Ineffective accounts receivable management and solution in case of hai son construction material company limited

Therefore, a specific and efficient trade credit policy is an important factor to improve the management of accounts receivable and working capital of the company.. 20 4.1 The trade cre

International School of Business

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NGUYEN HUU CANH

INEFFECTIVE ACCOUNTS RECEIVABLE MANAGEMENT AND SOLUTION IN CASE

OF HAI SON CONSTRUCTION MATERIAL

COMPANY LIMITED

MASTER OF BUSINESS (HONOURS)

Ho Chi Minh City – Year 2018

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

International School of Business

-

NGUYEN HUU CANH

INEFFECTIVE ACCOUNTS RECEIVABLE

MANAGEMENT AND SOLUTION IN CASE OF HAI SON CONSTRUCTION MATERIAL COMPANY

EXECUTIVE SUMMARY

Working capital management is very important for a company, especially for manufacturing, trading and distribution companies, because it has a significant impact on the profitability and liquidity of the company (1) As one of the three main elements of working capital, receivables also have an impact on the performance of the business This is the most important source of external financing of enterprises (2) and also a source of support for buyers (3) As a result, managers can use accounts receivable as an instrument to increase the revenue, profitability, and customer relationship However, the amount of receivables that are too high can lead to many downsizing effects on the company (4) So, keeping receivables in optimum amounts

is an important financial issue

Management of accounts receivable is also management of trade credit (8) Therefore, a specific and efficient trade credit policy is an important factor to improve the management of accounts receivable and working capital of the company

The thesis is about Hai Son's inefficient account receivable management, in which specification of the ineffective trade credit policy This leads to inefficient cash conversion cycles and working capital management has a negative impact on the profits Research will show the factors that make this inefficiency as well as its financial results After considering all the aspects that lead to the problem, the thesis then aims to find and advise on possible alternatives and practices to improve the company's management of receivables

ACKNOWLEDGEMENT

This thesis becomes a reality with the support and assistance of many individuals I want to send my sincere thanks to all of them First of all, I would like to express my gratitude and sincerely thank my adviser, Dr Pham Phu Quoc for his guidance, imparting knowledge and expertise to my studies Special thanks to the members of Hai Son Company for cooperation, support and provide necessary information related to this thesis My thanks and appreciation also came to my teammates who have collaborated with me to complete the thesis and my classmates who are ready

to help me with their abilities Last but not least, thanks for my family who always support and encourage me to complete this thesis

