Receivables represent the amounts owed to the company as a result of sales of goods and services in the normal course of business. The size of investment in receivables is influenced by a number of factors. Among them two factors, the volume of credit sales, and the average length of time between sales and collection are important. A business wants to increase sales by offering credit but also needs a way to keep track of how much money it is owed and how on-time customers are when it comes to payment.
Determinants of Investment in Receivables –
To illustrate, suppose National Enterprise, a newly established firm makes a credit sales of $ 5000 per day and its customers are allowed 15 days of credit. At the start of business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts receivables stand $ 5000 in the firm’s book. During the second day, it sold another $ 5000 on credit increasing the book receivables to $10,000. If it goes on granting credit of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end of 15th day. However in 16th day, it will make another $ 5000 credit sales, but payments for sales made on the first day will reduced receivables by $ 5000, so that total account receivable will remain constant at $ 75000 in 16th day and each day thereafter throughout the year. The average account receivable the firm must carry during the year is, therefore $ 75000.
Account receivable = Credit sales per day X Average length of collection period
= $ 5000 X 15 days = $ 75000.
Above illustration shows that the change in credit sales or change in collection period or both will affect the investment in account receivable. Trade credit management should contribute to the realization of the basic financial purpose of an enterprise which is the is the maximization of its value. However, in turn, the volume of credit sales and collection is affected by several factors such as industrial norms, credit standards, credit terms, collection policy, payment habits of customers, nature of a business, size of the enterprise, cost of investment in receivables and so on. Therefore, the financial manager must be able to look in depth and analyze the impact of these factors in the volume of sales and the cost-benefit tradeoff associated with credit decisions.