LOS 7

Monitoring Accounts Receivable

Learning Outcome Statement (LOS)

 understand why we need to monitor accounts

receivable
 identify the biasness in simple measures of
receivable turnover
 discuss about the better tools for monitoring
accounts receivable
 understand why we need to monitor bad debt
losses
 discuss about the management of accounts
receivable in practice
Why Monitor Accounts Receivable?

 A/R is a major investment, and the continuous assessment of the

state of A/R is a necessary function in the financial management of
the firm. Monitoring is intended to fulfill this assessment function.

 The firm has expectations regarding the turnover of A/R and the
amount of bad debt resulting from it. If these expectations are not
fulfilled, this is a signal to management that the assumptions used in
making the firm’s terms-of-sale and credit-granting policies may be
faulty, or these policies are not being implemented properly.

 Quite often, businesses have failed not because they weren’t

profitable, but because they weren’t collecting on sales and their cash
flows were inadequate.
Why Monitor Accounts Receivable?

 The A/R of a company are sometimes examined in order to

determine if the company is in financial trouble, or simply
suffering from an inadequate cash flow due to a lack of
receivables collections.
Why Monitor Accounts Receivable?
 Deviations from the expected levels of turnover and of bad debt can
signal several different problems. Three of these problems are -

 Changing Customer Payment Characteristics – the A/R

manager deals with a constantly changing portfolio of receivables as
customers pay invoices, and sales are made. Because of the rapid
maturation of these assets in this portfolio, changes in the firm’s
customers or in economic and competitive conditions can impact
receivables with remarkable suddenness.

 Inaccurate Policy Forecasts – there is substantial uncertainty in

estimating bad debt, A/R turnover, and other relevant variables.

 Improper Policy Implementation – if the implementation is

faulty, shareholder wealth will not be maximized. Difficulties in the
implementation of policies may stem from problems in
communicating the policies to employees, from inappropriate
evaluation of employees relative to these policies.
Why Monitor Accounts Receivable?
 Monitoring provides signals of deviations from expectations.
When a signal is detected, it is up to managers to investigate
and to assess the reasons for deviation.

 The managers must then take the necessary corrective action,

and the type of action will vary with the cause of the deviation.
However, if the problem is in implementation, the firm’s
managers need to assess why the firm’s policies are not being
executed.

 In any case, both positive and negative deviations in A/R

statistics need to be investigated, since deviations in either
direction signal differences from the results that management
believe to be the most advantageous for the firm.
Why Monitor Accounts Receivable?

 The monitoring process is a comparison of expectations and

outcomes. Within the firm, these expectations are captured in
the form of budgets, which detects the deviations from policy.

 Some of the deviations from budgeted figures will represent one

or more of the problems outline previously, while others will
represent random events. For example, a delay in the receipt of
some customer checks might be due to a strike of postal
employees (a random event), and not due to any factors
controllable by the selling firm.

 The task of monitoring A/R is to signal nonrandom deviations

from the budgeted receivables statistics.
Collection Policy

 Collection refers to obtaining payment on past-due accounts.

 Collection policy is composed of:

 Firm’s willingness to extend credit – reflected in the firm’s

investment in receivables.

 Collection effort
Collection Effort

 Most firms follow a protocol for customers that are past due:

 Send a delinquency letter

 Make a telephone call to the customer
 Employ a collection agency
 Take legal action against the customer

 Potential for a conflict of interest.

 Strike a balance.
Methods for Monitoring Accounts
Receivable

 Two common methods of receivables’ monitoring are:

 Days sales outstanding (DSO) and

 Aging fraction statistics.

 Unfortunately both of these approaches are seriously flawed. For

example, when sales vary over time, both days’ sales
outstanding and aging fractions will give inappropriate signals.
Methods for Monitoring Accounts
Receivable

Days Sales Outstanding (DSO)

 DSO indicates the average length of time it takes the firm to collect
for credit sales.

 A low DSO number means that it takes a company fewer days to

collect it’s A/R. A high DSO number shows that a company is
selling its product to customers on credit and taking longer to
collect money.
Methods for Monitoring Accounts
Receivable

Days Sales Outstanding (DSO)

 Due to the high importance of cash in running a business, it is in

a company's best interest to collect outstanding receivables as
quickly as possible.

 By quickly turning sales into cash, a company has the chance to

put the cash to use again – ideally, to reinvest and make more
sales.

 The DSO can be used to determine whether a company is trying

to disguise weak sales, or is generally being ineffective at
bringing money in. For most businesses, DSO is looked at either
quarterly or annually.
Methods for Monitoring Accounts
Receivable
Aging Fractions

 The aging fractions show the receivables by age of account. The

longer an account has been unpaid, the less likely it is to be
paid.