TABLE OF CONTENT

EXECUTIVE SUMMARY 1

ACKNOWLEDGEMENT 2

LIST OF FIGURES 4

LIST OF TABLES 4

1 INTRODUCTION 5

1.1 The information of Hai Son Construction Material Company Limited 5

1.2 The mission and vision of Hai Son Co., Ltd 6

2 PROBLEM CONTEXT 6

2.1 The current financial status of Hai Son 6

2.1.1 The fall in revenue and net profit after tax in recent years 6

2.1.2 The rising of days sales outstanding 8

2.2 Trade credit policy of Hai Son 10

2.3 Current status of Hai Son in comparison with key competitors 11

3 PROBLEM IDENTIFICATION 14

3.1 Potential problems 14

3.1.1 Ineffective trade credit policy 15

3.1.2 The inherent conflict between Accounting and Sales Department 16

3.1.3 The impact of economic situation 17

3.2 Problem validation 18

3.2.1 Eliminating conflict and economic condition as the main problem 18

3.2.2 Illuminating the lenient trade credit policy as the main problem 18

3.2.3 Causes and effect diagram 19

4 CAUSE VALIDATION 20

4.1 The trade credit policy without discounts for early payment and ineffective collection policy 20

4.2 The trade credit policy without credit standards 20

5 SOLUTION 21

5.1 Improving trade credit policy with cash discount and effective debts collection 21

5.2 Request bank guarantee to overcome the weakness of credit standards 24

5.3 Selection of Solution 25

6 ORGANIZATION OF ACTIONS 26

7 CONCLUSION 29

8 SUPPORTING INFORMATION REFERENCES

APPENDIX

LIST OF FIGURES

Figure 2.1 The decreasing in revenues and accounts receivable

Figure 2.2 ROA of Hai Son, Viet Trung

Figure 2.3 ROE of Hai Son, Viet Trung

Figure 2.4 Receivable turnover ratio of Hai Son, Viet Trung

Figure 2.5 Days sales outstanding of Hai Son, Viet Trung

Figure 2.6 Aging of Hai Son’s accounts receivable in 2017

Figure 2.7 Cause and effective tree

Figure 6.1 Cash conversion cycle

Figure 6.2 Consequences of high accounts receivable

LIST OF TABLES

Table 2.1 Revenue and net profit after tax of Hai Son

Table 2.2 ROA and ROE of Hai Son

Table 2.3 Percentage of accounts receivable on credit sales

Table 2.4 Receivables’ ratios of Hai Son

1 INTRODUCTION

1.1 The information of Hai Son Construction Material Limited Company

Hai Son Construction Material Company Limited was established in 2007 Currently, Hai Son is the exclusive distributor for INSEE Viet Nam and distributing materials for construction projects in Ben Tre province

Hai Son has step by step built a strong foothold for its brand in the market of construction for supplying the current materials Despite many difficulties and challenges, the strength and experience of Hai Son have been confirmed so as to try to achieve the stable growth by undertaking the extraordinary breakthrough with main purpose of building a sustainable brand in order to always meet and satisfy all customers’ demands

Some basic information about Hai Son:

Company Name: Hai Son Construction Material Co., Ltd

Office: Nghia Huan Hamlet, My Thanh Commune, Giong Trom District, Ben Tre Province

Capital: 4 billion dongs

Warehouse Department

STORES

1.2 The mission and vision of Hai Son

The world is changing to the time To thrive as business in the future, Hai Son have look ahead, understand the trends and prepare for what is to come Hai son must get ready for tomorrow today The vision of Hai Son is all about It creates a destination of business and lead Hai Son to face with the next challenges The mission of Hai Son is permanent such as creating the value and inspire moments of happiness and optimism

2 PROBLEM CONTEXT

Financial statements are the reports about the financial results, financial condition and cash flows Ross, Westerfield and Jordan (5) stated that financial statements are the snapshot of organizing and summarizing the assets and equity of a company, reflecting the results of business in one year Skim through the financial statements from 2014 to

2017 of Hai Son, there are some issues which is worthy to concern:

At first sight, Income statements presented the sharp fall in sales and net profit after tax from 2014 to 2017, even that the losses occurred in 2 years ago The fall in sales also contributed to the decreasing of accounts receivable on Balance sheet

Going to deeper analysis, the increasing with high speed from 2014 to 2017 of days sales outstanding ratio were disturbing in accounts receivable management

The following detail analysis will illustrate the problems which Hai Son is facing

2.1 The current financial status of Hai Son

2.1.1 The fall in revenue and net profit after tax in recent years

According to Income statement from 2014 to 2017, the most noticeable is the significant decreasing in total revenue and net profit after tax during four years period The company was even loss in 2016 and 2017 which illustrated at Table 2.1

Unit: Dongs

Revenue 26,441,898,554 34,229,467,009 50,348,740,177 83,873,256,671 Net profit after tax (252,311,629) (45,378,148) 26,388,869 1,185,546,509

(Hai Son’s Income statement, 2014-2017)

Table 2.1 Revenue and net profit after tax of Hai Son

The speed of decreasing in net profit after tax was too high If net profit after tax was 1.185 million dongs in 2014, net profit after tax was just negative number in 2017 Addition, during three years from 2015 to 2017, return of assets (ROA) and return of equity (ROE) of the company tend to decrease significantly According to Table 2.2, if ROA and ROE were rather high in 2014 (2.69% and 38.8%), both ratios reduced sharply

in 2017 (-0.88% and -7.18%) The main reason was the loss

(Financial statements of Hai Son from 2014 to 2017)

Table 2.2 ROA and ROE of Hai Son

To find out what happened, an interview with the individuals concerned is conducted Accordingly, the director of Hai Son is Mrs Hanh who understanding the problems that the company is facing In conversation, she state that

The major cause of the decrease in revenue is the change of business orientation Before

