Receivables management, Financial Management

Receivables Management

The decision on whether to grant or not to grant credit to a particular customer can be taken if certain subjective probabilities of the payment pattern of the customer can be specified based on an analysis of the customer's financial viability, the nature of profession or employment or business he is engaged in, his relationship with other suppliers, his past record of payments to other suppliers, etc. has been carried out. The decision to grant credit or not to grant credit is usually based on expected value calculations.

Example 

A textile manufacturer must decide whether a credit of Rs.30 lakh can be extended to a new customer who manufactures dresses. The customer is expected to make a repeat purchase. The textile manufacturer on credit evaluation of the customer feels that the probability that the customer will pay is 0.85 and the probability that the customer will default is 0.15. If the customer pays for the first purchase, the probability that he will pay for the repeat purchase would increase to 0.95. The repeat purchase is also expected to be worth Rs.30 lakh. The cost of sales for both orders is 80 percent of sales value. Should the textile manufacturer grant credit?

The possibilities when credit is granted for the first order are as follows:

  1. The customer defaults and no repeat purchase is allowed.

  2. The customer pays and places a repeat purchase order.

The outcome of the repeat order could be that the customer pays or does not pay.

In the example, at the first decision node we have two choices: to allow credit or not to allow credit. If credit is allowed on the first order, the subsequent events are the customer will pay with a probability of 0.85 or he will not pay with a probability of 0.15. If the customer pays then at the second decision node he is expected to make a repeat purchase. The subsequent events on allowing credit for the second order are that the customer will pay with a probability of 0.95 or not pay with a probability of 0.05.

We can draw the following decision tree:

Figure 

663_recievables management.png

Evaluating expected pay-offs from right to left,

At node D2:

Decision - Go for 2nd order

 

prob.

x

pay-off

=

Exp. pay-off

Event: customer will pay

0.85

x

(6 + 4.5)

=

8.925

Event: customer will not pay

(+)0.15

x

0.8*(-)30

=

(-)3.6

 

Net Expected Pay-off

=

5.325

Therefore, by going for the 2nd order the net expected pay-off is Rs.4.5 lakh.

At node D1:

Decision - Allow Credit and go for 1st order

 

prob.

x

pay-off

=

Exp. pay-off


Event: customer will pay

0.85

x

(6 + 4.5)

=

8.925

Event: customer will not pay

(+)0.15

x

0.8*(-)30

=

(-)3.6

 

Net Expected Pay-off

=

5.325

* (Note that for the event, customer will pay, we consider the total expected pay-off i.e. 6 + 4.5. This is because if the customer pays for the 1st order he will make a profit of Rs.6 lakh on the 1st order as well as make a net expected pay-off of Rs.4.5 lakh on the 2nd order which takes place as a result of the customer paying for the 1st order.)

Decision - Do not allow credit

Here the pay-off is 0.

We find that if the decision of allowing credit is followed then a net expected pay-off of Rs.5.325 lakh can be made as opposed to no pay-off by not allowing credit. Hence the decision of allowing credit is followed.

Posted Date: 9/15/2012 2:41:32 AM | Location : United States







Related Discussions:- Receivables management, Assignment Help, Ask Question on Receivables management, Get Answer, Expert's Help, Receivables management Discussions

Write discussion on Receivables management
Your posts are moderated
Related Questions
It is a bond that does not give periodic interest payments. In spite of that, interest is added to the principal balance of the bond and is either paid at maturity or, at some poin

discuss the applicability ofan operating cycle in a poultry business(broilers)

Accounting Framework - Convention of Materiality Materiality means relative significance. In other words whether a matter should be disclosed or not in the financial statement

Portfolio Classification of Mutual Funds Mutual Funds differ with reference to the type of instruments in which the money has been invested as per the requirements of the inves

Part 1: Contingency plan Create contingency plans for the following scenarios: > One of your highly qualified consultants has given three months notice and is planning to move to a

Q. Illustrate the method of appraising capital investments? One of the potency of internal rate of return (IRR) as a method of appraising capital investments is that it is a di

Brown has been in business for some years and has kept her drawings slightly below the level of profits each year. You are her accountant, and she has passed you the following list

Investing Surplus Cash : Cash not required for temporary periods of short durations can be invested in near-cash assets, i.e. marketable securities which are readily convertible in

Deseasonalizing a Time Series The Ratio to Average Method allows us to identify the component of the seasonal variation in time series data and the indices themselves help us

Evaluate the importance of leverage of financial management on a small scale company.