Account Receivables Management refers to the set of policies, procedures, and practices employed by a company with respect to managing sales offered on credit.
It encompasses the evaluation of client credit worthiness and risk, establishing sales terms and credit policies, and designing an appropriate receivables collection process.
Accounts receivables are found on the balance sheet of a company, and are considered a short-term asset.
They are the one of the backbones of sales-generation, and thus must be managed to ensure they are eventually translated into cash-flows.
A company that fails to efficiently convert its receivables into cash can find itself in a poor liquidity position, crippling its working capital and facing unpleasant operational difficulties.
Why Companies Offer Sales on Credit
The majority of enterprises offer their clients the opportunity to purchases their goods and services on credit. When designed appropriately, such an arrangement can be mutually beneficial for both the firm and their clients.
Companies can ramp up their sales in a given quarter, move inventories, and ensure stable operating cycles. On the other hand, clients can access company inventories while deferring payments, allowing them to manage their cash flows as they deem is best for their own operational cycle.
Assessing Credit Worthiness and Risk
Prior to engaging in a sales credit agreement with a client, a company typically conducts an analysis of client creditworthiness and short-term liquidity.
Payment history, financial statements, and general economic conditions are all scrutinized.
Particular attention is paid to the customer’s liabilities (short and long-term) which impacts ability to meet obligations.
Furthermore, third-parties that furnish credit-risk analysis and reports such (such as Dun and Bradstreet) are typically consulted, and in some cases completely outsourced.
Designing Sales and Credit Terms
Depending on the assessment of the client’s creditworthiness and credit risk profile, the ensuing step entails extending the actual terms of sales on credit. For example, the term 5/10 net 30 is a sale on credit policy allowing the client to pay the net purchase amount 30 days after the billing invoice date.
The client is also offered a 5% discount on the net purchase amount should the payment obligation be satisfied within 10 days of the invoice date.
Companies must critically balance the benefits of extending favorable terms to clients (e.g. offering lengthy terms) with their cash flow needs and working capital requirements.
While enticing clients with a lengthy term increases revenues, this also means that receivables will be tied up longer, and cash receipts delayed.
Moreover, the risk of receivables becoming uncollectable increases the longer they are outstanding.
The Collections Process
In most cases, the payment collections process is rather simple.
Using their respective banks, customers will send payments to meet their obligations and the sales terms.
The A/R department is responsible for keeping abreast of all communication, documentations, bookkeeping, and pertinent matters concerning collecting payments.
Upon receiving payments, companies perform an accounting journal entry, whereby the Account Receivables account is credited (reduced) and Cash is debited (increased).
In the event of non-payment, the use of collections agencies (or the company’s own department) can be effective in recuperating all or a portion of the bad debts.
Most companies create a specific account to deal with delinquent accounts, commonly referred to in the industry as Allowances for Doubtful Accounts or Bad Debt Accounts (a contra-account to Accounts Receivables).
By examining historical delinquent accounts and their patterns, management usually forecasts bad debt (typically as a percentage of sales), and take that into consideration when managing their sales and receivables.
Performance Evaluation of Accounts Receivables Management
Employing best-practices in receivables management can yield good results with respect to revenue and cash-flow generation, working capital, liquidity, and stable operating cycles.
Using certain financial ratios can help in evaluating a company’s receivables policies and practices.
Aging Receivables Analysis
This report tabulates the total amount of receivables outstanding for each client, as well as their duration. When aggregated, it is a useful assessment of receivables’ credit risk and collectability, and pinpoints financially problematic clients.
Receivables Turnover Ratio
Measures the average number of times receivables are collected during a period. A high ratio is congruent with efficient receivables management, and could indicate that the company’s credit and collection policies are sound.
Days in Sales Outstanding
A ratio that measures the average length of time required to convert receivables into cash receipts. Low ratios can indicate good receivables management and collection policies since the company is translating its receivables into cash efficiently.
Cash Conversion Cycle
Measuring the average amount of time (days) to transform inventory purchases into cash receipts. Specifically, it measures the average time inventory is stored, receivables collected, and suppliers paid all in one cycle. Low CCCs are supportive of healthy cash flows and liquidity. Management can use it to assess how efficient their receivables management is in supporting a low CCC
Net Working Capital (NWC)
Receivables can comprise a major part of working capital levels. Assessing how receivables management affects NWC levels can help in good liquidity management,
Current and Quick Ratio
Two other liquidity measures, the current and quick ratio is an excellent trend-analysis tool that can serve to raise warning or red flags with respect to receivables management.
Offering properly designed sales on credit policies can be effective in attracting clientele and efficient sales generation.
Efficient receivables management can lead to good sales growth, healthy cash flows, profitability, and stable operating cycles.
Balance must be struck between offering favorable terms and cash flow needs. The risk of bad debt must be examined and good collections procedures followed to ensure collectability.
Finally, the periodic evaluation of receivables management can be helpful using certain financial ratios.