LOS 7 Monitoring Accounts Receivable

1. LOS 7Monitoring Accounts Receivable Learning Outcome Statement (LOS) understand why we need to monitor accounts receivable identify the biasness in simple measures of receivable turnover discuss about the better tools for monitoring accounts receivable understand why we need to monitor bad debt losses discuss about the management of accounts receivable in practice

2. Why Monitor Accounts Receivable? • A/R is a major investment, and the continuous assessment of the state of A/R is a necessary function in the financial management of the firm. Monitoring is intended to fulfill this assessment function. • The firm has expectations regarding the turnover of A/R and the amount of bad debt resulting from it. If these expectations are not fulfilled, this is a signal to management that the assumptions used in making the firm’s terms-of-sale and credit-granting policies may be faulty, or these policies are not being implemented properly. • Quite often, businesses have failed not because they weren’t profitable, but because they weren’t collecting on sales and their cash flows were inadequate.

3. Why Monitor Accounts Receivable? • The A/R of a company are sometimes examined in order to determine if the company is in financial trouble, or simply suffering from an inadequate cash flow due to a lack of receivables collections. 

4. Why Monitor Accounts Receivable? • Deviations from the expected levels of turnover and of bad debt can signal several different problems. Three of these problems are - • Changing Customer Payment Characteristics – the A/R manager deals with a constantly changing portfolio of receivables as customers pay invoices, and sales are made. Because of the rapid maturation of these assets in this portfolio, changes in the firm’s customers or in economic and competitive conditions can impact receivables with remarkable suddenness. • Inaccurate Policy Forecasts – there is substantial uncertainty in estimating bad debt, A/R turnover, and other relevant variables. • Improper Policy Implementation – if the implementation is faulty, shareholder wealth will not be maximized. Difficulties in the implementation of policies may stem from problems in communicating the policies to employees, from inappropriate evaluation of employees relative to these policies.

5. Why Monitor Accounts Receivable? • Monitoring provides signals of deviations from expectations. When a signal is detected, it is up to managers to investigate and to assess the reasons for deviation. • The managers must then take the necessary corrective action, and the type of action will vary with the cause of the deviation. However, if the problem is in implementation, the firm’s managers need to assess why the firm’s policies are not being executed. • In any case, both positive and negative deviations in A/R statistics need to be investigated, since deviations in either direction signal differences from the results that management believe to be the most advantageous for the firm.

6. Why Monitor Accounts Receivable? • The monitoring process is a comparison of expectations and outcomes. Within the firm, these expectations are captured in the form of budgets, which detects the deviations from policy. • Some of the deviations from budgeted figures will represent one or more of the problems outline previously, while others will represent random events. For example, a delay in the receipt of some customer checks might be due to a strike of postal employees (a random event), and not due to any factors controllable by the selling firm. • The task of monitoring A/R is to signal nonrandom deviations from the budgeted receivables statistics.

7. Collection Policy • Collection refers to obtaining payment on past-due accounts. • Collection policy is composed of: • Firm’s willingness to extend credit – reflected in the firm’s investment in receivables. • Collection effort

8. Collection Effort • Most firms follow a protocol for customers that are past due: • Send a delinquency letter • Make a telephone call to the customer • Employ a collection agency • Take legal action against the customer • Potential for a conflict of interest. • Strike a balance.

9. Methods for Monitoring Accounts Receivable • Two common methods of receivables’ monitoring are: • Days sales outstanding (DSO) and • Aging fraction statistics. • Unfortunately both of these approaches are seriously flawed. For example, when sales vary over time, both days’ sales outstanding and aging fractions will give inappropriate signals.

10. Methods for Monitoring Accounts Receivable Days Sales Outstanding (DSO) • DSO indicates the average length of time it takes the firm to collect for credit sales. • A low DSO number means that it takes a company fewer days to collect it’s A/R. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.

11. Methods for Monitoring Accounts Receivable Days Sales Outstanding (DSO) • Due to the high importance of cash in running a business, it is in a company's best interest to collect outstanding receivables as quickly as possible. • By quickly turning sales into cash, a company has the chance to put the cash to use again – ideally, to reinvest and make more sales. • The DSO can be used to determine whether a company is trying to disguise weak sales, or is generally being ineffective at bringing money in. For most businesses, DSO is looked at either quarterly or annually.

12. Methods for Monitoring Accounts Receivable Aging Fractions • The aging fractions show the receivables by age of account. The longer an account has been unpaid, the less likely it is to be paid. • The aging fractions are computed by dividing the outstanding receivables of a particular age by the total receivables balance at the end of that month.

