Account Receivables are amounts of money owed to a firm by customers who have bought goods and services on credit. Management of receivables aims at determining the optimal level of investment in receivables, which maximizes the benefits and minimizes the costs of holding receivables.
Economic conditions, competition, product pricing, product quality and the firm’s accounts receivables management policies are the chief influences on the level of a firms accounts receivable. Of all these factors, the last one is under the control of the finance manager. Our concern is to focus on this last factor.
As with other current assets, the manager can vary the level of accounts receivable in keeping with the trade-off between profitability and risk. The firm’s financial manager controls accounts receivable through the establishments and management of:
- Credit policy, which is determination of credit selection, credit standards and credit terms, and
- Collection policy.
Let us consider these management variables.
This is the decision whether to extend credit to a customer and how much credit to extend. A credit investigation is first carried out on the prospective customer in whom the five Cs of credit are employed. The five Cs of credit are key dimensions – Character, Capacity, Capital Collateral and Conditions – used by the credit analysts to focus their analysis on an applicant’s credit worthiness.
A brief discussion of these characteristics follows.
• Character -This refers to the creditor’s willingness to honor obligations. The applicants record of meeting past obligations – financial, contractual, and moral – is closely scrutinized. Any past litigation against the applicant would also be relevant.
• Capacity- This considers the applicants ability to generate cash to repay the requested credit. Financial statement analysis, especially liquidity and debt ratios are useful in assessing capacity.
• Capital- Considers the financial strength of the applicant as reflected by his net worth position. The applicant’s debts relative to equity and the profitability ratios will be used in this assessment.
• Collateral- Looks at the amount of assets the applicant can pledge to secure the credit to be advanced. The asset structure as revealed in the balance sheet and record of any legal claims against the applicant will be helpful in this assessment.
• Conditions- The prevailing economic and business climate as well as unique circumstance affecting the applicant will be considered.
Character and Capacity receive primary attention; capital, collateral and conditions play a supplementary role.