Analysis of Accounts Receivable
Analysis of accounts receivable involves two issues: the relative size of accounts receivable and the adequacy of the allowance for uncollected accounts (Murray, Neumann, & Elgers, 2000, p. 220).
Size-The size of accounts receivable is usually assessed relative to the amount of credit sales. This seems appropriate because credit sales give rise to accounts receivable (accounts receivable earns no return after the discount period has expired). Most firms do not separately disclose credit sales, so net sales are usually used. This is figured using the following ratio:
accounts receivable as a percentage of sales =
accounts receivable gross
Adequacy of allowance for uncollectible accounts (an overall estimation of the accounts receivable amounts that will not be collected). These are presented as a contra-asset account that is subtracted from the accounts receivable. This is figured using the following ratio:
Allowance for uncollectible accounts
Accounts receivable gross
The implication this has for managers is that management should attempt to maximize the return on accounts receivable. Managers must also decide which customers will be granted credit. Managers need to set a minimum credit rating for its customers so that profitability is maximized.
Inventory-Inventory consists of products that are acquired for resale to customers. For many companies inventory is a major asset and a significant source of revenue.
Cash flow-Cash flow is the amount of cash a company generates and uses during a period calculated by adding non-cash charges to the net income after taxes. Cash flow can be used as an indicator of a company s financial strength. In essence, cash flow measures real money flowing into or out of a company s bank account (Equade Internet ltd, 2000).
Cost flow assumptions-Most businesses purchase inventory items on an ongoing basis. Usually these purchases are not made at a uniform price. This, in some cases, causes an accounting problem when the inventory is sold (what is the cost of goods sold vs. cost of goods on hand). This can be determined by several different methods:
a. Specific identification method-determines the cost of inventory by maintaining the identity and cost of each item.
b. Average cost method-determines the per unit cost of inventories by summing the beginning inventory cost plus all purchases and then dividing by the number of units available for sale.
c. FIFO-First in first out method which values inventory that assumes the goods first in are those first out as they are sold or used in a production process.
d. LIFO-Last in first out method which values inventory that assumes the last in purchases of inventory are those first sold or first used in the production process (Murray, Neumann, & Elgers, 2000, p. 714-721).
Credit sales-Many companies make a large portion of their sales on credit. Credit transactions enable purchasers to use their cash for a longer period of time before paying the seller. Murray, Neumann, & Elgers, 2000, p. 216).
Industry practices and competitive pressures force many businesses to sell on credit therefore increasing the company s accounts receivable. There are several areas that must be dealt with in reference to accounts receivables and credit. These include:
a. discounts-When selling on credit, many businesses offer discounts for early payment. Two reasons discounts are offered include 1) early payment enables the seller to have access to cash sooner and 2) the quicker an account is paid means there is less chance for non-payment.
Typical discount terms are 2/10, net 30 (meaning a 2% discount if paid within 10 days, otherwise net 30).
b. factoring accounts receivable-selling accounts receivables for a fee can be a valuable source of quick cash for growing companies. Factoring, converting accounts receivable into cash by selling them to a financing firm for a fee, can play a critical role in business. In factoring, after the business owner sells some or all of the company s accounts receivable to a factor, the financing company typically advances 50 to 80 percent of the face value of the invoices. The factor assumes the risk and responsibilities of making collection. When the factor collects on the receivables, it takes out its fees and pays the balance to the business owner. While this process can be expensive, it allows a business to turn assets into cash in a few days, opposed to waiting 30 or more days for customers to pay Reynes and R (1999).
