Section C2d) of the Financial Management Study Guide states that candidates should be able to ‘discuss, apply and evaluate the use of relevant techniques in managing accounts receivable’.
Section C2d) of the Financial Management study guide states that students should be able to ‘discuss, apply and evaluate the use of relevant techniques in managing accounts receivable’. Further detail of what is required is then given in six sub-sections.
While this article aims to assist students in this area, it does not intend covering ground which has already been covered in previous articles. Hence, for full coverage of this syllabus area students, should also read the following Financial Management technical articles:
- Management of foreign accounts receivable
- Receivables collection
Key areas of accounts receivable management
There are three key areas of accounts receivable management.
- Before a company grants credit to a customer it should ensure, as far as possible, that the customer is worthy of that credit and that bad debts will not result. Checks should continue to be carried out on existing customers as a company would like to have early warning of any problems which may be developing. This is especially true for key customers of the company.
- Once the decision has been taken to grant credit, then suitable credit terms must be set and the receivables that arise must be monitored efficiently if the costs of giving credit are to be kept under control.
- A key area of the management of accounts receivable is the final collection of cash from customers. Any company must have a rigorous system to ensure that all customers pay in a timely fashion as, without this, the level of receivables and the cost of financing these receivables will inevitably rise, as will the risk and cost of bad debts.
These key areas will now be explored in more detail.
The methods a company could use to assess the creditworthiness of a customer or a potential customer include:
- a bank reference – while a bank reference can be fairly easily obtained, it must be remembered that the other company is the bank’s customer and so a bank reference will stick to the facts. It is most unlikely to raise any fears the bank may have about the company
- a trade reference – this is obtained from another company who has dealings with your potential customer/customer. Due to the litigious nature of society these days, it may not be so easy to obtain a written reference. However, you may be able to call contacts you have in the trade and obtain an informal oral reference
- credit rating/reference agency – these agencies’ professional business is to sell information about companies and individuals. Hence, they will be keen to give you the best possible information, so you are more likely to return and use their services again
- financial statements – financial statements of a company are publicly available information and can be quickly and easily obtained. While an analysis of the financial statements may indicate whether or not a company should be granted credit, it must be remembered that the financial statements available could be out of date and may have suffered from manipulation. For larger companies, an analysis of their accounting information can generally be found through various sources on the internet
- information from the financial media – information in the national and local press, and in suitable trade journals and on the internet, may give an indication of the current situation of a company. For example, if it has been reported that a large contract has been lost or that one or more directors has left recently, then this may indicate that the company has problems
- visit – visiting a potential new customer to discuss their exact needs is likely to impress the customer with regard to your desire to provide a good service. At the same time, it gives you the opportunity to get a feel for whether or not the business is one which you are happy to give credit to. While it is not a very scientific approach, it can often work quite well, as anyone who runs their own successful business is likely to know what a good business looks, feels and smells like!
Setting credit terms and monitoring accounts receivable
As soon as a customer is given credit, the credit terms of the company should be explained to them. For instance, the normal credit period granted and any discount for prompt payment, or interest charged on late payment, should be explicitly detailed to the customer. Very often, the credit terms a company adopts are the terms that are most common in its trade.
To use something different can cause problems as customers will be expecting, and are likely to take, what is normal in the trade. Having said that, variations within a trade do occur and, indeed, a company may well offer different terms to different customers, depending on the credit rating of each customer and their relationship with each customer.
Initially, a suitable credit limit should be set for each customer. This credit limit should only be allowed to grow slowly as your faith in the customer grows and all attempted breaches of the credit limit should be brought to the attention of the credit controller or other responsible person. It should be remembered that a common trick of an unethical company is to find a new supplier, make a small order and pay for it promptly. A large order is then made and, having taken delivery of this order, the customer delays payment for a significant time.
The accounts receivable should be continuously monitored. In order to do this a number of reports are useful:
- Accounts receivable aged analysis – this shows the amounts outstanding from each customer and for how long they have been outstanding. This will indicate any breaches of the credit terms.
- A credit utilisation report – this shows the proportion of each customers credit limit that is currently being utilised. Therefore, it will indicate where credit limits may need to be reviewed upwards or downwards and whether any credit limit breaches have occurred.
Taken together, these reports show how exposed a company is to its accounts receivable. In larger organisations, customers may be classified by trade and country as it is then possible to evaluate exposure by both country and trade. Larger businesses may also create their own in-house credit ratings for their customers.
Whether or not the basic credit terms offered by the company are suitable should be regularly reviewed. There is no point offering unnecessarily long periods of credit – however, equally, a company may find that extending its credit terms leads to an increase in sales. Any alteration in credit terms could be evaluated using the techniques demonstrated in the aforementioned ‘Receivables collection’ technical article.
It may seem very obvious, but if cash is to be collected, then the customer must be invoiced. It is essential that the invoice is sent out quickly and accurately. The receipt of your invoice is the first indication a company gets of the efficiency of your debt collection system. If the invoice takes a long time to arrive and is not accurate, then your accounts receivable department will be viewed as inefficient and customers may seek to exploit this perceived weakness and delay payment.
Furthermore, if an invoice is inaccurate some customers will take this as an opportunity to claim that there is a dispute on the account and, therefore, stop payment of all invoices until the dispute is resolved.
