In whatever business you operate in, you can’t be always on top of the game and know every detail. Nobody does. Yet, there are things that you need to keep fresh in mind when using tools crucial to your job. In a credit department these would be without a doubt accounts receivable.
They require discipline when selling to other companies. Yes, because they are usually a hell of a headache when you discover that your customers cannot or won’t pay you on due date.
So, how to treat accounts receivable? And how do they fit in your daily tasks? How can you use them to boost trade and exports?
Let’s see some of the most asked questions and help finding a satisfactory answer. We aim at fixing each concept to keep it easy and memorable.
Why Do Accounts Receivable Increase and are Negative on the Balance Sheet?
Accounts receivable are the invoices you issue to your customers, your buyers.
They are your current asset and you find them on your balance sheet. If these amounts increase, it means that you are giving something away now for cash you will receive at a later date. Thus a reduction of cash.
If you start getting the money for each account receivable, you increase cash. In double entry accounting this means you must reduce accounts receivable, your asset.
You should see every single transaction as based on debit and credit. An “in” and “out” process referring to that same transaction.
Accounts Receivable Like Boxes
Let’s say you sell one line of products at a time. Now, imagine having this product items sitting inside their individual boxes. Each box represents the obligation of the buyer you sell the product to pay you for that item. Each box is your customer.
When your sale occurs, you take it out of that box and send it to your buyer. That box is now empty but you register that sale as income.
So, the box now represents your buyer who has to replace the product with the money. This is a debt your customer has. For this reason you debit the associated account receivable. But, payment is not immediate. It’s deferred to a later date so there is no cash transaction yet.
Net Income and Cash Flow Statement talk to each other
When you sell you have revenues. But, selling costs you money. So, the Net Income is the difference between your revenues and any costs involving the sale of goods, expenses and taxes in one period, e.g. year.
In the Income Statement (or Profit & Loss, P&L) the Net Income increases only when you receive the cash for the goods you sold. For all the other sales where there was no money exchange, the Cash Flow Statement doesn’t register those transactions. Thus, the increase is the result from the difference between the Net Income and the accounts receivable.
Accounts receivables remain your assets until the equivalent cash materialises by hitting your bank account. It’s your stuff out there, in your customer’s hands. If there’s no cash, there’s no income. The boxes stay empty waiting for the cash.
What is Accounts Receivable Management?
It’s the process covering three key stages:
1) Credit check
You want to sell as much as possible, right? But, you also need to ensure your customers pay you. To do this you have to investigate about their ability to pay and if they deserve receiving credit.
If you don’t do this, bad debts will occur in the future after payments become overdue and you must be ready. So, you must carry out some checks to assess the buyer ability to pay and make sure there are no worrying signs of future troubles.
2) Credit granting / extension
Once you complete these checks you can decide to grant credit on specific terms. These will enable the buyer to get goods from you with a deferred payment plan. At the same time you track the account until you receive payment.
Here you reach the stage when time has come for your buyer to pay you. You need a rigorous system in place to track and enforce timely payment from customers. If you don’t have such system, or an approximate version of it, a chunk of your accounts receivable are likely to become outstanding.
These delays will cause you increasing costs of financing, DSO and reduction in profitability.
Always remember that “Cash is King”.
But, you can still play your cards close to your chest. For example, one option to reduce the inherent costs of collection is to use factoring. Another is offering discounts on early payments to customers, and they can both be useful.
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Factoring is selling your accounts receivables to a third-party firm which takes ownership and collects these invoices. Factoring is also called accounts receivable financing and plays a major role in the financing of businesses of any size, especially SMEs.
Again, if your company needs to boost its cash flow and can’t wait 30, 60 or even 90 days, you can opt for factoring the invoice. Instead of waiting for your customers to put their money back in the items’ box, it’s the factor doing it.
So, how does it work?
The factoring provider will assess your customer’s credit history and the industry you operate in. Then, it makes a cash advance to you of between 80% and 95% of the invoice face value minus fees.
The advantages of using factoring are many. You can factor invoices of almost any amount and acceptance is not down to your company’s credit history or performance. As said, it’s down to that of your customer’s.
Thus, you can reduce your collection efforts and costs. And you can access the factor services as you grow or need at any time. Finally, note that it’s not a bank loan. What you you’re doing instead is transferring title of ownership to the factoring provider by receiving cash for it.
In a way the factor is telling you: get this money, give the invoices and I’ll take care of the rest.
What is Discounts on Early Payments?
Following this last example let’s say you sold goods for $10,000 on Net 60 payment terms. Even if this is one of your best terms, you still have to finance your working capital.
