When businesses sell products or services to customers, the proceeds or payments for those products and services are known as accounts receivable. In other words, accounts receivable represents the cash owed to the business for the products or services purchased by customers, essentially on credit.
In the majority of businesses, accounts receivable is carried out by generating an invoice that is sent to the customer, either electronically or through the mail. Then, the customer is expected to pay the invoice within a predetermined amount of time, known as the credit terms or payment terms. This process is facilitated by a business’s accounts receivable department using a sales ledger, which records all sales of goods and services made by the business, the amount of money received for those sales, and the amount of money owed by customers, or debtors, at the end of each month.
There are two approaches available to companies for measuring the net value of accounts receivable. Typically, this value is calculated by taking the balance of an account receivable account and subtracting the balance of an allowance account.
Under accrual accounting, a firm can recognize revenue when it has:
There are three steps a company must undergo when developing a credit policy:
Another important factor in determining credit standards involves a company evaluating the creditworthiness, or credit score, of an individual or business. This refers to the risk that the buyer will default on extended credit by failing to make payments which it is obligated to do. When ascertaining risk, possible losses include both the selling price as well as potential disruptions to cash flows and additional collection costs. Actions that can be taken by a seller to mitigate risk include performing a credit check on the buyer or requiring collateral against credit offered.
Some common types of discounts include:
Often, credit terms are quoted as “net X,” where X represents a specific number of days. The number of days of the credit term includes transit time of the purchase.
EXAMPLEA common credit term is “Net 30,” which translates to the payment being due 30 days from the invoice’s issue date. If a customer purchases an item and this item take seven days to arrive, the payment is due to the seller in 23 days, because those seven days of transit time were subtracted from the Net 30 credit term.
While Net 30 is the most widely used credit term for businesses and municipalities (federal, state, and local) in the United States, other common payment terms include Net 10, Net 15, Net 45, Net 60, and 30 days end of month. It should be noted that Net 60 is less commonly used because it reflects a longer payment term.
Now, a debtor has the option of paying before the due date, and some businesses will offer a reward in the form of a discount for such early payment, stated, for example, as “2/10, Net 30.” This means the buyer would benefit from a 2% discount if they choose to pay by the 10th day instead of the 30th. Otherwise, they would simply pay the full amount in 30 days.
In this scenario, the operator has the entire term of 60 days to pay the invoice in full. If the operator has a good week with robust sales, they can make a partial or full payment towards the invoice amount, making an extra 20% on the ice cream sold in the process. On the other hand, if the operator experiences a bad week of sales - contributing to a month of low cash flow - then they may opt to pay the invoice within 30 days, which garners the 10% discount, or simply wait the full 60 days to pay the invoice, which allows them use of the funds for an additional 30 days.
The ice cream distributor has similar options, because they receive trade credit from companies that supply the milk and sugar, under terms of Net 30, with a 2% discount if paid within 10 days. In this situation, it appears that they would be taking a loss in this complex network of trade credit balances. Why would the distributor do this? There are several reasons.
- They apply a considerable markup to the cost of the ingredients and other production costs associated with the ice cream sold to the operator, an amount that equates to the part of the selling price that is added to the cost of acquiring the inventory.
- It is in the best interest of the distributor for its customers to stay in business, as opposed to failing due to cash flow instabilities. In this manner, the financial terms at play in this situation strive to enable start-ups to manage their inventory investments, which essentially translates to providing them with a short-term business loan. It also allows the distributor to identify potential problems by tracking which customers pay, so they can, in turn, act accordingly to decrease or increase its amount of trade credit.
Collecting upon accounts receivable is the final step in the credit extension process, and arguably the most difficult.
|Accounts Receivable Days||
The accounts receivable days is the average number of days that it takes a firm to collect on its sales. By comparing this number to the number in the credit policy, a business can determine whether its policy is effective or not. The accounts receivable days are important because investors utilize this measure to evaluate a firm’s credit management policy.
This method does have its weaknesses. Seasonal sales patterns may cause accounts receivable days to change depending on when the calculation occurs. Therefore, management can potentially manipulate accounts receivable days to hide important information.
The other method commonly used is an aging schedule which categorizes accounts by the number of days they have been on the books. It can be constructed in one of two ways: using the number of accounts or using the dollar amount of the outstanding accounts receivable. If the percentages in the lower half of the schedule begin to increase, the firm needs to evaluate the effectiveness of its credit policy.
Payment patterns provide information on the percentage of monthly sales that the firm collects each month after the sale. The payment pattern can be used to forecast the working capital needs for the business.
|Receivable Turnover Ratio||Another way to evaluate a credit policy is to look at the receivable turnover ratio. This is a financial ratio that measures the number of times, on average, receivables are collected during a period.|
There are many kinds of collection agencies, the majority of which act as agents of creditors and collect debts, charging a fee or percentage of the total amount owed. One type, first-party agencies, are often a subsidiary of the company to whom the debt is obligated. Another type is third-party agencies, who are distinct companies that a business contracts on their behalf for a fee, to collect the money owed.
A company may protect against bad-debt losses by purchasing trade credit insurance. This is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their accounts receivables from loss due to credit risks like protracted default, insolvency, or bankruptcy.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Accounts Receivable” TUTORIAL.