2015, our revenues were very high However, since 2015, Hai Son oriented to become a specialized project distributor because of highly competitive market in building material distribution Thus, Hai Son reduces supplying for 2nd level agencies to concentrate on construction projects especially government construction projects That explains for the fall

in the revenue in the next 2 years Another reason, I think, is the highly sovereign debts So, the government restricts to build or repair the public construction Therefore, the results of Hai Son’s business is negative in recent years

Mr Hai who working in Sale department for 7 years continued that

In recent year, the massive competition of other distributors have caused problems for the introduction of products and sale Many new distributors appeared and offered lower price

to agents It is reason which forces Hai Son to change orient business and aims to supplying building material to construction projects

Basically, the fall in revenue and profit were starting from 2015 when Hai Son changed orientable business and aims to supplying goods to construction projects

2.1.2 The rising of day sales outstanding

After studying the reasons that caused to the fall in revenue and profit, a further consideration of sale activities will show the details of problems

Based upon balance sheet, it can be seen that the amount of receivables fell significantly during 2014 to 2017 This reduction was not only due to the management

of accounts receivable but also the reduction of revenue The speed of decreasing in accounts receivable was even lower than that of revenues indicating that credit terms seem more loosely During 4 years, revenues decreased more than 68% while accounts receivable decreased by less than half Figure 2.1 will show the detail of the speed of decreasing in revenues and accounts receivables

Figure 2.1 The decreasing in revenues and accounts receivable

In theory, Subramanyam (6) indicated that there are many factors which impact to the amount of accounts receivable, but the amount of credit sales has directly impacted

to this account To figure out, credit sales and the percentage of accounts receivable on credit sales are shown in the table 2.3 below:

Unit: Dongs

Credit sales 15,691,555,213 20,840,975,616 29,150,598,951 47,074,803,226

% AR/credit sales 47.56% 42.83% 36.68% 23.16%

(Hai Son’s Income statement, 2014-2017)

Table 2.3 Percentage of accounts receivable on credit sales

According to Table 2.3, though credit sales decline sharply from 2014 to 2017, the ratio of accounts receivable to total credit increased from 23.16% to 47.56% in 2017

So, the decreasing in accounts receivable was also slower than the decreasing in credit sales

Thus, it is possible that the collection of accounts receivables is not good leading to the low speed of decreasing in accounts receivable

The next financial ratios related to accounts receivable will presented the number

of days that Hai Son could collect the receivables from the customers The detail is shown by Table 2.4:

Table 2.4 Receivables’ ratios of Hai Son

According to Table 2.4, receivable turnover ratio fell significantly from 4.32 to 2.1 from 2014 to 2017 and day sales outstanding rose from 85 days to 174 days in 2017

In theory, Subramanyam (6) told that the significance of receivable turnover ratio

is the number of time which are accounts receivable collected in the year and the efficiency using working capital of a company The increasing in day sales outstanding ratio showed that the company managed accounts receivable ineffectively and took more time to transfer accounts receivable into cash This is a sign that the company has difficulty to collect the credit sales

2.2 Trade credit policy of Hai Son

Through analysis of the numbers on financial statements and financial ratio related

to account receivables, initially, Hai Son has difficulty in accounts receivable management Therefore, researching trade credit policy of Hai Son to find out the issues

is important

Trade credit is considered an investment in a customer According to Ferris (7), trade credit is a loan that tied in both timing and value to the exchange of goods When trade credit is granted, an accounts receivableis created Deloof and Jeger (8) indicated that accounts receivable can be used as an instrument to enhance revenues because the customers can evaluate the product quality before making the payment Management of accounts receivable is also management of trade credit The company has to establish procedures for extending credit and collecting As recommended by Brigham and Ehrhardt (9), a trade credit policies should include the credit standards, credit period, discounts and collection policy Since the initial operation, Hai Son has set up the trade credit policy and applied to the present

Through directly interview with Mrs Hanh about trade credit policy, she said that

We mainly set up credit limit on the basis of cost estimate of construction project The credit period is 45 days for all customers and the cash discount for immediate payment is 2% There is no discount for early payment on credit sales The customers have to pay all the

value of sales contract on time We will stop to deliver goods to the customer when their debts is greater than credit limit or who do not pay their debts on time.

