Ineffective accounts receivable management interrupts the business operations on a day to day basis. As a result, business faces insufficient cash flows to meet its short term obligations. Furthermore, poor management of accounts receivable negatively impacts business profits in two ways:
- Firstly, the increased bad debts reduce the profits directly as a result of receivables mismanagement
- Secondly, the majority of funds get tied up in accounts receivable. As a result the business has to borrow funds in order to finance its operations. Such borrowed funds carry interest that reduces the profit of the business in return.
Therefore, the business reaches on the verge of collapsing. This is due to liquidity challenges caused by excessive funds blocked in accounts receivable. So, putting funds in accounts receivables can be both good and bad for the business. It is good because increase in accounts receivable means increase in sales and customers for business. On the other hand, it is bad for business because it leads to liquidity challenges as a result of non paying customers. Therefore, a business needs to have a sound system for managing accounts receivable.
So let’s understand what is accounts receivable management before discussing the strategies for managing such receivables.
What is Accounts Receivable Management?
The meaning of accounts receivable management originates from the objectives with which receivables are managed.
The primary purpose of managing receivables is not to boost sales. Nor it is to reduce bad debt risk. But, the main objective behind managing receivables is to maximize the enterprise value. Thus, a business needs to maintain a balance between liquidity, risk and profitability in order to maximize the enterprise value.
This means that a business should expand sales through trade credit to the extent to which risk of bad debts remains within limit. This is because the main objective of business in managing receivables is to improve the overall return on investment in accounts receivable. Furthermore, the investment in accounts receivable needs to be of optimum level. So, the business needs to compare benefits with costs involved in maintaining receivables. This is done to determine the optimum level of investment to be made in receivables.
So, the objectives of accounts receivable management are to:
- achieve optimum not maximum volume of sales
- control the cost of credit and retain it to the minimum possible level
- maintain investment in accounts receivables at an optimum level
Accounts Receivables Best Practices
As stated above, the objective of management of receivables is not to expand sales but is to maximize overall returns on investment in them. Therefore, a business should not concentrate on merely collecting receivables within the shortest time possible. But, it should aim at comparing benefits with costs of various practices adopted to manage receivables.
Therefore, a business should follow sound principles of trade credit management in order to bring effectiveness to the process. Following are certain well established principles of credit management that a business needs to practice:
1. Credit Extension Policy
A clearly laid out credit policy helps a business to extend credit to its customers. The main objective of establishing guidelines in a credit policy is to avoid granting credit to non – paying customers. Thus, a good credit policy helps business in attracting and retaining quality customers. As a result, such a policy does not have a negative impact on cash flows of a business. Furthermore, a well written credit policy enhances the productivity of the organization. So, following are the reasons why a company must have a written credit policy.
- makes the whole task of managing receivables a serious affair
- brings consistency among various departments within the organization
- provides a consistent approach to be followed towards customers
- gives recognition to the credit department as a separate entity
Therefore, a business needs to determine an effective credit policy. This policy is determined after comparing the profit arising out of additional credit sales with the cost incurred in managing receivables arising out of such sales.
Now a credit extension takes into consideration various variables. These include:
a. Credit Standard
Credit standard refers to the financial strength of a debtor that is acceptable to a business. It concerns with the minimum level of credit worthiness of a customer to whom a business would readily want to extend trade credit. Now, a business can have either a strict or liberal credit standard. In a liberal credit standard, a business establishes lenient minimum requirements to be met by a credit customer.Thus, a lenient credit standard has the following attributes:
- increase in sales and customers
- increased clerical costs
- large investment in accounts receivable
- higher probability of default due to trade credit given to non – paying customers
long average collection period
- increased profit due to increased sales
However, a strict credit standard includes an increased number of minimum requirements to be met by a trade creditor. Following are the implications of a strict credit standard:
- decrease in sales as trade credit is extended to only quality customers
- reduction in bad debts
- less amount of working capital invested in trade receivables
- high quality of credit standards of the business
- low costs of maintaining accounts receivables
- decrease in profits due to reduction in sales
In conclusion, the amount of sales of a business is bound to increase if the business has lenient credit standard. Whereas, the amount of sales for a business tends to fall if it practices strict credit standards. Therefore, a business needs to compare the profits resulting from increased sales with costs associated with it before making a credit standard lenient.
