CHAPTER TWENTY-ONE

Management of Accounts Receivable

ACCOUNTS RECEIVABLE MANAGEMENT directly affects corporate profitability and cash flow. For example, too much money tied up in accounts receivable would be a drag on earnings. The CFO must consider discount policy, whether to grant credit to marginal customers, how to hasten collections and reduce uncollectible accounts, and how to establish credit terms.

MANAGING RECEIVABLES

How should accounts receivable be handled?

The order entry, billing, and accounts receivable activities should be evaluated to ensure that proper procedures and controls exist from the day an order is received until collection is made. What is the average time lag between completing the sales transaction and invoicing the customer? If it is excessive, why?

There are two kinds of float in accounts receivable management—invoicing and mail. Invoicing float is the days between the time goods are shipped to the customer and the time the invoice is rendered. Invoices should be timely processed. Mail float is the time between the preparation of an invoice and the time it is received by the customer. Mail float can be reduced by:

• Decentralizing invoicing and mailing
• Coordinating outgoing mail with post office schedules
• Using express mail services for large invoices
• Enforcing due dates
• Offering discounts

In managing accounts receivable, the CFO should take into account the opportunity cost of holding receivables. The opportunity cost is tying up money in accounts receivable that could be invested elsewhere for a return. Therefore, ways to analyze and hasten collections should be undertaken.

An important consideration is the amount and credit terms given to customers, since this will impact sales volume and collections. For example, a longer credit term will likely increase sales. The credit terms have a direct bearing on the costs and revenue derived from receivables. If credit terms are stringent, there will be less investment in accounts receivable and less bad debts. However, this will result in lower sales, reduced profits, and adverse customer reaction. If credit terms are lax, there will be higher sales and gross profit. This will result in greater bad debts and a higher opportunity cost of carrying the investment in accounts receivable because marginal customers take longer to pay. Receivable terms should be liberalized when you want to dispose of excessive inventory or obsolete items. Longer receivable terms are recommended for industries in which products are sold before retail seasons (e.g., swimsuits). In the case of perishable goods, short receivable terms or even payment on delivery is advised.

In appraising a prospective customer’s ability to pay, take into account the customer’s honesty, financial strength, and pledged security. A customer’s creditworthiness may be evaluated by using quantitative techniques, such as regression analysis. These models are useful when there are many small customers. Bad debt losses can be accurately forecasted when a company sells to many customers and when its credit policies have remained static.

The CFO has to consider the costs of granting credit, including administrative costs of the credit department, computer services, fees to rating agencies, and periodic field investigations.

What credit reporting agencies supply information?

Reference can be made to retail credit bureaus and credit reference services in evaluating a customer’s ability to pay. One service is Dun and Bradstreet (D&B), which rates companies. D&B reports contain information about a company’s nature of business, financial status, prior payment history as reported by suppliers, amounts currently owed and past due, lawsuits, insurance coverage, audit opinion, leases, number of employees, terms of sale, banking relationships and account information (e.g., current bank loans), location of business, criminal proceedings, and seasonality characteristics.

What standards should be used in accounts receivable operations?

To monitor and improve accounts receivable activities, unit credit standards may be established. For invoice preparation, a cost per invoice, order, or item may be set. For credit investigation and approval, unit cost standards may include cost per account, sales order, or credit sales transaction. In examining credit correspondence records, cost per sales order, account sold, or letter may be used. In preparing customer statements, unit cost standards may be cost per statement or account sold. The standard for the computation of commissions on cash collections may be based on cost per remittance.

How can accounts receivable be managed to maximize earnings?

There are many ways to optimize profitability from accounts receivable and keep losses to a minimum. These include:

• Minimize billing float, which refers to the amount of time between the time of shipment, when a bill or invoice could have been rendered, to the time a bill or invoice is actually mailed. Billing may be accelerated through electronic data interchange rather than using the mails.
• “Cycle bill” for uniformity in the billing process.
• Mail customer statements within 24 hours of the end of the accounting period.
• Mail an invoice to customers when the order is processed at the warehouse rather than when merchandise is shipped.
• Bill for services periodically when work is performed or charge a retainer. Tip: Bill large sales immediately.
• Use seasonal datings. When business is slow, sell to customers with delayed payment terms to stimulate demand from those who cannot pay until later in the season. Compare profitability on incremental sales plus the reduction in inventory carrying costs, which have to exceed the opportunity cost on the additional investment in average accounts receivable.
• Carefully evaluate customer financial statements before granting credit. Ratings should be obtained from financial advisory services.
• Avoid high-risk receivables (e.g., customers in a financially depressed industry or locality). Be careful of accounts in business less than one year. (About 50 percent of businesses fail within the first two years.)
• Note that customer receivables have greater default risk than corporate accounts.
• Adjust credit limits based on changes in customer’s financial soundness.
• Accelerate collections from customers having financial difficulties. Also, withhold products or services until payment is received.
• Request collateral for questionable accounts. Tip: The collateral value should equal or exceed the account balance.
• Age accounts receivable to identify delinquent customers. Interest should be charged on such accounts. Aged receivables can be compared to previous years, industry standards, and competition. Prepare bad-debt loss reports showing cumulative bad debt losses detailed by customer, size of account, and terms of sale. These reports should be summarized by department, product line, and type of customer (e.g., industry).

• Use outside collection agencies when net savings result.
• Factor accounts receivable when immediate funds are needed. However, confidential information may have to be disclosed.
• Have credit insurance to guard against unusual bad debt losses. What to consider: In deciding whether to obtain this insurance, consider expected average bad debt losses, financial soundness of your firm to withstand the losses, and the insurance cost.
• Consider marketing factors, since a tight credit policy may mean less business.
• Monitor customer complaints about order item and invoice errors and orders not filled on time.
• Identify customers taking cash discounts who have not paid within the discount period.
• Look at the relationship of credit department costs to credit sales.

The collection period for accounts receivable partly depends on corporate policy and conditions. In granting trade credit, competition and economic conditions have to be considered. In a recession, the CFO may liberalize the credit policy to obtain additional business. For example, the company might not rebill customers who take a cash discount even after the discount period expires. In times of short supply, however, credit policy may be tightened because the seller has the upper hand.

What are the attributes of a good credit system?

A credit system should be:

• Clear, fast, and consistent
• Careful of customer’s privacy
• Inexpensive (e.g., credit analysis and decision making is centralized).
• Based on prior experience, attentive to account characteristics of good, questionable, and bad accounts.

Tip: Determine the correlation between customer characteristics and future uncollectibility.

INVESTMENT IN ACCOUNTS RECEIVABLE

The CFO must determine the dollar investment tied up in accounts receivable. The accounts receivable balance depends on many factors, including terms of sale, financial soundness of customers, product quality, interest rates, and economic conditions.

Should customers be offered a discount for the early payment of account balances?

The CFO has to compare the return on freed cash resulting from customers paying earlier to the cost of the discount.

Should the company give credit to marginal customers?

In granting credit to marginal customers, compare the profit on sales to the added cost of the receivables.

The company may have to decide whether to extend full credit to presently limited credit customers or no-credit customers. Full credit should be given only if net profitability occurs.

How are your receivable records excluding those for customers?

Some receivable transactions other than regular sales may result in losses. Examples include insurance and freight claims. The CFO should formulate a plan to handle these transactions. Unfortunately, some companies lack the needed record keeping. In fact, some firms only retain pieces of correspondence.