Receivable Management I Introduction - Working Capital Management

Accounts receivable present the amount due from its customers to whom the company has extended credit. In the modern world, the extension of credit is inevitable and most of companies have to offer the credit to maintain the existing level of sales. Also to improve the sales performance, the company may be required to change the terms of its credit.

For most of the companies, investment in accounts receivable constitutes a major component.

When a company sells on credit, it does not get cash at the time of sale, while during the process of manufacturing, it has already spent money to pay for labour, raw material and other expenses, therefore, the company has to find out source of financing which would provide funds to finance that transaction for the time period for which credit has been granted (i.e. difference between date of sale and date of realization). It is in this sense that accounts receivable imply investment and involve certain costs.

This investment in accounts receivable is an important aspect which requires careful management. Besides the cost of investment, there are two types of risks which are associated with the accounts receivable management. One is the risk of opportunity loss and the other liquidity risk. The firm has to extend the credit to its customers to generate enough sales. The grant of credit is an important tool to realize the operating plans and budgets of the company. But at the same time, management has to see that the company has not extended too much of credit to its customers which has resulted in high degree of liquidity risk. By liquidity risk, we mean the ability to collect back the amounts due from the customers. This would happen if the company extends the credit to customers whose financial position is doubtful or weak and subsequently the funds tied up with them are recovered after a long period or they are not all realized. If this happens, it would result into the company’s ability to meet its own obligations and thus affecting short-term and long-term solvency of the company.

The decision to extend the credit to its customers also determines the timing and amount of cash flows accruing to the company. At the same time, minimization of liquidity risk would imply the risk of opportunity loss of sales by refusing the credit to its potential customers. This would further affect the loss of revenue and the loss of profit. Thus, the objective of accounts receivable management is to arrive at an optimum balance of these two risks and help the company to realize its operating plans. This balancing is not a static but a dynamic one. To arrive at the balance of these two risks, the company would frequently require to adjust their credit policies. Management of the company would also be required to consider general economic conditions while making such adjustments.

The management of accounts receivable broadly involve the following steps:

  • Firstly, management has to decide to whom the company should sell its products on credit. This would require the development of the credit standards. In this regard, the company has to analyze the contribution of marginal accounts towards the profitability of the company and also whether the company should hold the policy of extending the credit to such accounts.
  • Secondly, what are the factors the company should take into account while analyzing the potential customers who are interested in availing the credit facility of the company. How to draw upon the customer’s past records or his past financial statements? What are the other sources of information which one can use in such analysis have to be settled?
  • Thirdly, the company has to determine the terms on which the company would be interested in selling the goods. How long the company should allow its customers to pay their bills? Should the company allow any cash discounts to its customers to motivate them to pay promptly? What should be the discount rate and discount period? What should be the extent of credit unit to each customer or group of customers? This would require the development of credit terms for each customer or group of customers.

Once the decision to grant the credit has been implemented, what should be the collection policy of the company? How would the company monitor its accounts receivable and subsequently control them? Are some other questions of concern? In brief, the concerns of the company in managing the accounts receivable would be the following 4Cs: Credit Standards, Credit term analysis, Control and Monitoring.

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