b. Credit Terms
Credit terms are conditions set by a business on the basis of which a firm extends credit to its customers. Therefore, the magnitude of accounts receivables gets impacted by the terms of credit. Now, the credit terms may include techniques like:
1. Extending the Credit Period
Credit period refers to the amount of time a business gives to its credit customers for the purchases made. Usually, customers favor long credit periods. Therefore, increasing the credit period leads to increase in sales for the business. However, longer credit periods lead to longer cash conversion cycle for the business. This means a business will have to block more funds into trade receivables that turns out to be costly for the business. Furthermore, there is a higher chance of the customer defaulting in case the receivables remain outstanding for a longer period. Therefore, a business needs to compare the costs and benefits attached with extending the credit period. This can be done by formulating a sound credit policy.
2. Offering Discounts
A business can also offer discounts in order to attract customers. The discounts are the incentives given to the customers in order to make payments early. Now, the credit term pertaining to discounts mentions the percentage reduction in price as well as the earliest time within which payments must be made. Thus, a customer needs to abide by such conditions in order to become eligible for availing such discounts. Therefore, a business has two advantages in giving discounts to its customers:
- discounts add to sales as they lead to reduction in prices
- price reductions or discounts offered to customers encourages them to make early payments. This leads to a short cash conversion cycle for the business. However, discounts also lead to a decrease in prices that further reduces revenue for the business. Therefore a business needs to compare benefits and costs of offering discounts when creating a credit policy.
3. Credit Risk Analysis and Evaluation
The main objective of managing accounts receivable is to ensure that an optimum level of investment is made in accounts receivable. Furthermore, it aims to reduce the amount of bad debt losses considerably. Hence, a business should formulate guidelines that help in determining the creditworthiness of the customers before extending credit to them.
Following are the things management should consider while undertaking the credit risk analysis of the credit customer:
- Review the financials of customers
- Verify the payment history of customers
- Analyse the working of a company as a whole
- Consider the efforts made by customers with a weak credit worthiness in order to turn around their position
- Compare the opportunity cost of losing a customer under strict credit policy as against incurring bad debts under lenient policy
- Asking for guarantee or a letter of credit in case of customers with relatively weak credit worthiness
- Review the credit worthiness of the important existing customers regularly
- Focus on the five Cs that define the credit risk of the customer – character, capacity, capital, collateral, conditions
- Gain access to internal and external sources in order to gather information about the credit applicant
- Specify the rights and duties of a business with regards to its debtors. Furthermore, clearly state the legal consequences customers might face in case of late payments.
- Mention the various means through which payments are accepted by business
- Clearly indicate the way in which discounts are given to customers, Also specify the authority responsible for giving such discounts.
2. Credit Collection Policy
Credit collection policy refers to methodology adopted by a business to collect payments that are overdue. A business can have either a strict or lenient credit collection policy. Thus a business can improve its cash flows by reducing its average debt collection period. This is achieved by keeping a regular check on customers. However, a firm should not excessively pressurize customers to make payments as that would mean loss of business. Thus a business needs to compare costs and benefits of strict and lenient credit policy. Following are the best practices that a business can adopt to enhance its collection policy:
- Send constant reminders to customers
- Stop making sales on credit to non – paying customers until they clear their previous balances
- Print and mail invoices to customers quickly
- Ensure accuracy of invoices
- Offer incentives like discounts to pay early
- Penalize late paying customers to ensure timely payments
Thus, the above strategies showcase how important it is to manage accounts receivable. So, to know what is accounts receivable and how to manage accounts receivable in a much simpler way, here is an infographic.