c. credit scoring-a method of evaluating the credit worthiness of customers through the implementation of a formula or set of rules. Credit scoring provides clear benefits to the credit department. These benefits include speed, accuracy, consistency, reduction in bad debts, prioritization of selective activities and reduction time required for risk assessment. There are 3 factors considered in credit scoring. These include traditional credit information, credit agency information and financial statement scores. Traditional credit information includes pay history bank ratings, tax liens, NSF checks reported or placed for collection. Credit agency information includes D & B ratings and paydex scores, NACM evaluations and Experian DBT, and intelliscores. Financial Statement scores include liquidity ratios such as current and quick ratios:
current assets = current ratio quick assets = quick ratio
current liabilities current liabilities
Profitability ratios such as return on equity:
Average stockholder s equity
And solvency ratios such as debt to equity:
Total liabilities = Debt to Equity
Total Stockholders equity
There are also several different approaches to credit scoring. Behavior based scoring (a statistical based scoring model that relies on multi-variate correlation). It attempts to find common threads between problematic deletion and sound business. Rules based scoring, which is a judgmental scoring model based upon the experience of those assigning the model. It provides automation to the traditional risk assessment process. Neutral network modeling is also a statistical based scoring model. The basis for this type of model is a series of algorithms that are constantly and automatically being refined and updated as time moves forward and information pertinent to the model is gathered and incorporated into the model parameters (Wallis, 2001).
Continued growth in collections
How to make sure your fees are collected. A few simple reports can keep you in the know about your accounts receivable. 1) Keep tabs on bank deposits. At the very least you should know what s going to the bank. A steady monitoring of these reports lets you detect abnormalities in cash flow. 2) Get a monthly financial summary (to track your collections). 3) Track adjustments to gross income. 4) Analyze aged accounts receivable. Aging accounts receivable is a standard diagnostic technique. Consultants should pay close attention to accounts older than 90 days, because those accounts are harder to collect. 5) Take advantage of computer technology. Know everything there is to know about you company s software programs. Management should also master the software that is being used. (Lowes, 1998)
What s behind your revenues?
How can a company account for its revenue? How do we know if all the necessary steps are being taken to assure revenue generation? Are their revenue leaks? If so, is the company aware of them? Let s take a brief look at the revenue cycle.
Revenue = a recurring set of business activities and related information processing operations associated with providing goods and service to customers and collecting cash in payment for these sales.
Four basic revenue cycles business activities that all accountants should know something about includes: Sales order entry, shipping, billing and cash collections (Gross, 2000).
Revenue assurance is also a company issue. A company has the responsibility to assure all possible revenue is not only accounted for, but also available to be placed on an invoice. Each department within the business in one-way or another, needs to work with each of the other departments. Some of the departments involved in this process include:
Sales-Without sales, there is no company;
Provisioning-They are responsible for accepting the sales order and turning it into an engineering order; Network-Takes the engineering order and coordinates the physical network; Billing-They are responsible for the entry of sales orders and creating the actual invoice which is sent to the customer; Accounts receivable department-They are responsible for properly posting payments and handling adjustments; and customer service (Marsh, 1999).
The organizational structure of a business can affect the management of accounts receivable. Management must be aware of all other departments and how these departments interact with each other. In regards to point of billing, if the information in your system is incorrect, it slows the assembly line down, ultimately affecting the timeliness of payment. A company s revenue assurance stream requires managers who can be innovative, handle criticism, be strong willed, and above all understand how their departments actions affect their interfacing departments.
Automation provides collectors with a scarce commodity: time. Companies who have automated their collections have seen dramatic improvements in several areas. Improvements include:
1) Shorten the time spent on support activities. Increase the time spent ing delinquent accounts. 2) Increase the effectiveness of each . 3) Increase the number of s in a specific time period. 4) Provide immediate follow-up documentation to the customer. 5) Generate additional feedback. However the single-most clear benefit to an automated collection system is the ability to collect receivables faster. Rapid collection of accounts receivable is vital to the success of any company.
10 trends transforming the future of credit collections
1. Transaction complexity in business-to-business commerce will increase.
2. The need to process more transactions and more customers per dollar of the credit services budget.
3. Innovative ways to utilize external resources and services will be developed.
4. The internal use of in-depth credit analysis will be limited.
5. Credit management will move out of its present functional silo.
6. Silver bullet solutions will appear, initial feedback will look great, reality will follow.
7. Credit managers who are able to effectively manage information will prosper.
8. The change agents that transform credit and collections may come from other functions within the company.
9. Reaching your customers to resolve problems will become more difficult.
10. Credit management will become necessary but secondary skill (Piumelli, 2000).
Slow paying customers
Are your customers paying their bills slower these days? Companies have many reasons for delaying payment. Some of their excuses
Your product doesn t work ;
You just missed our last computer run; we ll pay again in two weeks ;
We lost your invoice ;
Our computer is down .