Thus, trade credit policy of Hai Son includes the following component:

 Terms of sale: Hai Son grants different the amount of credit sales for each customer The credit period is 45 days for all customers and offer 2% cash discount for immediate payment of purchasing There is no cash discount for early payment of credit sales After one day, customers have to pay all the value of contract

 Credit analysis: There are no procedures to evaluate the probability that customers will not pay Hai Son bases on the cost estimate of construction project which

is supplied by customers in granting credit Hai Son will stop supplying goods to customers who does not make the payment on time and occur overdue debts

 Collection policy: The sale contract is attached the penalty interest rate for late payment If the customers are unwilling to pay and postpone the payment in longtime, Hai Son will take them to court When an account receivable is due, the accountant often contacts with the customers to remind or send request payment letter to customers Hence, in general, trade credit policy of Hai Son is lack of discount for early

payment and specific credit standards to evaluate the probability of unpaid customers 2.3 Current status of Hai Son in comparison with key competitors

Compared with Viet Trung Building Material Company Limited, also a distributor of a building materials in the same area, the data also show the negative results of Hai Son During 3 years from 2015 to 2017, the rate of return of Viet Trung increased rather high It is easy to see that business performance results has declined over the past four years The pictures below will show details

Figure 2.2 Return on assets of Hai Son, Viet Trung

Figure 2.3 Return on equity of Hai Son, Viet Trung

Adoption of financial statements, it can be seen that the amount of receivables decreased significantly in the period 2014 to 2017 However, this reduction was not due

to the efficient management of accounts receivable but also the reduction of revenue The rate of reduction of accounts receivable is even lower than that of sales indicating that credit terms seem more tolerant In 4 years, sales decreased more than 68% while accounts receivable decreased by less than half

As such, the company is incurring more and more overdue debts and this is also the cost of holding receivables for a longer period of time Financial indicators relating to receivables of Hai Son are compared with Viet Trung as follows:

Figure 2.4 Receivable turnover ratio of Hai Son, Viet Trung

Figure 2.5 Days sales outstanding of Hai Son, Viet Trung

Compared with Viet Trung, the ratio of Hai Son is the worst There is a significant gap between the sales of Hai Son and Viet Trung This is a sign of ineffective account management That means the company is having trouble collecting account receivable and customers hold large amounts of working capital in long time The liquidity of

accounts receivable of Hai Son and the speed of transfer from accounts receivable into cash is quite low

Next, the evaluation of aging of account receivables is going to show more detail

of current accounts receivable management situation Details of aging of accounts receivable in 2017 are as follows:

Figure 2.6 Aging of Hai Son’s accounts receivable in 2017

At the end of 2017, the majority of accounts receivable with maturity from 3 to 6 months are overdue from 1.5-4.5 months In addition, 8% of the debt is over 2 years and the company considers it irrecoverable In fact, the company offers 45 days of credit sales to all customers, the payments of accounts receivable more than 45 days are overdue In 2017, there are only 17% of accounts receivable on time and overdue debt accounted for 83% of accounts receivable It is shown that the management of accounts receivables of Hai Son is not effective

3.1.1 Ineffective trade credit policy

One of the serious reasons to manage ineffective receivables in Hai Son comes from the trade credit policy Cheng and Pike (3) stated that trade credit is considered as

an alternative to providing interest-free loans to customers when compared to borrowing money from a financial institution to make purchases The fall in accounts receivable was lower than sales indicated that trade credit policy is too lenient The advantages of lenient trade credit policy can attract customers and increase sales because of high accounts receivable However, according to Garcia-Ternuel and Martinez-Solano (10), the large amount of trade credit could cause the higher costs and risk of overdue debts

As such, the company does not issue specific credit standards or evaluate the financial situation of customers when creating sales Hai Son only stops to supply goods

to customers when their debts are overdue Hai Son has not set up the credit standards for assessing the financial situation of customers but depending on the cost estimation

of the construction projects This loose credit policy can attract customers but also generating overdue debt of weak financial customers According to trade credit policy

of Hai Son, the customers would have 45 days to pay whole the value of purchasing contract Hai Son is applying a fix credit period Cheng & Pike (3) said that the length

of credit period is equivalent to the product price, it means that the price of goods would reduce equivalent to the time that the customers hold their payment So, the strong financial customers often wait for the last day of credit period to make the payment Brigham and Ehrhardt (9) suggested that the discount could be a price deduction which would attracts and encourages the customers to pay early Hai Son does not apply the discount, it means that there is no encouragement for customers to make the early payment and cause the postponement in payment

