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Credit Management: Costs in Extending Credit & ROI on Receivables
Published by slang March 28th, 2006 in Credit ManagementCLICK THIS TO GET TO THE MAIN PAGE FOR ALL ARTICLES ON CREDIT MANAGEMENT/CREDIT CONTROL
Costs in Extending Credit:
Do you know what are the costs in extending credit? Well, let’s hope that your answers include the following:
- Cost of capital tied up in debtors,
- Cash discounts,
- Staffing costs of sales, ledger administration,
- Expenses on printing, stationery, postage, space, equipment, etc.
- Debt recovery costs, e.g. legal, credit insurance and debt collection agencies,
- Bad debts.
The cost of capital tied up could be the additional overdraft, factoring, bills acceptance facility and other borrowings tied up. In most cases, the company will be using collaterals to obtain these facilities. Here, the cost of capital is essentially the interest payments from these borrowings, which can reduce the profit or income of the company.
Also, if we are able to get the debtors to pay earlier, then besides seeing the incomes/returns increased by lessening the interest costs of borrowing to finance debtors, we will also see a better RETURN ON INVESTMENT (ROI) in our Receivables/Assets.
Illustration:
Return on Investment (ROI) In RECEIVABLES
| Year 2004 | Year 2005 | ||
| Sales | $2m | $5m | |
| Profits say 5% | (a) | $100k | $250k |
| Assets Employed | $1m | $1.8m | |
| Return on Assets | 10% | 13.9% | |
| Receivables | (b) | $600k | $650k |
| DSO |
110 days | 47 days | |
| If DSO=110 days (original) |
(d) | $1,507,000 | |
| Reduction in Receivables because DSO now is 47days | (d-b) | $ 857,000 | |
| Say overdraft interest @12% savings from reduction of receivables (DSO from 110 to 47 days) | 12%x(d-b) | $ 102,700 | |
| Profit is now increased to |
(c) | $352,700 | |
| ROI in RECEIVABLES | (a/b) | 16.7% | |
| ROI in RECEIVABLES |
(c/b) | 54.3% |
If you look at the table, with the concerted effort from management to reduce receivables from a DSO of 110 days to 47 days, big savings from interests from borrowing is derived, which gives the Company a better return/income and leading to better ROI in Receivables. (in ROA, besides receivables there is also inventory and other assets), Here we are only demonstrating that receivables are improving, but others assets might be deteriorating, etc.
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