Accounts Receivable Management

Meaning of Accounts Receivables

When goods and services are sold under an agreement permitting the customer to pay for them at a later date, the amount due from the customer is recorded as accounts receivables; So, receivables are assets accounts representing amounts owed to the firm as a result of the credit sale of goods and services in the ordinary course of business. The value of these claims is carried on to the assets side of the balance sheet under titles such as accounts receivable, trade receivables or customer receivables. This term can be defined as “debt owed to the firm by customers arising from sale of goods or services in ordinary course of business.”

Accounts Receivable Management

According to Robert N. Anthony, “Accounts receivables are amounts owed to the business enterprise, usually by its customers. Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed by customers, and the latter refers to amounts owed by employees and others”.

Generally, when a concern does not receive cash payment in respect of ordinary sale of its products or services immediately in order to allow them a reasonable period of time to pay for the goods they have received. The firm is said to have granted trade credit. Trade credit thus, gives rise to certain receivables or book debts expected to be collected by the firm in the near future. In other words, sale of goods on credit converts finished goods of a selling firm into receivables or book debts, on their maturity these receivables are realized and cash is generated.

The customer who represent the firm’s claim or assets, from whom receivables or book-debts are to be collected in the near future, are known as debtors or trade debtors. A receivable originally comes into existence at the very instance when the sale is affected. But the funds generated as a result of these ales can be of no use until the receivables are actually collected in the normal course of the business. Receivables may be represented by acceptance; bills or notes and the like due from others at an assignable date in the due course of the business. As sale of goods is a contract, receivables too get affected in accordance with the law of contract e.g. Both the parties (buyer and seller) must have the capacity to contract, proper consideration and mutual assent must be present to pass the title of goods and above all contract of sale to be enforceable must be in writing. Moreover, extensive care is needed to be exercised for differentiating true sales form what may appear to be as sales like bailment, sales contracts, consignments etc.

Receivables, as are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied up in trade debtors. Hence, a great deal of careful analysis and proper management is exercised for effective and efficient accounts receivable management to ensure a positive contribution towards increase in turnover and profits.

Purpose of Accounts Receivable Management

The basic purpose of accounts receivable management is to determine effective credit policy that increases the efficiency of firm’s credit and collection department and contributes to the maximization of value of the firm. The specific purposes of receivable management are as follows:

  1. To evaluate the creditworthiness of customers before granting or extending the credit.
  2. To minimize the cost of investment in receivables.
  3. To minimize the possible bad debt losses.
  4. To formulate the credit terms in such a way that results into maximization of sales revenue and still maintaining minimum investment in receivables.
  5. To minimize the cost of running credit and collection department.
  6. To maintain a trade off between costs and benefits associated to credit policy.

Controlling Accounts Receivables

The investments in accounts receivable should be within accepted level. To achieve this, control measures are needed so that when actuals fall outside the prescribed range, corrective actions can be taken. In controlling accounts receivables certain techniques are adopted. Three such techniques are described below. These are: Debtors turnover ratio, Debtors velocity and Age of debtors.

  1. Debtors Turnover Ratio (DTR) refers to ratio of sales to accounts receivable (Sundry debtors plus bills receivables). The accounts receivable may be closing figure, or average of year beginning and year-end figures or average of monthly opening and closing figures. An acceptable range for the ratio be fixed. Say a DTR of 5 to 6 times is fixed as ideal. When the actual ratio is within this band, it is all right. If the actual DTR is less than 5, it means more money’s locked up in accounts receivables. Either sales have slumped relative to size of debtors, or debtors have risen relative to sales. If the ratio exceeds the upper band, it means customers promptly pay willingly or by out offeree. However, if more sales can be booked through relaxation should be considered.
  2. Debtor’s velocity refers to how many days’ sales are outstanding with the customers. This is given by: Accounts receivables/Per day credit sales. In fact, debtors’ velocity indicates the average collection period (ACP). If the ACP is hovering around the credit period allowed, every thing is fine. If it exceeds the credit period allowed, it signals snag in our collection, or unattractiveness of cash discount allowed, which should be corrected. If ACP is less than credit period allowed, it can be considered as good, but behind it a very stingent collection policy or very liberal cash discount facility might be there. The exact cause and the desirability of its continuation needs to be examined. Debtors’ velocity can be computed by: Number of working days in the year/DTR.
  3. Age of debtors refers how long debts are outstanding. Say 10% of accounts receivable is 6 months old, 15% is 5 months old, 25% is 4 months old, 25% is 3 months old, 15% is 2 months old and 10% is 1 month old. The average  age of debtors comes to: ΣWiAi, Where Wi is proportion and Ai is age in months. = .6 + .75 + 1.00 + .75 + .3 + .1 = 3.5 months. An ideal breakup of accounts receivables can be established and actual position is monitored accordingly. The ideal average age and actual average age on accounts receivables can be compared and control is exercised and accounts receivables.

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