Report Accounts Receivable Management

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Philippine Christian University
Center for Graduate Studies

A Report on Accounts Receivable Management

In Partial Fulfillment of the Requirements of the Subject, Managerial Finance

Submitted by: Castillo, Irma S.

Submitted to: Prof. Faustina C. Rana

August 19, 2011

Accounts Receivable Management

Accounts Receivable are among a company’s most liquid asset. As a finance manager it is important to know how to analyze the companys accounts to be able to set its credit standards and collection system to be able to control its company’s accounts receivable. Accounts Receivable represents the total monies owed the firm by its customers on credit sales made to them.

Types and objectives of customer credit Customer credit is the financing provided by the seller to the customer in the course of sale of goods or services.

Open account – The common type of customer credit. The evidences of customer liability under this are purchase order, shipping documents and an invoice.

Charge card – This is commonly used by customers to pay goods and services. It is usually applied in banks by the customers. In typical charge card transaction, the customer presents his/her card at the purchase counter. The stores verifies the validity of the cars, and if the purchase and the cumulative purchases are within the credit limit. After verification, the store clerk prepares a draft of the bill for signature of the customer accepting the liability. Comapnies that allow charge card purchases collect the receivables from the bank which issue the card plans. The bank takes the risk of default by customers. Banks collect a service charge from companies, ranging from about one percent for low margin goods to seven percent for high margin goods.

Installment credit -

Import and export trade financing - Is the financing of offshore parties through banks.

The possible benefits of credit:

1. Increased sales. Credit expands the market of a company. Credit is convenient, especially for customers of consumers goods. Companies take advantage of business opportunities by purchasing on credit and then funding it later by collections of accounts receivable during the credit period or by borrowing. 2. Avoidance of lost sales. Credit helps a company to hold its existing markets. A new competitor who offers more liberal credit terms to gain a foothold in the market can force a company to match the competitor’s credit terms. In declining markets, a company can offer liberal credit terms to chack a decline in sales.

Key Factors affecting acoounts receivable

The three most important factors that directly determine a company’s investment in accounts receivable and the profitability of that investment are: sales, credit policy, and collection efficiency. Credit policy includes the term of the credit, the cash discount and credit standards. By varying these policy variables, a finance manager could influence the level of investment in accounts receivable and profitability of that investment. Collection policy and procedures of the company are the third major influence factor. Cusomer payment of accounts depends on the collection efforts of the company.

Factors that determine the level of accounts receivable The level of investment of accounts receivable depends on the amount of sales per day, the length of credit period, and the payment policy of the customers. Accounts receivable increase with sales and length of the credit period.

Determining the required investment in receivables To determine the required investment in receivables first (1) determine its cash and capital, credit period, sales per day cost of goods., then compute Accounts receivable = daily sales x credit period. Required investment = cost of goods/day x credit period.

Effect of a change in credit period A change in credit period would affect the level of accounts receivable. A company may lengthen its credit period to encourage sales. It may shorten its credit period to conserve cash. Accounts receivable = sales per day x new credit period. Combined effect of simultaneous changes in credit terms and sales A company might change its credit term in order to influence sales. A liberal credit period can increase sales. Tightening the credit period is likely to constrain sales. Gross profits are higher due to higher sales. The possible disadvantages of the increase in credit terms are additional financing costs, collection expenses, and bad accounts. Investment in accounts receivable= new sales per day x new credit period. Reported profits and accounts receivable Profits in the financial statements included those in the form of uncollected receivables. If these accounts receivable remain uncollected, such profits will not be realized. To anticipate this possibility: A) Management should estimate the amount of bad accounts and deduct it from total accounts receivable, reporting them as bad debts, an expense. External auditors should test the adequancy of the estimate. B) Financial analysts should review the quality of accounts receivable. Analysis techniques focus on the growth, concentration and maturity of a company’s accounts receivable.

Techniques in analyzing accounts receivable Collection of accounts receivable is a last step in converting goods to cash. Failure at this stage of operating cycle causes loss of an asset and dissipation of working capital. Some of the indicators of the efficiency of accounts receivable management are: a. Turnover of accounts receivable, b.average age of the accounts receivable portfolio, and c.degree of bad debt losses. Measuring the efficiency of accounts receivable management Turnover ratios measure the efficiency of management of accounts receivable An aging schedule of receivable reveals possible problems of collection and the proportion of slow-paying customers. Turnover of accounts receivable Accounts receivable turnover is the ratio of sales for a given time period to the accounts receivable. It indicates the multiple by which investment in receivables generate sales.