Furthermore, there is no effective collection policy of Hai Son’s credit policy The current debts collection policy are not enough pressure to force the customer to make the payment Though, the sale contracts has presented the penalty interest rate for overdue payment and take unpaid customers in court but Hai Son seldom uses this method The preferential collection policy encourage customers to postpone their payments which increasing day sales outstanding

3.1.2 The inherent conflict between Accounting and Sales Department

In general, the conflicts between the Sales department and the Accounting department are also the reason for ineffective accounts receivable management

Through the interview, Ms Thanh who working in Hai Son as chief accountant for 9 years said that

The salesman did not concern the qualification and effective business of customers when offered sale contracts They just aimed to increasing revenues As the result, the Accounting department has to face with the large amount of bad debts In my opinion, it is really the real conflict between Accounting and Sale departments

And, Mr Hai who is salesman and currently works in Hai Son told that

In reality, the primary income of salesman bases on commission and bonus related to revenues Therefore, the salesman usually try to sell as many goods as possible, salesman seldom concerns about the paying capacity of customers on credit sales Beside, revenues are decreasing and difficult to sell goods in recent years So, we all do everything to attract the customers and increase the revenues

Theoretically, Burez and Vandenpoel (11) told that the Finance and Accounting department consider the credibility of customers as the most important condition when offering credit contracts They do not want the working capital bound in overdue debts

or lose money for irrecoverable debts In contrast, the sales department wants the total sales as high as possible whether the customer is trustworthy or not

In Hai Son, this problem has occurred in the last four years Moreover, total sales of the company decreased significantly, leading to increase the pressure for Sales department

To achieve sales target, salesman try to sign more sale contracts and sell more goods without the careful consideration of customer status or credibility Therefore, the Accounting department has to deal with the high level of overdue debts and bad debts Burez & Vandenpoel (11) also indicated that the Sales department must comply with trade credit policy when looking for the customers However, because of the inefficient trade credit policy, salesman is primarily concentrates on increasing sales and achieving their target Therefore, the Sales department can meet their target while the risk and costs are also increasing, the amount of accounts receivable has deteriorated in this period

3.1.3 The impact of economic situation

García-Teruel and Martínez-Solano (10) indicated that the economic situation is also impacted to the numbers of accounts receivable The cash flows from operating activities declined because of deteriorating economic conditions The financial position

of the debtors can be change after granting the trade credit As a result, some customer have no afford to pay their debts on time and increasing the day of sales outstanding ratio In addition, there are more risks in selling to construction projects because the contractors usually keep their cash longer because their cash flows depend on the market and the economic condition

Mrs Hanh told that

Due to competition from other distributors, the distribution of goods to secondary agents has become more difficult than before Therefore, from 2015, Hai Son promotes the supply

of building materials for construction projects It explains for the decreasing in sales and profits in recent years

Ms Thanh shared in addition

Since Hai Son reduced supplying goods for second level agencies, some customers are not willing to make the payment for the previous sale contracts According to my investigation, the reason is that these customers have not sold all of the goods yet so they could not pay all of debts The large amount of accounts receivable became doubtful debts

The reasons above also contribute into the decreasing of revenue and profit as well as increasing the overdue debts

3.2 Problem validation

The current financial status reflected the business difficulty of Hai Son Therefore, validation of the main problem among three potential problems above is an important foundation to have appropriate solutions for positive changes

3.2.1 Eliminating conflict and economic condition as the main problem

The conflict between Accounting and Sales Department occurred because Hai Son does not set up the specify credit analysis procedures There are not standards to classify customers which are basis for Sale department in finding out the appropriate customers Burez & Vandenpoel (11) indicated that the inherent conflict between sales and accounting department could be reduce if there are appropriate standards to evaluate the customers and sales department will target on creditworthy customers