 The aging fractions are computed by dividing the outstanding

receivables of a particular age by the total receivables balance at
the end of that month.
Aging Schedule

Age of A/C Percent of Total Value of A/R

0 – 30 days 55%

31 – 60 days 10%

61 – 90 days 15%

Over 90 days 20%

Aging Fractions

 Thanks now to the extensive use of computers, aging A/R

reports are available with the click of a button.

 Standard reports can be generated that will detail customer

information, ship dates, invoice dates, and payment due
dates.

 Outstanding or aging accounts are readily noted and can be

contacted for immediate payment arrangements.
Better Tools for Monitoring A/R

 Because of the way they compare sales and receivables, DSO

and aging fractions give the proper signals of receivables
movement only in the special case where sales exhibit no
fluctuations over time.

 While managers might try to judgmentally adjust DSO or aging

fraction figures to reflect these inaccuracies, it would be very
hard for them to know how much adjustment is necessary.

 A more appropriate approach is to use a tool that is not subject

to distortions caused by sales fluctuations.
Better Tools for Monitoring A/R

 Three such tools are:

 Ratios of receivables outstanding to original sales

 Customer’s payment proportions
 Sales-weighted DSO

 All these three methods do a much better job than aging

fractions or traditional DSO in monitoring payment behavior
since they do not give false signals when no deviations from
the expected payment pattern have occurred and do give
proper signals when such deviations have actually occurred.
Ratios of Receivables Outstanding to
Original Sales

 Here receivables outstanding at any particular time are

compared only to sales in the period during which the
receivables were generated.

 The ratios of receivables outstanding are computed by dividing

the receivables outstanding from a particular month by the sales
from that month.

 This gives a true picture of receivables payment behavior.

Customer’s Payment Proportions

 The payment proportions figures are computed as the proportion

of a month’s sales that are collected in the month being
analyzed.

 The payment proportions figures are calculated by comparing

changes in receivables balances with sales for the month during
which the receivables originated.
Sales-Weighted DSO (SWDSO)

 SWDSO allows for fluctuations in sales by weighting the

receivables balances by the sales incurred in the month during
which the receivables were generated.

 The SWDSO can be calculated as:

SWDSO =  (ARt/St) (30 days/month)

where t is the month of sale, n is the number of months for

which receivables are outstanding, ARt is the outstanding A/R
balance from month t, and St is the sales in month t.
Deciding Which Method to Use in
Monitoring Collections

 In prior sections, we had discussed five monitoring methods:

traditional DSO, aging fractions, ratios of receivables
outstanding, payment proportions and the sales-weighted
DSO (SWDSO).

 While the first two methods can be inaccurate in their

measurement of payment behavior, other arguments are
sometimes made in their favor. Typical arguments for these
methods include:

1. They are simple to compute

2. Industry figures are reported – particularly with regard
to DSO – giving management some standard of
comparison in assessing trends in the payment behavior
of customers.
Deciding Which Method to Use in
Monitoring Collections

 However, none of these arguments hold much weight. Regarding

the first, the additional effort necessary to compute performance
statistics for more accurate methods is very small. The second
argument would be important only if the firm was limited to the
computation of one measure of payment behavior.

 However, there is no reason that the firm cannot use an

accurate measure of payment behavior to assess its own
patterns of receipts and another measure to compare this
behavior to published figures.

 The choice of receivables monitoring methods for internal control

purposes is then among the more accurate methods: ratios of
receivables outstanding, payment proportions and the sales-
weighted DSO (SWDSO), and other similar measures.
Deciding Which Method to Use in
Monitoring Collections

 Each of these measures has advantages and disadvantages.

 Measures such as ratios of receivables outstanding and payment

proportions include payment performance via a series of
numbers, while SWDSO is a single-number measure. Therefore,
SWDSO is simpler to interpret.

 However, this single-figure may hide deviations from

expectations among the collection rates from the various sales
periods.
The Management of A/R in Practice

 Interestingly, there is a substantial divergence between the

techniques displayed in the academic literature and those
commonly used in credit management. Some of the techniques
discussed in this LOS are extensively used, while others have
not yet been widely adopted.

 The prevalence of trade credit in the sale of goods –

vast majority of manufacturing output is sold via trade
credit.

 Terms-of-Sale Decisions – most firms simply utilize the

traditional terms-of-sale in their markets. When competitors
change terms, other sellers typically will “follow the leader.”
The Management of A/R in Practice

 Credit Investigation Policies – larger firms collect more

information in making credit-granting decisions on larger
orders.

 Credit-Granting Decisions on Marginal Accounts –

firm’s usually use the traditional “5 C’s of Credit” to make
judgmental decision on credit applicants, though a substantial
fraction use some type of credit-scoring approach.

 Monitoring A/R – published survey results from the mid-

1970s showed aging fractions to be the most popular method
of monitoring customer payment patterns at the time.