13. Aging Schedule

14. Aging Fractions • Thanks now to the extensive use of computers, aging A/R reports are available with the click of a button.  • Standard reports can be generated that will detail customer information, ship dates, invoice dates, and payment due dates.  • Outstanding or aging accounts are readily noted and can be contacted for immediate payment arrangements.

15. Better Tools for Monitoring A/R • Because of the way they compare sales and receivables, DSO and aging fractions give the proper signals of receivables movement only in the special case where sales exhibit no fluctuations over time. • While managers might try to judgmentally adjust DSO or aging fraction figures to reflect these inaccuracies, it would be very hard for them to know how much adjustment is necessary. • A more appropriate approach is to use a tool that is not subject to distortions caused by sales fluctuations.

16. Better Tools for Monitoring A/R • Three such tools are: • Ratios of receivables outstanding to original sales • Customer’s payment proportions • Sales-weighted DSO • All these three methods do a much better job than aging fractions or traditional DSO in monitoring payment behavior since they do not give false signals when no deviations from the expected payment pattern have occurred and do give proper signals when such deviations have actually occurred.

17. Ratios of Receivables Outstanding to Original Sales • Here receivables outstanding at any particular time are compared only to sales in the period during which the receivables were generated. • The ratios of receivables outstanding are computed by dividing the receivables outstanding from a particular month by the sales from that month. • This gives a true picture of receivables payment behavior.

18. Customer’s Payment Proportions • The payment proportions figures are computed as the proportion of a month’s sales that are collected in the month being analyzed. • The payment proportions figures are calculated by comparing changes in receivables balances with sales for the month during which the receivables originated.

19. Sales-Weighted DSO (SWDSO) • SWDSO allows for fluctuations in sales by weighting the receivables balances by the sales incurred in the month during which the receivables were generated. • The SWDSO can be calculated as: SWDSO =  (ARt/St) (30 days/month) where t is the month of sale, n is the number of months for which receivables are outstanding, ARt is the outstanding A/R balance from month t, and St is the sales in month t.

20. Deciding Which Method to Use in Monitoring Collections • In prior sections, we had discussed five monitoring methods: traditional DSO, aging fractions, ratios of receivables outstanding, payment proportions and the sales-weighted DSO (SWDSO). • While the first two methods can be inaccurate in their measurement of payment behavior, other arguments are sometimes made in their favor. Typical arguments for these methods include: • They are simple to compute • Industry figures are reported – particularly with regard to DSO – giving management some standard of comparison in assessing trends in the payment behavior of customers.

21. Deciding Which Method to Use in Monitoring Collections • However, none of these arguments hold much weight. Regarding the first, the additional effort necessary to compute performance statistics for more accurate methods is very small. The second argument would be important only if the firm was limited to the computation of one measure of payment behavior. • However, there is no reason that the firm cannot use an accurate measure of payment behavior to assess its own patterns of receipts and another measure to compare this behavior to published figures. • The choice of receivables monitoring methods for internal control purposes is then among the more accurate methods: ratios of receivables outstanding, payment proportions and the sales-weighted DSO (SWDSO), and other similar measures.

22. Deciding Which Method to Use in Monitoring Collections • Each of these measures has advantages and disadvantages. • Measures such as ratios of receivables outstanding and payment proportions include payment performance via a series of numbers, while SWDSO is a single-number measure. Therefore, SWDSO is simpler to interpret. • However, this single-figure may hide deviations from expectations among the collection rates from the various sales periods.

23. The Management of A/R in Practice • Interestingly, there is a substantial divergence between the techniques displayed in the academic literature and those commonly used in credit management. Some of the techniques discussed in this LOS are extensively used, while others have not yet been widely adopted. • The prevalence of trade credit in the sale of goods – vast majority of manufacturing output is sold via trade credit. • Terms-of-Sale Decisions – most firms simply utilize the traditional terms-of-sale in their markets. When competitors change terms, other sellers typically will “follow the leader.”

24. The Management of A/R in Practice • Credit Investigation Policies – larger firms collect more information in making credit-granting decisions on larger orders. • Credit-Granting Decisions on Marginal Accounts – firm’s usually use the traditional “5 C’s of Credit” to make judgmental decision on credit applicants, though a substantial fraction use some type of credit-scoring approach. • Monitoring A/R – published survey results from the mid-1970s showed aging fractions to be the most popular method of monitoring customer payment patterns at the time.