Although most problems stem from delay, there are a few customers you will have difficulty collecting from. Therefore, all companies should have an uncollectible accounts policy. Accounts should be written off a business s financial account records when all collection procedures, including those required by the Office of the Attorney General have been conducted without results and management deems the account uncollectible. Uncollectible accounts may be written off a business s accounting record and no longer recognized as collectible receivables for financial reporting purposes, but the legal obligation to pay the debt still remains (Unknown 2000).
Charged off accounts
Selling charged off debt provides a quick hit to seller s balance sheets. Accounts receivable managers are looking at the current value of their charged-off accounts in a whole new light. They re viewing these as an asset rather than a headache . Credit card debt is a particularly attractive proposition for companies interested in buying debt (Reynes, 1999). There is no doubt that the market for charged-off credit card receivables is constantly evolving. When evaluating write-offs, estimation methods are used. One such method is the aging method. The aging method classifies accounts receivable by the number of days they are past due (i.e. 0-30, 31-60, 61-90, more than 90). In its simplest form, the aging method classifies the year-end accounts receivable balance in 2 categories: 1-current, 2-past due. Businesses also use a year-end adjustment to recognize that some of their accounts receivable will probably not be collected. The collection period for accounts receivable is the average length of time it takes to collect a receivable. To calculate the collection period requires two steps. First you need to average the sales per day. The ratio for this would be:
Sales = average sales per day
Then you take the gross accounts receivable and divide it by the average sales per day. This ratio is as follows: (Cleaver, 2000).
Accounts receivable gross = collection period
Average sales per day
How to invigorate your accounts receivables (and staff)
1. Use part-time staff to supplement your staff;
2. Hire quality account representatives;
3. Invest in training;
4. Collection follow-up;
5. Consider a bonus for performance;
6. schedule collection work;
7. Use evening hours to work self-pay accounts;
8. Send confirmation of an oral contract;
9. Follow-up within 2 days of a broken promise to pay;
10. Offer installment-charge payments. (Denning, 2000)
When all collection efforts fail, it may be time to consider a more aggressive use of a collection agency or small claims court.
In conclusion, it running any business, it is important to know in which direction you re heading; to know on a day-to day basis your progress in that direction; to be aware of what our competitors are doing and to practice good money management at all times. This will prepare you to recognize potential problems before they arise. In order to survive, regardless of the economic climate, it is essential to surround yourself with smart people (a very informed accounts receivable staff) and to practice sound business management at all times.
Cleaver, J. (2000, November). Get your chargeoffs here. Credit Card Management, 13, 25-32.
Denning, J. (2000, December). How to reinvigorate your accounts receivable staff. Opthalmology Times .
Equade Internet ltd (2000). Cash Flow. Retrieved 5/17/01 from the World Wide Web: http://www.investopedia.com
Gross, J. (). The Revenue Cycle [On-line]. Available: http://bradley.edu
Lowes, R. (1998, June). "Show us the money!" How to make sure your fees are collected. (techniques for collecting accounts receivable). Medical Economics .
Marsh, J. (1999, August). What's behind those revenues? America's Network 18-20.
Murray, D., Neumann, B., Elgers, P. (2000). Analysis of Accounts Receivable. In (Ed.), Using Financial Accounting (2nd ed., p. 220). United States of America: South-Western College Publishing.
Piumelli, F. (2000, March). Trends and strategies: Transforming the future of credit and collections. Business Credit, 102, 23-26.
Reynes, R (1999, January). A Big Factor in Expansion (selling accounts receivable for a fee). Nation's Business, , .
Reynes, R. (1999, January). A big factor in expansion (selling accounts receivable for a fee is a source of cash for small businesses). Nation's Business .
Uncollectible accounts policy. (2000). Retrieved 5/17/01 from the World Wide Web: http://www.investopedia.com
Wallis, L. (2001, March). Credit scoring: The future of decisioning in the a/r process). Business Credit.