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
Modi Wires and Cable Ltd intends to finance its INR 20 million modernization plan for which it is trying to decide between debt and external equity. The management feels that the e

Under what circumstances will the foreign subsidiary’s financial structure become relevant? The subsidiary’s own financial structure will become applicable when the parent firm

applicability of an operating cycle in vegetable growing in uganda

Calculate the amplitude of the DC component: A periodic voltage consists of sinusoidal pulses having an amplitude of 150 V (SEE DIAGRAM BELOW). Use Fourier Series Expansion to

Bond Indenture An indenture builds the formal conditions of a lending relationship between a borrower and a lender. It is a written record, and it outlines most important func

(a) Prior to FAS 133 if companies qualified for hedge accounting their hedges were assumed to be perfect-no valuation or testing required. Currently under FAS 133 risk managers se

The price charged when one segment of an organization provides goods or services to another segment of the organization.

What does it mean when we say that the correlation coefficient for two variables is -1? What does it mean if this value were zero? What does it mean if it were +1? Correlation

Explain foreign equity ownership restrictions. Why do you think countries entail these restrictions? Several countries restrict the maximum fractional ownership of local organiza

You are still a consultant for the Excellent Consulting Group. You have completed the first assignment, developing and testing a forecasting method based on linear regression (Case