Read this article to learn about the receivables management: it’s introduction, average collection period and ageing!
Introduction
Accounts receivables or debtors management is a vital aspect of sound working capital management.
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In order to maintain current customers and attract new ones, most of the manufacturing and trading firms find it imperative to offer trade credit. The practice of selling the produced goods on credit gives birth to accounts receivables.
It is considered an essential marketing tool acting as a catalyst for the sales— maximization leading subsequently to profit-maximization. ‘Credit is the soul of business’ is an ancient saying of the business world. Receivables constitute a substantial portion of current assets of business firms.
For instance, in India trade debtors after inventories are the major component of current assets. Receivables from about one-third part of current assets and near about 11-15 per cent of the total business assets. Granting trade credit and creating debtors result to the blocking of the firms funds loosing current incomes.
But at the same time, it boosts up the sales increasing the firm’s profitability. Hence, the problem of receivables management is basically a problem of balancing profitability and liquidity. The basic goal of trade credit management is to maximize the value of the firm by achieving a trade-off between liquidity and profitability.
The purpose of managing customer receivables is neither to maximize sales nor to minimize the risks of bad debts. If the objective were to maximize sales, the firm would sell goods on credit to all and sundry without evaluating their credit worthiness. On the contrary, if minimization of bad debts’ risk were the aim, the firm would not sale on credit to anyone.
In fact, the basic goal of receivables management is to manage the credit in such a way that sales are expanded to an extent to which risk remains within an acceptable limit. The objectives of managing debtors are:
(i) To obtain optimum volume of sales,
(ii) To control the cost of credit and keep it at the minimum,
(iii) To maximise owner’s wealth and income, and
(iv) To maintain investment in debtors on optimum level.
The management of accounts receivable is primarily concerned with the trade-off between the profit from increased sales generated by credit policies and the costs of such policies. The cost of receivables includes interest on investment in trade debtors, accounting charges in maintaining their accounts, collection charges and bad debts.
The benefits are the increased sales and profits anticipated because of a more liberal policy. The return or benefit on receivables investment must cover all the costs in that connection. The management should make use of marginal concept in deciding the optimum level of credit it should continue to grant credit upto a level where the profitability of the additional unit of sales continues to be above the additional costs of account receivables.
The level of receivables is affected by the general economic conditions as well as internal policy decisions. General economic conditions and industry practices are largely beyond the control of financial executives. The policy variables, e.g., terms of sale, sales volume, credit policies, stability of sales, policy of cash discount, credit collection policy, length of credit terms, bad debts expenses, credit information, operating efficiency etc., may be influenced by financial decisions.
The firm will be called efficient if they maintain a small amount of receivables, depending upon nature of business, customs of industry, policy of competitors, financial position of the concern, inflation, type of product etc. The finance manager should try to keep the receivables low for reducing unnecessary blockage of working capital in order to set a equilibrium between cash and credit sales.
Average collection period:
For any business prompt payment by customers is an excellent attribute of success. The trade debtors must be collected at the planned time if the concern has to remain solvent and in profitable status. An account becoming older, there is greater possibility of its becoming had debts. Moreover, the collection costs and capital costs increase with the age of an account.
It increases approximately in direct proportion to the length of time. So the finance manager should establish the average length of time for which receivables should be allowed to out- stand and if the actual length of receivables’ time exceeds speedy action should be initiated to reduce the age of receivables.
The calculation of average collection period and its analysis is one of the methods; the finance manager can make use for judging the concern’s efficiency of debts’ management. It is a genuine indicator of the effectiveness of a concern’s credit and collection policy especially when it is compared to prior experience and companies in the same industry, The average collection period relates to the time between the debt occurring and it being paid; the more that is spent on collection, the faster the debts can be collected and the smaller the bad debts expenses. Average collection period is calculated as follows:
Trade Debtors (including bills receivables) x 365 / Annual Credit Sales
The average collection period represents the days, a concern takes a collecting its debtors. The analysis reveals whether the concern is taking a longer or a shorter period, to collect its debtors as compared to previous years and how the concern is comparable to other companies in the same size group or same industry group.
The answer to these questions provides the management serviceable information’s for evaluating the performance of the credit or/and collection department.
Ageing of receivables:
The study of ageing of trade debtors shows to what extent the concern has been able to collect its debtors within the time allowed by the credit department and its efficiency in collecting past debts.
The higher the amount of long due debts and longer the outstanding time of debts, the lower will be the efficiency of concern’s credit collection department, the ageing schedule will be important as it will enable the management to know more accurately the extent and the amount which may be taken as toad and doubtful of recovery and in this way enable them to appreciate the liquidity position of debtors.
In a common practice, in almost all business concerns keep aside some reserve out of profit and loss account to compensate doubtful debts. As a general rule, the doubts outstanding exceeding six months duration are treated for doubtful debts reserve.