Your bank charges you an 9% for using an overdraft facility. You prefer, of course, receiving money as soon as possible. So you have to come up with a solution to reduce your financing costs.
What you do is offering a 1.5% discount if the customer pays you within 10 days, or 1.5/10 Net 60.
But, you must ensure to check if the cost of financing this discount is convenient to you and the buyer alike. Your customer will do their math. Besides the above, you also have other instruments that are not through financing. One of these is trade credit insurance, which we cover further down.
How to Calculate and Find Net Accounts Receivable?
Net accounts receivable is the amount of money customers owe you and of which you are confident to receive. This means how much of what you sold on credit you’re actually going to receive.
That is, your gross amount of outstanding accounts receivable less the allowance for doubtful accounts. This is like imagining some of those boxes ending up with nothing in them.
This amount tells you how effective you are in your granting credit and collecting it. You can also include it in your cash forecast to see how much cash you’re going to get.
Gross trade receivables – Allowance for doubtful accounts = Net receivables
If you want to express it as a percentage, you must take your outstanding gross receivables and your expected loss. This will be your allowance for doubtful (or uncollectible) accounts.
For example, you have $500,000 of gross receivables outstanding and an allowance for doubtful accounts of $20,000. Then, the percentage is:
(500,000-20,000) / 500,000 = 96%
The above percentage is for when you collect payments. So, your remaining 4% can be set as allowance for uncollectible accounts. Over time you learn on past payment performance and you can adjust your allowance to better represent your losses, how much becomes uncollectible. Your bad debts, that is the boxes that, unless you prepare yourself, will never fill up.
How to Calculate Accounts Receivable Average Balance?
If your business is seasonal or experiences burst of growth or decline during the year, calculating the accounts receivable average balance may mislead you.
In fact, this is an information that you calculate at the end of each month over a certain period, e.g. year. So, it will only tell you the balance of your receivables for that year period.
But, if you want to know how much of your sales in that period your customers still have to pay you, it’s useful.
So, what you do is to add up each end of month balance over the year and calculate the average balance. If you instead want more accuracy, do it over a 24-30 months.
What is Accounts Receivable Insurance? What does it cover?
Insurance, you know, allows to protect yourself from the cost of damages to things and people.
So, when you sell your products abroad, for example, things can get tricky and risky too. Yet, you may still want to sell on open account terms. But, if you don’t trust your foreign customers, it’s better to prevent potential losses.
This is what accounts receivable insurance does. Accounts receivable insurance, or trade credit insurance, covers you against some risks of loss. As we covered in our brief report about Insuring Trade Credit, there are two types risk. Commercial and Political.
Commercial risk coverage is simple. It covers against non-payment from customers. If you sell to importers in countries where the currency starts to depreciate, you have serious non-payment risks. Insurers will make an assessment and may cover up to 90% of the invoice amount.
Political risk is different and in the eyes of the insurer less likely to materialise. This is because the probability of social unrest or government collapse is low. Well, it should be but we see these days things are turning more unpredictable.
You can download our brief report to find out more how you can benefit and exploit your trade credit insurance.
How to Schedule and Calculate Aging Accounts Receivable?
We already talked many times about the importance of having a written and solid Credit Policy. This helps you craft your strategy for getting paid on time. And it aligns with the business strategy goals. If collections of your receivables are in line with your credit terms, say 60 days, then you’re doing a good job.
But how do you calculate the customers portfolio to know that?
First you need to know how much your receivables age, that is how long your customers take to pay you. If late payers keep being late, you must go back to your credit terms for those customers and make the appropriate changes.
As we discussed earlier, early payment discounts can help boost cash flow. In the table below you see an example of an aging schedule. It’s clear that while 20% of customers use this offer, 16% are at least 30 days late in payment.
|Age of Accounts (days)|| |
|Value of Receivables|
If they keep being late, collections become harder and cost your business in effort and cash flow. Remember that banks look at your ability to collect your receivables and you should do that too. Therefore, don’t stop reminding yourself how important is to have a strong process against delinquency to prevent bad debts.
The reason why companies fail is their lack of internal procedures and strong policies. Being able to sell is a great asset for any business, but unpaid invoices make those sales only some scribbled ink on paper. You must ensure you know who you sell to and have tools to do that. Don’t forget you must always refill those empty boxes with money. That’s your ultimate goal.
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This article contains general legal information and material for informational purposes only which are not intended and should not be taken as legal advice. Recoupera is not a collection agency and it is not a law firm or a substitute for an attorney or law firm. All informational material provided may not reflect changes in the law. For legal advice, contact a lawyer.