Having sent out the invoice quickly and accurately, the methods a company could use to ensure customers pay in a timely fashion include:
- monthly statements – these can be produced quickly and easily by any computerised sales ledger system and sent to customers. Exactly how much impact they have is however debatable
- chasing letters – these should be directed to a specific person preferably at a reasonably senior level. However, preparing and sending these letters has a cost and, like the monthly statements, their impact is often limited
- chasing phone calls – these can often have a great impact as all businesses have to answer the telephone and, hence, they have a nuisance value which can generate results. A credit controller who regularly contacts a suitably senior person at their customers with overdue amounts and politely, but firmly, demands payment can often achieve good results
- personal approach – a personal approach from a senior person in the company to a senior person at the customer can often yield results. This is quite common in trades where the personal relationship with clients is important. For instance, this often occurs in professional accountancy and legal firms
- stopping supplies – this is a cash collection tool that must be used with care. If the product being sold is built specifically to the customers design, and you are the only supplier who currently makes the product, then it is a powerful tool as, in the short term, you are the only supplier and, hence, payment is likely to be forthcoming. However, in the longer term it is always possible for the customer to train up an alternative supplier to make the product. If the product is a generic product that could be purchased from many suppliers, then quite obviously this is a weak tool that is simply likely to lead to the loss of the customer
- legal action – this is costly and is likely to lead to the customer being lost
- external debt collection agency – as with legal action this is costly and is likely to lead to the loss of the customer.
Many larger businesses have their own in-house debt collection departments that can be used before external debt collection agencies are used or legal action is taken. There have been instances where companies recently suffered reputational damage. They had branded their in-house debt collection departments in such a way that the customer believed that it had been referred to an external debt collection agency and, hence, was scared into making payment.
Methods of speeding up cash collection from accounts receivable
Two key methods of speeding up cash collection from accounts receivable are using factoring and using early settlement discounts. Students should be conversant with these methods and their advantages and disadvantages.
Furthermore, a common exam question requires students to evaluate, in ‘$’ terms, the net benefit or cost of a proposed new debt collection policy. All of these areas are covered in the aforementioned ‘Receivables collection’ technical article.
Additionally, a question (potentially a multiple-choice question) could require the calculation of the percentage cost of offering an early settlement discount. This is best explained through an example.
A company offers its customers 30 days credit but, at present, customers are taking an average of 41 days credit. In order to speed up cash collection, the company is considering introducing a 1% discount for payment within 10 days. The company finances its working capital requirement using an overdraft at an annual cost of 9%.
Required – Calculate the annual cost of offering the discount and evaluate whether or not the discount should be offered.
Let us assume a customer has purchased goods and has been invoiced $100. If the customer takes the discount, then the company will receive $99 in 10 days rather than $100 in 41 days. This is like the company borrowing $99 from the customer for 31 days (41 – 10) and paying $1 interest. Therefore, the 31-day interest rate is 1/99 x 100%. This needs to be compounded up to an annual rate in the following way:
(1 + 1/99)(365/31) – 1 = 0.126
Therefore, the annual cost of offering the discount can be said to be 12.6%.
If the discount is not offered, the company will be borrowing more on its overdraft while it waits for the customer to pay.
As the cost of borrowing on the overdraft is only 9%, the discount proposed is more costly and should not be offered.
Please note how the 30 days credit offered is not relevant in the calculations. Such additional information, which is not required, can be given in questions, especially multiple-choice questions where it is called a distractor. The use of distractors is a good way of testing who is really certain and confident in their knowledge.
The calculations above have been carried out from the point of view of the supplier. A question could also look at the same issue from the point of view of the customer and ask for a calculation of the customer’s cost of refusing the discount.
Students should note that:
The customer’s cost of refusing the discount = the supplier’s cost of offering the discount
Hence, in the above example, if a customer were to refuse the discount, the cost to it would also be 12.6%. If the customer is to accept the discount, then this will often require it to borrow extra funds in the form of an overdraft in order to make the early payment. We can assume that the customer’s overdraft rate is the same as the supplier’s rate of 9%. This is a reasonable assumption, as if both companies are operating in the same economy their overdraft rates are likely to be similar.
Therefore, the customer has a choice of refusing the discount at a cost of 12.6% or accepting the discount at a cost of 9%. Hence, the discount is attractive and should be accepted.
The above calculations have demonstrated a key problem with settlement discounts. As in this example, if the discount is attractive to the customer it may well be too costly to the supplier. It is also the case that a discount which is attractive to a supplier may well be too costly for the customer.
The formula to remember for calculating the cost of offering or refusing a discount is:
(1 + D/(100 – D))(365/t) – 1 x 100%
Where: D = the discount (2% = 2 etc.)
t = the period by which the payment is advanced if the discount is taken
Invoice discounting is another method a company can use to speed up the receipt of cash from its receivables. If a company is short of cash, it can approach an invoice discounter who will lend cash against the security of one or a few invoices that customers have still to pay.
For instance, the invoice discounter may advance 75% of the outstanding amounts. In some invoice discounting deals, the invoices/debts are legally sold to the invoice discounter and in others they are not. When the customer finally pays, the invoice discounter recovers the amount lent and also receives interest and charges.
Confidential invoice discounting is where the customer is not aware of the discounting arrangement and, as long as they pay their debt, they will never become aware of it.
Therefore, invoice discounting is similar to factoring in the way that the finance is provided and, indeed, many factoring companies will also provide invoice discounting services. However, with invoice discounting the company continues to run its own sales ledger. Additionally, while factoring is an ongoing arrangement, invoice discounting consists of one-off deals to cover temporary cash shortages.
Invoice discounting can be of particular use to SMEs who are starting to win contracts with large customers. While winning a contract with a large customer can be good news for a company, it can lead to cash flow problems. This is because the contract with the large customer is likely to involve sums that are very significant to the SME, and while large customers are generally reliable payers, they often only pay after a significant delay.
In combination with the other two articles highlighted, this article provides students with the core knowledge required in this frequently-examined syllabus area, which forms part of one of the core Financial Management topics. At all times it should be remembered that the costs involved in managing accounts receivable must be kept below the benefit received from granting credit to customers.