Therefore, the conflict will be solved if the company can improving the trade policy Addition, the economic situation could not be controlled by the company Therefore, the main problem for the accounts receivable management is ineffective trade credit policy

3.2.2 Illuminating the ineffective trade credit policy as the main problem

The main problem for the ineffective of accounts receivable management comes from ineffective trade credit policy Gupta and Gupta (9) stated that trade credit policy

is a guide for the firm granting or rejecting credit to customers It directly impacts to the accounts receivable management Thus, an ineffective trade credit policy could be

caused the wrong decision in granting credit Because of ineffective trade credit policy, there are unclear regulations for all compliance departments in granting and collecting credit sales This is also the cause of the conflict between departments

3.2.3 Cause and effect diagram

From the above analyzing, together with theories and literatures and interview results, the cause and effect tree will be developed as follow:

Figure 2.7 Cause and effective diagram

Three factors caused ineffective accounts receivables management include the ineffective trade credit policy, the conflict between accounting and sales department and

Ineffective trade credit policy

Ineffective accounts receivable management

The bad debts losses

The decreasing

of profit The conflict

Sale

target

Accounting principles

the economic situation Ineffective accounts receivable lead to the bad debts losses and the decreasing in profit

According to Brigham and Ehrhardt (9), “the cash discount is the price deduction given to customers for the early payment Customers will get reducing in price when they make the payment within the stipulated period” Hai Son does not apply the discount, it means that there is no encouragement for customers to make the early payment and cause the postponement in payment Thus, trade credit policy will not work well if it does not regulate the specific cash discount for early payment The customers will wait for maturity date to pay their debts

Besides that, ineffective collection policy is not enough pressure to obligate the customer for payment The liberal collection policy promote customers to delay the payment and distribute to the rise in day sales outstanding

4.2 The trade credit policy without credit standards

The loose credit policy with no credit standards to evaluate financial status easily leads to supply goods for weak financial customers and occur overdue debts even bad debts Hai Son grants credit for the customers on the basis of cost estimation without considering criteria about financial status and effectiveness of business performance

Firstly, it can reduce the costs of bad debt and improve the cash flow of the company Secondly, an effective trade credit policy will reducing the inherent conflict between sales and accounting department This can also solve the potential problem of Hai Son Through setting up clear policy, all the departments of the company have to be compliance and there would not be any bias on offering trade credit to the customers Finally, it can bring the consistency in approaching customers and making proper decision, on the basis of credit standards It will create the fairness between the customers as well as improving the relationship with customers Hence, it can be true view that composing a specific trade credit policy is necessary for Hai Son It is an opportunity to improve accounts receivable management and complete the entire operation of the company

In specification, Brigham and Ehrhardt (9) indicated that an effective trade credit policy should include the credit standards, the credit period, cash discount and the collection policy

As a results, Hai Son has to improve trade credit policy especially concentration on the following contents:

Issuing the credit standards: The credit standards is a scale for company to categorize their customers to offer the credit limit and the credit term The credit limit granting to customers directly relate to the amount of investment in receivables

A generous credit standards can attract more customers and rise up revenue However, the investment in accounts receivable will be expanded along with many costs

Contrary, the strictly credit standards can reduce the investment in accounts receivable, prevent company from bad debts losses and costs But it is also results of decreasing sales and profits Therefore, composing specific credit standards is necessary for Hai Son It helps Hai Son to classify customer and set up the appropriate credit limit Mian and Smith (15) told that granting trade credit needs to depend on the creditworthiness of the customer and its financial capacity

Offering cash discount: The credit term should include discount for early payments Brennan, Maksimovic and Zechner (16) indicated that there are two methods for Hai Son to distinguish the selling price, including:

First, offering the credit period

Second, setting up the discount in payment which can be seen as a price reduction Applying discount for early payment can encourage the customers to pay their debts earlier than waiting for expire of credit period It is benefit for customers on payment and the seller in collecting debts Brigham and Ehrhardt (9) also said that the discount not only attracts customers with price deduction but also distribution of reducing in day sales outstanding In order to get discount, the customers have to meet requirement in the discount term Hence, instead of trade credit without discount for early payment, Hai Son should offer discount rate for early payment to the buyers The discount policy will attract customers and motivate the speed of debts collection