Consideration should be given to the company’s investment in accounts receivable since there is an opportunity cost associated with holding receivable balances. The major decision regarding accounts receivable is the determination of the amount and terms of credit to extend to customers. The credit terms offered have a direct bearing on the associated costs and revenue to be generated from receivables. For example, if credit terms are tight, there will be less of an investment in accounts receivable and less bad debt losses, but there will also be lower sales and reduced profits. In evaluating a potential customer’s ability to pay, consideration should be given to the firm’s integrity, financial soundness, collateral to be pledged, and current economic conditions.
Through some case examples, this post provides management and decision making techniques for Account Receivables. Enjoy!
Accounts Receivable Management and Procedure
A customer’s credit soundness may be evaluated through quantitative techniques such as regression analysis. Such techniques are most useful when a large number of small customers are involved. Bad debt losses can be estimated reliably when a company sells to many customers and when its credit policies have not changed for a long period of time. The collection period for accounts receivable partly depends on the firm’s credit policy and economic conditions, such as a recessionary environment, a period of limited or tight credit, or both.
In managing accounts receivable, the following procedures are recommended:
Step-1. Establish a Credit policy
- A detailed review of a potential customer’s soundness should be made prior to extending credit. Procedures such as a careful review of the customer’s financial statements and credit rating, as well as a review of financial service reports.
- As customer financial health changes, credit limits should be revised.
- Marketing factors must be noted since an excessively restricted credit policy will lead to lost sales.
- If seasonal datings are used, the firm may offer more liberal payments than usual during slow periods in order to stimulate business by selling to customers who are unable to pay until later in the season. This policy is financially appropriate when the return on the additional sales plus the lowering in inventory costs is greater than the incremental cost associated with the additional investment in accounts receivable.
Step-2. Establish Billing Policy
- Customer statements should be sent within 1 day subsequent to the close of the period.
- Large sales should be billed immediately.
- Customers should be invoiced for goods when the order is processed rather than when it is shipped.
- Billing for services should be done on an interim basis or immediately prior to the actual services. The billing process will be more uniform if cycle billing is employed.
- The use of seasonal datings should be considered. (See item 4, concerning credit policy.)
Step-3. Collection Policy
- Accounts receivable should be aged in order to identify delinquent and high-risk customers. The aging should be compared to industry norms.
- Collection efforts should be undertaken at the very first sign of customer financial unsoundness.
Determining Investment in Accounts Receivable
1. Lie Dharma Corp. sells on terms of net/60. Its accounts are on the average 30 days past due. Annual credit sales are $500,000. The investment in accounts receivable is:
90/360 x $500,000 = $125,000
2. The cost of a given product is 40 percent of selling price, and carrying cost is 12 percent of selling price. On average, accounts are paid 90 days subsequent to the sale date. Sales average $40,000 per month. The investment in accounts receivable from this product is:
3 months x $40,000 sales = $120,000
Investment in accounts receivable:
$120,000 x (0.40 + 0.12) = $ 62,400
3. A company has accounts receivable of $700,000. The average manufacturing cost is 40 percent of the sales price. The before-tax profit margin is 10 percent. The carrying cost of inventory is 3 percent of selling price. The sales commission is 8 percent of sales. The investment in accounts receivable is:
$700,000 x (0.40 + 0.03 + 0.08) = $700,000 x 0.51 = $357,000
Determining Average of Accounts Receivable Balance and Investment
1. If a company’s credit sales are $120,000, the collection period is 60 days, and the cost is 80 percent of sales price, what are:
(a) the average accounts receivable balance? and
(b) the average investment in accounts receivable?
(a) Accounts receivable turnover: 360/60 = 6
Average accounts receivable balance = credit sales / turnover
= $120,000 / 6 = $20,000
(b) Average investment in accounts receivable = $20,000 x 0.80 = $16,000
Decision Making 1: To Not Or Provide a Discount for Early Payment
It pays for a firm to give a discount for early payment by customers when the return on the funds received early is greater than the cost of the discount.
Lie Dharma Inc. provides the following data:
- Current annual credit sales = $12,000,000
- Collection period = 2 months
- Terms = net/30
- Rate of return = 15%
Lie Dharma proposes to offer a 3/10, net/30 discount. The corporation anticipates 25 percent of its customers will take advantage of the discount. As a result of the discount policy, the collection period will be reduced to 1.5 months. Should Lie Dharma offer the new terms?
