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The average balance in the receivables account is average daily credit sales multiplied by average collection period.
The objective of receivables management is to promote sales and profits until that point is reached where the returns that the company gets from funding of receivables is less than the cost that the company has to incur in order to fund these receivables.
The credit policy of a company can be regarded as a kind of trade-off between increased credit sales leading to increase in profit and the cost of having larger amount of cash locked up in the form of receivables and the loss due to the incidence of bad debts.
The objective of collection policy is to achieve timely collection of receivables, thereby releasing funds locked up in receivables for a longer period than they should have been under the credit terms and to minimize bad debt losses.
In judging the creditworthiness of an applicant, three basic factors the three C's have to be considered. And they are character, capacity, and collateral.
Character refers to the willingness of the customer to honour his obligations. It reflects integrity, a moral attribute considered very important by credit managers.
Capacity refers to the ability of the customer to honour his obligations. It reflects integrity, a moral attribute considered very important by credit managers.
Collateral represents the security offered by the firm in the form of mortgages.
Capacity refers to the ability of the customer to pay on time. It depends on the financial situation (particularly the working capital position and profitability) and the general business conditions affecting the performance of the customer.
Credit evaluation of the prospective customer involves obtaining information from which the financial capacity as also the paying habits can be evaluated.
An important aspect of receivables management is to monitor the payment of receivables. Several measures are employed by the credit manager for this purpose. (i) Days Sales Outstanding, (ii) Ageing Schedule and (iii) Collection Matrix are some of the measures employed.
The average number of days sales outstanding at any time, say end of the month or end of the quarter, is same as for an average collection period.
In case, the days sales outstanding is within a pre-specified norm linked to the credit period followed by the company then the status of receivables is regarded to be under control. In case it is found to be higher, then the collection policy has to be strengthened as the collections are slow.
The age-wise distribution of accounts receivable at a given time is depicted in the ageing schedule.
The ageing schedule can be compared with the credit period extended by the company, when the percentage of receivables belonging to higher age groups is above a stipulated norm, action has to be initiated before they turn into bad debts.
If sales are decreasing, average collection period and the ageing schedule will differ from what they would be if sales are constant.
From the collection matrix, one can judge whether the collection is improving, stable, or deteriorating. A secondary benefit of such an analysis is that it provides a historical record of collection percentages that can be useful in projecting monthly receipts for each budgeting period.