Section C2d) of the Financial Management study guide states that students should be able to ‘discuss, apply and evaluate the use of relevant techniques in managing accounts receivable’. Further detail of what is required is then given in six sub-sections.
While this article aims to assist students in this area, it does not intend covering ground which has already been covered in previous articles. Hence, for full coverage of this syllabus area students, should also read the following Financial Management technical articles:
There are three key areas of accounts receivable management.
These key areas will now be explored in more detail.
The methods a company could use to assess the creditworthiness of a customer or a potential customer include:
As soon as a customer is given credit, the credit terms of the company should be explained to them. For instance, the normal credit period granted and any discount for prompt payment, or interest charged on late payment, should be explicitly detailed to the customer. Very often, the credit terms a company adopts are the terms that are most common in its trade.
To use something different can cause problems as customers will be expecting, and are likely to take, what is normal in the trade. Having said that, variations within a trade do occur and, indeed, a company may well offer different terms to different customers, depending on the credit rating of each customer and their relationship with each customer.
Initially, a suitable credit limit should be set for each customer. This credit limit should only be allowed to grow slowly as your faith in the customer grows and all attempted breaches of the credit limit should be brought to the attention of the credit controller or other responsible person. It should be remembered that a common trick of an unethical company is to find a new supplier, make a small order and pay for it promptly. A large order is then made and, having taken delivery of this order, the customer delays payment for a significant time.
The accounts receivable should be continuously monitored. In order to do this a number of reports are useful:
Taken together, these reports show how exposed a company is to its accounts receivable. In larger organisations, customers may be classified by trade and country as it is then possible to evaluate exposure by both country and trade. Larger businesses may also create their own in-house credit ratings for their customers.
Whether or not the basic credit terms offered by the company are suitable should be regularly reviewed. There is no point offering unnecessarily long periods of credit – however, equally, a company may find that extending its credit terms leads to an increase in sales. Any alteration in credit terms could be evaluated using the techniques demonstrated in the aforementioned ‘Receivables collection’ technical article.
It may seem very obvious, but if cash is to be collected, then the customer must be invoiced. It is essential that the invoice is sent out quickly and accurately. The receipt of your invoice is the first indication a company gets of the efficiency of your debt collection system. If the invoice takes a long time to arrive and is not accurate, then your accounts receivable department will be viewed as inefficient and customers may seek to exploit this perceived weakness and delay payment.
Furthermore, if an invoice is inaccurate some customers will take this as an opportunity to claim that there is a dispute on the account and, therefore, stop payment of all invoices until the dispute is resolved.
Having sent out the invoice quickly and accurately, the methods a company could use to ensure customers pay in a timely fashion include:
Many larger businesses have their own in-house debt collection departments that can be used before external debt collection agencies are used or legal action is taken. There have been instances where companies recently suffered reputational damage. They had branded their in-house debt collection departments in such a way that the customer believed that it had been referred to an external debt collection agency and, hence, was scared into making payment.
Two key methods of speeding up cash collection from accounts receivable are using factoring and using early settlement discounts. Students should be conversant with these methods and their advantages and disadvantages.
Furthermore, a common exam question requires students to evaluate, in ‘$’ terms, the net benefit or cost of a proposed new debt collection policy. All of these areas are covered in the aforementioned ‘Receivables collection’ technical article.
Additionally, a question (potentially a multiple-choice question) could require the calculation of the percentage cost of offering an early settlement discount. This is best explained through an example.
Example
A company offers its customers 30 days credit but, at present, customers are taking an average of 41 days credit. In order to speed up cash collection, the company is considering introducing a 1% discount for payment within 10 days. The company finances its working capital requirement using an overdraft at an annual cost of 9%.
Required – Calculate the annual cost of offering the discount and evaluate whether or not the discount should be offered.
Solution
Let us assume a customer has purchased goods and has been invoiced $100. If the customer takes the discount, then the company will receive $99 in 10 days rather than $100 in 41 days. This is like the company borrowing $99 from the customer for 31 days (41 – 10) and paying $1 interest. Therefore, the 31-day interest rate is 1/99 x 100%. This needs to be compounded up to an annual rate in the following way:
(1 + 1/99)(365/31) – 1 = 0.126
Therefore, the annual cost of offering the discount can be said to be 12.6%.
If the discount is not offered, the company will be borrowing more on its overdraft while it waits for the customer to pay.
As the cost of borrowing on the overdraft is only 9%, the discount proposed is more costly and should not be offered.
Please note how the 30 days credit offered is not relevant in the calculations. Such additional information, which is not required, can be given in questions, especially multiple-choice questions where it is called a distractor. The use of distractors is a good way of testing who is really certain and confident in their knowledge.
The calculations above have been carried out from the point of view of the supplier. A question could also look at the same issue from the point of view of the customer and ask for a calculation of the customer’s cost of refusing the discount.
Students should note that:
The customer’s cost of refusing the discount = the supplier’s cost of offering the discount
Hence, in the above example, if a customer were to refuse the discount, the cost to it would also be 12.6%. If the customer is to accept the discount, then this will often require it to borrow extra funds in the form of an overdraft in order to make the early payment. We can assume that the customer’s overdraft rate is the same as the supplier’s rate of 9%. This is a reasonable assumption, as if both companies are operating in the same economy their overdraft rates are likely to be similar.
Therefore, the customer has a choice of refusing the discount at a cost of 12.6% or accepting the discount at a cost of 9%. Hence, the discount is attractive and should be accepted.
The above calculations have demonstrated a key problem with settlement discounts. As in this example, if the discount is attractive to the customer it may well be too costly to the supplier. It is also the case that a discount which is attractive to a supplier may well be too costly for the customer.
The formula to remember for calculating the cost of offering or refusing a discount is:
(1 + D/(100 – D))(365/t) – 1 x 100%
Where: D = the discount (2% = 2 etc.)
t = the period by which the payment is advanced if the discount is taken
Invoice discounting is another method a company can use to speed up the receipt of cash from its receivables. If a company is short of cash, it can approach an invoice discounter who will lend cash against the security of one or a few invoices that customers have still to pay.
For instance, the invoice discounter may advance 75% of the outstanding amounts. In some invoice discounting deals, the invoices/debts are legally sold to the invoice discounter and in others they are not. When the customer finally pays, the invoice discounter recovers the amount lent and also receives interest and charges.
Confidential invoice discounting is where the customer is not aware of the discounting arrangement and, as long as they pay their debt, they will never become aware of it.
Therefore, invoice discounting is similar to factoring in the way that the finance is provided and, indeed, many factoring companies will also provide invoice discounting services. However, with invoice discounting the company continues to run its own sales ledger. Additionally, while factoring is an ongoing arrangement, invoice discounting consists of one-off deals to cover temporary cash shortages.
Invoice discounting can be of particular use to SMEs who are starting to win contracts with large customers. While winning a contract with a large customer can be good news for a company, it can lead to cash flow problems. This is because the contract with the large customer is likely to involve sums that are very significant to the SME, and while large customers are generally reliable payers, they often only pay after a significant delay.
In combination with the other two articles highlighted, this article provides students with the core knowledge required in this frequently-examined syllabus area, which forms part of one of the core Financial Management topics. At all times it should be remembered that the costs involved in managing accounts receivable must be kept below the benefit received from granting credit to customers.
William Parrott is a freelance FM tutor and senior FM tutor at MAT Uganda