Account Receivable, being one the largest accounts on most companies Statement of Financial Position ( Balance Sheet), represents all outstanding credits, other monies that need to be collected and obligations such as promotional credits and over payments; the reason why it is very important to monitor accounts receivable in your working capital management.
In relation to Accounts payable and inventories, raw materials are bought and vendors are owed through accounts payable. Same raw materials are converted into inventory and stored for sale. Sales give rise to accounts receivable which converts revenues into cash on hand.
As sales are converted to cash, cash is then invested in buying more materials for inventory. If companies can turn around receivables faster than their payable, positive working capital will result. Poor accounts receivable monitoring can lead to a scenario where payable outpace receivables, forcing you into inventory financing. This adds unnecessary costs to selling product.
This relationship implies that accounts receivable definitely turns accounting money into real cash, therefore, poor management of account receivable may lead to less available cash for business activities. Lack of cash on hand will impact a company’s ability to manage operations.
They are all key elements of a company’s cash flow. Monitoring accounts receivable and your aging of accounts will help you identify companies that do not pay their bills, preventing possible future bad debt. The longer receivables are outstanding, the less likely they will be able to be collected. Once a receivable is deemed uncollectable, it is expensed against gross profit as bad debt.
When to Tighten Credit and/or Intensify your collection efforts
Here’s an illustration. Say you’re operating with a gross profit margin of 20% and your uncollectible receivables are $10,000. Your business must generate an additional $50,000 (i.e. $10,000/20%) in new sales to make up for the $10,000 of uncollectible receivables.
How can you determine whether you need to tighten credit and/or intensify your collection efforts? Different formulas applied to your receivables collections can help you make the determination.
For example, the “accounts receivable collection period” ratio gives you the average length of time customers take to pay. To calculate the collection period ratio, divide your average outstanding receivables by annual credit sales. Then multiply the resulting decimal by 365 (the number of days in a year). This gives you the average number of days customers take to pay their accounts.
Account Receivable Collection period ratio = (Average outstanding Receivables/ Annual Credit Sales) X 365
Once you’ve done the calculation, put your new knowledge to use. Compare the collection period ratio from year to year. If you find customers are taking longer to pay, you may want to strengthen your policies for extending credit and pursue collections more vigorously. Even when sales are growing, the average number of days customers take to pay should not increase.
According to DPCPA, Here are more suggestions to improve collections on receivables:
1. Check the credit status of new customers.
2. Invoice promptly. Your customers may not pay for products or services until you send a bill.
3. Consider offering discounts for early payment of invoices.
4. Prepare an accounts receivable aging schedule every month and monitor past-due accounts.
5. Invoice for partially filled orders and bill for ongoing services as performed.
6. Put customers who habitually pay late on cash-on-delivery terms.
7. Hire a collection agency to pursue delinquent accounts.
A well-defined and regularly followed system can help keep your receivables collections on track and maintain your business’s all-important cash flow.
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