Accounts receivables (also properly termed as receivables) constitute a significant portion of the total currents assets of the business next after inventories. They are a direct consequences of “trade credit” which has become an essential marketing tool in modern business.
When a firm sells goods for cash, payments are received immediately and, therefore, no receivables are credited. However, when a firm sells goods or services on credit, the payments are postponed to future dates and receivables are created. Usually, the credit sales are made on open account, which means that, no, formal acknowledgements of debt obligations are taken from the buyers. The only documents evidencing the same are a purchase order, shipping invoice or even a billing statement. The policy of open account sales facilities business transactions and reduces to a great extent the paper work required in connection with credit sales.
Meaning of Receivables
Receivables are assets accounts representing amounts owed to the firm as a result of sale of goods / services in the ordinary course of business.
They, therefore, represent the claims of a firm against its customers and are carried to the “assets side” of the balance sheet under titles such as accounts receivables, customer receivables or book debts. They are, as stated earlier, the result of extension of credit facility to then customers a reasonable period of time in which they can pay for the goods purchased by them.
Accounts receivables are created because of credited sales. Hence the purpose of receivables is directly connected with the objectives of making credited sales.
The objectives of credited sales are as follows:
- Achieving growth in sales: If a firm sells goods on credit, it will generally be in a position to sell more goods than if it insisted on immediate cash payments. This is because many customers are either not prepared or not in a position to pay cash when they purchase the goods. The firm can sell goods to such customers, in case it resorts to credit sales.
- Increasing profits: Increase in sales results in higher profits for the firm not only because of increase in the volume of sales but also because of the firm charging a higher margin of profit on credit sales as compared to cash sales.
- Meeting competition: A firm may have to resort to granting of credit facilities to its customers because of similar facilities being granted by the competing firms to avoid the loss of sales from customers who would buy elsewhere if they did not receive the expected output.
The overall objective of committing funds to accounts receivables is to generate a large flow of operating revenue and hence profit than what would be achieved in the absence of no such commitment.
Costs of Maintaining Receivables
The costs with respect to maintenance of receivables can be identified as follows:
- Capital costs: Maintenance of accounts receivables results in blocking of the firm’s financial resources in them. This is because there is a time lag between the sale of goods to customers and the payments by them. The firm has, therefore, to arrange for additional funds top meet its own obligations, such as payment to employees, suppliers of raw materials, etc., while awaiting for payments from its customers. Additional funds may either be raised from outside or out of profits retained in the business. In both the cases, the firm incurs a cost. In the former case, the firm has to pay interest to the outsider while in the latter case, there is an opportunity cost to the firm, i.e., the money which the firm could have earned otherwise by investing the funds elsewhere.
- Administrative costs: The firm has to incur additional administrative costs for maintaining accounts receivable in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of conducting investigation regarding potential credit customers to determine their creditworthiness, etc.
- Collection costs: The firm has to incur costs for collecting the payments from its credit customers. Sometimes, additional steps may have to be taken to recover money from defaulting customers.
- Defaulting costs: Sometimes after making all serious efforts to collect money from defaulting customers, the firm may not be able to recover the overdues because of the of the inability of the customers. Such debts are treated as bad debts and have to be written off since they cannot be realized.
Factors Affecting the Size of Receivables
The size of the receivable is determined by a number of factors. Some of the important factors are as follows:
1. Level of sales:
This is the most important factor in determining the size of accounts receivable. Generally in the same industry, a firm having a large volume of sales will be having a larger level of receivables as compared to a firm with a small volume of sales.
Sales level can also be used for forecasting change in accounts receivable.
2. Credit policies:
The term credit policy refers to those decision variables that influence the amount of trade credit, i.e., the investment in receivables. These variables include the quantity of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. A firm’s credit policy, as a matter of fact, determines the amount of risk the firm is willing to undertake in its sales activities. If a firm has a lenient or a relatively liberal credit policy, it will experience a higher level of receivables as compared to a firm with a more rigid or stringent credit policy.
This is because of two reasons:
- A lenient credit policy encourages even the financially strong customers to make delays in payments resulting in increasing the size of the accounts receivables;
- Lenient credit policy will result in greater defaults in payments by financially weak customers thus resulting in increasing the size of receivables.
3. Terms of trade:
The size of the receivables is also affected by terms of trade (or credit terms) offered by the firm.
The two important components of the credit terms are:
- Credit period: The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of “net days”.
- Cash discount: Most firms offer cash discount to their customers for encouraging them to pay their dues before the expiry of the credit period. The terms of the cash discounts indicate the rate of discount as well as the period for which the discount has been offered.
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