Management Decisions
6.5 Accounts Receivable Management
Many firms sell goods or provide services on a credit basis. Although firms grant credit to stimulate sales, they also incur costs when granting credit. One cost is the bad debt expense that the firm incurs if the customer does not pay. Another cost of granting credit involves the interim financing needed until the customer pays the account. As we discuss later in this section, firms should grant credit as long as the net cash flows (profits) from additional sales exceed the cost of carrying the receivables.
Firms generate accounts receivable when they sell goods or provide services on credit.
Trade credit is credit granted to other firms; consumer credit is credit granted to consumers.
Effective management of a firm’s accounts receivable is important because such receivables account for about one-sixth of the assets of US industrial firms. In this section, we consider many important aspects of accounts receivable management including the five Cs of credit, sources of credit information, credit scoring, collection policy, and optimal credit policy.
Five Cs of Credit
Credit analysts generally consider five factors when determining whether to grant credit including character, capacity, capital, collateral, and conditions.
• Character involves the customer’s willingness to pay off debts. It is usually the most important aspect of credit analysis. An applicant’s prior payment history is generally the best indicator of character.
• Capacity represents the customer’s ability to meet its obligations. Firms granting credit typically measure capacity by looking at the customer’s liquidity ratios and cash flow from operations. If meeting obligations from cash flow from operations appears weak, the credit granting firm may then look to the customer’s capital.
• Capital refers to the relative amounts of the customer’s debt and equity financing. Credit granting firms often consider the customer’s debt-to-equity ratio and times interest earned ratio.
• Collateral refers to the customer’s assets that are available for use in securing the credit.
The more valuable the collateral, the lower will be the credit risk.
• Conditions refer to the impact of economic trends that may affect the customer’s ability to repay debts. A firm that is marginally able to repay its debts in a normal or strong economy may be unable to do so during an economic downturn.
Sources of Credit Information
Firms obtain important credit information from both internal and external sources. Primary internal sources include a credit application with references, the applicant’s previous credit history, and information from sales representatives. External sources include recent financial statements, credit rating agencies such as Dun & Bradstreet Business Credit Services and credit bureau reports.
178 WORKINGCAPITALMANAGEMENTDECISIONS
Credit Scoring
Firms sometimes use credit scoring to assign a numerical rating for a customer based on the information they collected about the customer. The firm then bases its decision to grant or refuse credit on the numerical credit score. Credit scores for commercial firms are typically based on factors such as net worth, return on equity, operating cash flow, current ratio, and return on sales. The overall credit score for a firm is based on the individual factor scores and the weights applied to each factor. One method used to assign the factor weights is a statistical technique called multiple discriminant analysis (MDA).3 Firms usually design credit-scoring systems to give quick accept/reject decisions because they know that the cost of a single bad scoring mistake is usually rather small. Firms may have to reevaluate their credit scoring formula if bad debts increase.
Collection Policy
An important aspect of a firm’s collection policy involves the monitoring of its accounts receivable to detect troubled accounts and past-due accounts. Firms generally monitor their accounts receivable by tracking the receivables collection period (RCP) over time. We saw in Chapter 3 that RCP measures how many days a firm takes to convert accounts receivable into cash.4 Taking into account expected changes in the RCP due to seasonal fluctuations, firms look carefully for unexpected increases in the RCP. Unexpected increases are usually a cause for concern.
A common method used to monitor accounts receivable is an aging schedule. An aging schedule classifies the firm’s receivables by the number of days outstanding (the age of the receivable). It provides useful information about the quality of a firm’s receivables. Table 6.1 provides an example of an aging schedule.
3 For an example of multiple discriminant analysis used to predict bankruptcy, see Edward I. Altman, Corporate Financial Distress and Bankruptcy, John Wiley & Sons, New York, 1993.
4 Computing the receivables collection period involves dividing 365 by the receivable turnover ratio. See Equation 3.12 in Chapter 3 for more details.
Table 6.1 Aging schedule for accounts receivable
Age of account Receivable amount ($) Percentage of total value
0–10 days 130,000 43.3
11–30 days 100,000 33.3
31–60 days 50,000 16.7
61–90 days 15,000 5.0
More than 90 days 5,000 1.7
Total value 300,000 100.0
Table 6.2 Calculating the average age of accounts receivable
Age of account (in days) Percentage of total value Weighted average
[1] [2] [1] ××××× [2]
5.0 0.433 2.17
20.5 0.333 6.83
45.5 0.167 7.60
75.5 0.050 3.78
105.5a 0.017 1.79
Average age of accounts receivable = 22.17 days
a Assumes midpoint of receivables more than 90 days outstanding.
Table 6.1 shows that 76.6 percent of the firm’s accounts receivable have been outstanding for 30 days or less. If the firm allows 30 days for payment of credit sales, 23.4 percent of the receivables are past due. The firm would probably need to discover why so many of its outstanding receivables are past due. Are customers experiencing temporary financial diffi- culties? Are customers delaying payment because they are unhappy with the firm’s products or services? Which of these customers will eventually pay and which receivables will the company have to write off as a bad debt expense?
Another tool for managing accounts receivable is the average age of accounts receiv- able. One method for computing the average age of receivables is to compute the weighted average of all individual outstanding receivables. The weight for each individual receivable is the dollar amount of that receivable divided by the total dollar amount of outstanding receivables. Managers can simplify the calculation by assuming all receivables in a given class are at the midpoint of that class. For example, in the aging schedule shown above, all receivables outstanding 0–10 days would be assumed to be 5 days outstanding; all receiv- ables outstanding 11–30 days would be assumed to be 20.5 days outstanding, and so forth.
The manager then computes the weighted average of these midpoints with the weights calculated as the percentage of receivables in each range. Using this method, the average age of accounts receivable from the above aging chart would be 22.17 days.
Another way to monitor accounts receivable is to compute the bad debt loss ratio, which is the proportion of the total receivables that are not paid. An increase in the bad debt loss ratio increases the cost of extending credit. Equation 6.9 shows the bad debt loss ratio.
Bad debt loss ratio =
Bad debt expenses
Credit sales (6.9)
After identifying delinquent accounts, managers must determine the appropriate course of action. Some of the delinquent accounts may be with customers who have a long history of paying their bills on time. Other delinquencies may be with customers who do not intend to pay their bills. Many customers will fall somewhere between these two extremes.