Accounts Receivable-The Risk of Granting Credit

Accounts Receivable-The Risk of Granting Credit

Accounts Receivable (A/R) is money yet to be received for goods sold or services rendered. There are several reasons why a company will allow those purchasing their widgets to pay at a later date.

One of the most famous philosophers, Wimpy always wanted to get a hamburger on credit and was willing to pay back on Tuesday. The burger joint owner could either choose to sell his goods today and reduce inventory or wait to sell the goods. Inventory turnover is always something to consider when selling goods or services on credit especially if the inventory has a shelf life. Inventory turnover, which includes raw materials, is very important in the business cycle; it keeps the entity running daily at a high efficiency, which improves margin.

Receivables are found on almost every business's balance sheet. And there is a matching entry for this on the income statement in the revenue's account. Goods are sold on credit and the sale is accounted for in the period, and an A/R is generated. A/R is reduced when the money received for the invoice is paid and cash is credited.

Some companies produce goods and rarely take in cash at the time of the sale. Most periodicals and newspapers are given out on credit to news agencies and book stores. Larger capitalized corporations utilize credit to increase margin; floor plans at car dealerships are an example of this. The local dealer takes possession of the vehicles so that they have inventory to sell to customers and pays interest back to the manufacturer until the vehicle is sold. Could a car dealership and their manufacturing company sell as many cars if someone could not drive off the lot with one? The answer is probably not. The more widgets that are sold, the greater the profit margin because fixed costs stay relatively the same; and as the company passes the breakeven point, the net margin of the business steadily increases with more widgets sold.

Every time credit is extended to existing and new customers there is a risk that the invoice may not be paid. This is true even for existing customers that have paid on time for years. There are many reasons why a business may fail, and receivables are not likely to be collected in liquidation. Most invoices are 2/10 net 30, which means that there is a 2% discount for payment within 10 days and the invoice is due without interest in 30 days. As accounts pass the repayment period, they become aging receivables; usually a charge of 1.5% per month of the invoice is added to the amount owed. While this interest receivable does add up with customers who are considered slow pay, the business owner would rather have the cash sooner than later.

A way to improve cash flow and keep the business cycle pounding forward is to borrow money from the bank based on the amount of receivables outstanding at any given time. The bank may lend 50-80% of the eligible receivables to allow the business access to cash to continue to fund the business cycle. Certain receivables may be disqualified because of their current age, generally over 90 or 120 days. Each month a new A/R report is analyzed by the bank and the amount borrowed may be reduced if the amount of A/R falls below the minimum advance rate. The bank wants to protect the assets that are loaned to the business by only advancing a certain percentage of eligible receivables; this is because the bank knows that not all of the receivables are collectable.

Collecting on receivables is very complex. No one knows if a customer with satisfactory repayment history will be able to pay tomorrow. And how does a Financial Controller or similar party know if the new customer coming in the door will even pay their first invoice. Because of this, internal controls are set up with parameters to help control the risk of nonpayment. Based on the age of the receivable, a certain portion is set aside and reduces the amount of A/R; these are accounted for on the balance sheet by being placed in the Allowance for Bad Debts account. The formula calculates the amount of receivables and the age of the receivables. It is impossible to determine who isn't going to pay, so the formula gives management the ability to work with a somewhat accurate number. The matching of this balance sheet entry goes to the Bad Debt Expense on the income statement.

If all else fails and an account can not be collected upon, the account is most likely written off and sent to a professional collection agency to improve the probability of the account being collected. Managing receivables is a very difficult. Management needs to evaluate the risk in improving margin versus the ability to collect. Constant supervision of the accounts as they age is very important. So is it a wonder that Wimpy never actually got to get a hamburger 2/10 net 30?

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