOUNT POLICY 622,146.12 i) 75% customers will avail 2% Discount and will pay in 10 days   =10,000,0000 x 75% x 10/365 205,479.45 ii) 25% customer will pay after 2 months =10,000,000 x 25% x 2/12 416,666.67 Reduction in Debtors 1,044,520.55 Saving on Reduction in Debtors =1,044,520.55 x 18%  188,013.70 Cost of Discount 2% =10,000,000 x 75% x 2%  150,000.00 Net Saving under New Policy 38,013.70

EXTENTION OF CREDIT Not always the companies consider reduction in credit period. Some time the companies may consider increase in sales by increasing the debtor period. This increase in extension should be evaluated in terms of value addition. When cost of extending period is less than the benefit, only when the policy will be accepted.

EXAMPLE: EXTENSION OF CREDIT M/s Red Cloud Ltd’s income statement for the period just ended has been presented as under:- Sales 2,100,000/- Cost of sales 1,470,000/- Gross profit 630,000/- Bad debts 31,500/- Profit 598,500/- The management is contemplating a strategy of easing the credit terms by extending the current one month collection period to two month. The new policy details are as under:

Increase in sales under new policy will be 20% over and above the current level. Average collection period will be two months Bad debts will also increase to 3% from existing 1.5% level. Other details: Cost of sales are 80% variable and 20% fixed. Fixed portion will not increase when sales will increase by 25%. Stock and creditors level will remain unchanged. Do you think the New Policy is worth undertaking?

Solution: Debtors Management ROI 0.15   Existing Bad Debt 0.02 COS Var. 0.80 COS % 0.70 COS Fix. 0.2 New Bad Debt Level 0.03 Inc. in Sales Var. COS 0.56 C/S 0.44

Solution: Debtors Management Existing sales 2,100,000.00 Cost of sales 1,470,000.00 Gross profit 630,000.00 Bad debt 31,500.00 Net profit 598,500.00

Solution: Debtors Management Variable Cost of sales COS=1470000 x Variable Portion of 80% 1,176,000.00 Cont Margin = 2,100,000 - 1,176,000 924,000.00 C/S ratio = 924,000 / 2,100,000 0.44 or 44%   Increase in Contribution Margin Sales=2,100,000 x Inc. 20%x C/S Ratio 0.44 184,800.00 Increase in Bad Debts = Sales 2.1m X Increase (1+0.2)xBad Debt 0.03 - BD=31,500 44,100.00 Increase in Profit 140,700.00 Intended investment in debtors (New Sales (2.1 million + 20%) /12) x 2 420,000.00 Existing investment in debtors = 2.1million / 12 175,000.00 Additional investment required 245,000.00 Cost of Additional Investment = 245,750 x ROI 15% 36,750.00 Net Benefit =140700 - 36750 103,950.00

DEBTORS MANAGEMENT