The discount policy is disadvantageous. Why? See the following calculation:
Current average accounts receivable balance ($12,000,000/6) = $2,000,000
Average accounts receivable-
balance—after policy change ($12,000,000/8) = $1,500,000
Reduction in average accounts receivable = $ 500,000
Rate of return x 0.15
Dollar return earned = $ 75,000
Cost of discount:
(0.25 x $12,000,000 x0.03) = $ 90,000
Disadvantage of discount policy:
($90,000 – $75,000) = $ 15,000
Decision Making 2: To Tighten or To Relax a Credit Policy
A firm may consider offering credit to customers with a higher-than-normal risk rating. Here, the profitability on additional sales generated must be compared with the amount of additional bad debts expected, higher investing and collection costs, and the opportunity cost of tying up funds in receivables for a longer period of time. When idle capacity exists, the additional profitability represents the incremental contribution margin (sales less variable costs) since fixed costs remain the same. The incremental investment in receivables represents the average accounts receivable multiplied by the ratio of per-unit cost to selling price.
Dharma Putra Corporation, which has idle capacity, provides the following data:
- Selling price per unit = $80
- Variable cost per unit = $50
- Fixed cost per unit = $10
- Annual credit sales = 300,000 units
- Collection period = 2 months
- Rate of return = 16%
The corporation is considering a change in policy that will relax its credit standards. The following information applies to the proposal:
- Sales will increase by 20 percent.
- Collection period will go to 3 months.
- Bad debt losses are expected to be 3 percent of the increased sales.
- Collection costs are expected to increase by $20,000.
Will relaxing the credit policy benefit the company?
Here is how to analyze the proposed credit policy change:
Concerning incremental profitability:
Increased unit sales (300,000 x 0.20) = 60,000
Per-unit contribution margin ($80 – $50) x $30
Incremental profit = $1,800,000
Concerning additional bad debts:
Incremental dollar sales (60,000 x$80) = $4,800,000
Bad debt percentage x 0.03
Additional bad debts = $ 144,000
New average unit cost is:
Units Unit Cost Total Cost
Current 300,000 $60 $18,000,000
Increment 60,000 $50 (y) $ 3,000,000
Total 360,000 $21,000,000
New average unit cost = $21,000,000 / 360,000
Note: (y) Since idle capacity exists, the per-unit cost on the incremental sales is solely the variable cost of $50.
Additional cost of higher investment in average accounts receivable is:
Investment in average accounts-
receivable after the change in policy = $5,249,700 (q)
Current investment in average-
Accounts receivable = $3,000,000 (r)
Incremental investment in-
average accounts receivable = $2,249,700
Rate of return x 0.16
Additional cost = $ 359,952
(q) [Credit sales / turnover] x [unit cost/selling price]
= [$28,800,000/4] x [$58.33/$80.00] = $5,249,700
(r) = [$24,000,000/6] x [$60/$80] = $3,000,000
The net advantage/disadvantage is:
Incremental profitability $1,800,000
Less: Additional bad debts ($144,000)
Additional collection costs ($ 20,000)
Opportunity cost ($ 359,952)
Net advantage/disadvantage $1,276,048
Conclusion: Since the net advantage is considerable, Dharma Putra Corporation should relax its credit policy.
Decision Making 3: To Not or Liberalize the Credit Policy
Lie Dharma Putra Corporation is considering liberalizing its credit policy to encourage more customers to purchase on credit. Currently, 80 percent of sales are on credit and there is a gross margin of 30 percent. Other relevant data are:
Sales $300,000 $450,000
Credit sales $240,000 $360,000
Collection expenses 4% of credit sales 5% of credit sales
Accounts receivable turnover 4.5 3
Here is how to analyze the proposal yields:
Average accounts receivable balance (credit sales/accounts receivable turnover):
Expected average accounts receivable ($360,000/3) = $120,000
Current average accounts receivable ($240,000/4.5) = $ 53,333
Increase = $ 66,667
Expected increase in credit sales
($360,000 – $240,000) = $120,000
Gross profit rate x 0.30
Increase = $ 36,000
Expected collection expenses (0.05 x $360,000) = $ 18,000
Current collection expenses (0.04 x $240,000) = $ 9,600
Increase = $ 8,400
Conclusion: Lie Dharma Putra Corporation would benefit from a more liberal credit policy.