Accounts receivable turnover Accounts receivable turnover is closely related to the average collection period. The average collection period is equal to the number of days in the sales period divided by turnover. Turnover and collection period measure the effect on accounts receivable of a company’s credit standards, credit terms, and collection efforts. A higher credit standard reduces the level of sales and receivables, and decreases turnover. Cash discounts reduce the level of accounts receivable and increase turnover. Longer credit terms decrease turnover. More collection efforts increase turnover. Average age of accounts receivable. Accounts receivable turnover is an average rate for all accounts. It indicates the average age of accounts receivable. A company may have a high average turnover but is still concerned with some past due accounts. To monitor accounts receivable according to maturity, management prepares ana ging schedule of accounts receivable. An aging schedule breaks up the total accounts receivable of a company into currect and past due categories. Significance of past due accounts. The degree of bad debts is the ratio of estimated bad debts to total accounts receivable. Bad debts ratio= bad debts/accounts receivable. The classification of accounts as bad debts depends on qualitative and quantitative criteria. Qualitative criteria cover a customer’s commitment to pay its account, its business environment and other factors. Qualitative criteria include the financial status of the customer, the status of the credit as to maturity, and recent movement in the account. Management controls the degree of bad debts through its credit standards, credit terms, and collection policies. Strict credit standard, shorter credit periods, and rigorous collection procedures are associated with low levels of bad debts. Credit standards Credit standards are the criteria in evaluating the creditworthiness of a customer. A customer is creditworthy if he can repay the credit according to the terms of sales. A company may set strict or aggressive credit policies and standards . A tight credit standard will lead to a lower investment in accounts receivable, a lower risk of bad debts, and lower collection expense. An aggressive credit standard, on the other hand, will increase the balance of accounts receivable, increase the risk of bad debts, and bring about more collection problems. A company’s choice of credit policy and standard will depend on external competitive pressure and on its own willingness to accept default risk.

The quality of accounts receivable depends on credit standards. The company trades off more sales with the attendant costs of more customer credit. A slack credit standard will increase sales but will also increase receivables and bad debts as credit is extended to marginally creditworthy customers. A tight standard reduces accounts receivable and bad debts but may prevent the company from achieving its sales potential. The finance manager should evaluate alternative credit and collection policies by comparing incremental benefits from higher sales with incremental costs from credit processing, bad debts and opportunity cost of incremental investment in receivables. Incremental analysis formula for credit standards:  Relax credit standards as long as: (Incremental Income – Incremental Cost) > Opportunity cost of a change in average accounts receivable.  Incremental income = contribution margin ratio x incremental sales due to change in credit standard  Incremental costs = incremental credit processing cost + incremental bad debts  Opportunity cost of change in accounts receivable = required rate of return x incremental accounts receivable. Management should lower its credit standard as long as the incremental profit exceeds the sum of incremental costs of bad debts, credit processing and the opportunity costs of incremental accounts receivable. Most credit policy alternatives affect the level of accounts receivable. In such cases, not only should the alternative policy increase income to cover expenses due to the alternative policy; it should also exceed the opportunity cost of the additional investment. In a choice between alternative credit standards that do not result in a change in the level of accounts receivable, the finance manager should adopt the credit and collection policy that yields the higher expected net benefit.

Information regarding the creditworthiness of customers One popular credit selection technique is the five C’s, which provides a framework for in-depth credit analysis. The 5 C’s are: 1. Character: The applicant’s record of meeting past obligations. 2. Capacity: The applicant’s ability to repay the requested credit, as judged in terms of financial statement analysis focused on cash flows available to repay debt obligations. 3. Capital: The applicant’s debt relative to equity. 4. Collateral: The amount of assets the applicant has available for use in securing credit.

5. Conditions: Current general and industry-specific economic conditions, and any unique conditions surrounding a specific transaction.

Credit Terms Credit terms include the credit period and any cash discounts. Companies give cash discounts to encourage prompt payment by the customers. It shortens the average collection period of the company and reduces the company’s investment in accounts receivable. Lengthening the credit period increases sales and profits, collection expenses and investment in accounts receivable. Offering cash discount for early payment by customers reduces the investment in accounts receivable, reduces collection expenses and may increase sales. Cash discounts reduce the gross margin rate of the sales affected by the discount. Management evaluates its credit period and cash discount policy using the incremental costbenefit approach. The approach involves preparing an income statement for each alternative and comparing the resulting after tax income. The finance manager should choose an alternative whose incremental net income exceeds the opportunity cost of incremental accounts receivable. Cost-benefit analysis is an approach limited by static nature and dependence on forecasts of sales, profit margin, bad debts costs, etc. the analysis assumes that other factors will be constant. There are uncertainties in those estimates. The analyst improves the technique by: a. using a range of values (low-high) for each parameter that is subject to prediction errors, and b. conducting sensitivity analysis on key parameters.

Collection Program The objectives of a collection program are to reduce the company’s investment in accounts receivable and to reduce losses from bad debts. Incremental cost-benefit analysis and the spreadsheet approach are useful techniques in analyzing a proposed collection program.

Credit information: Managements can obtain credit information from various sources. Because of the costs of credit investigation, collateral assessment and financial statement analysis, the company requires a minimum order from its customers before it grants credit.

Internal Sources of Information Analysis base on its experience with the customer. Existing accounts receivable yield a profile of customer types and payment patterns. External Sources of Information The company gathers other information on the credit applicant form the applicant and from other sources. Various useful information come from financial statement, credit investigation, banks and suppliers.

Evaluating Customer Credit Before giving credit, a company evaluates whether the customer meets its standards for creditworthiness. A customer is creditworthy if he has the capacity and the willingness to pay his obligations. Capacity to pay is a quantitative criterion. Willingness to pay is a qualitative criterion.

How a supplier analyzes its customer’s financial statements A supplier’s goal in evaluating a customer’s financial statements is to determine its capacity to repay the credit. In analyzing the customer’s financial statement, a supplier concentrates on inventory turnover, liquidity and profitability indicators. The key financial ratios to a supplier are inventory turnover, accounts receivable turnover, current ratio and profit margin ratio.

Reducing Credit Risk through Diversification and Credit Limits A company protects itself against credit losses by diversifying its customer credit. Diversification requires changes in credit policy by: A) Spreading out credits to different types of customers B) Limiting the maximum amount of credit given to any customer.

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