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"Plastic" has become a way of life. Those
wallet-size credit cards are accepted all over the world in
millions of stores for many millions of products and services.
To be competitive, you too must offer credit to your customers.
After all, your own business purchases are probably on credit.
Management of Receivables
As the operator of a small business, you must extend credit
to customers on competitive terms so that sales will not be
lost. At the same time, you must avoid long overdue accounts so
that your capital will not be tied up and there will be less
chance of accounts becoming uncollectible. If you manage your
accounts receivable as suggested in this module, you will
realize the marketing advantages of credit extensions and avoid
the common problems noted above.
Section Objectives
This section has been designed to guide you in the management
of your accounts receivable. In here, you will learn how to
establish sound policies that will serve as guidelines in
granting credit. You will be shown collection techniques that
will minimize uncollectible accounts and reduce the volume of
past-due accounts so that your credit sales are more quickly
converted to cash. You will learn how to analyze your accounts
receivable to determine whether or not a problem exists, if
corrective action is needed, or if reevaluation of your credit
and collection policies is necessary. You will learn how to
evaluate credit applications so that many problems can be
eliminated before they occur. You will learn how to initiate a
collection program with all accounts, the delinquent and the not
yet delinquent. You will learn how to follow up by mail and
telephone to accelerate collections and the flow of cash to your
business. You will learn when to resort to external resources
such as collection agencies or the courts and how to use them to
your advantage.
Benefits
If you apply the techniques you learn in this section to the
management of your business, your dollars tied up in accounts
receivable should be reduced, allowing for profitable
application elsewhere. In addition, your credit losses should be
reduced.
Credit
Extensions
Many potential
credit problems can be eliminated before they happen through
investigation and prudent judgment when granting credit to
customers. The need for sound judgment is particularly critical
since credit extension policies should be neither too liberal
nor too restrictive. Overly liberal policies invite excessive
receivables and uncollectible accounts while overly restrictive
policies cause lost sales.
Investigation
Before you decide, get the facts. Thorough investigation of
credit requests protects you from the fraudulent applicant who
has no intention of paying as well as the applicant who is
extremely slow in paying.
Credit Applications
The basic source of information for decisions on credit
extensions is the credit application. There are three major
factors to consider in evaluating a credit applicant. The first
is the applicant's ability to pay, based upon income and
obligations. The second is willingness to pay, which can be
determined from the applicant's credit history. The third factor
is potential profitability of the account. You stand to lose
your cost of the product or service sold to the customer if you
cannot collect an account. If your cost is relatively high
compared to the selling price, then you have to be particularly
careful in assessing credit risks.
Application Evaluation
Your evaluation of any credit application will depend upon a
number of factors. In the case of an individual applicant, you
will want to consider the following:
- Employment history
- Current position
- Current income
- Time on job
- Job security
- Monthly obligations (rent, loan payments, food, utilities,
etc.)
- Bank balances
- Personal assets (house, cars, stocks, bonds, etc.)
- Credit standing
- Amount of credit desired
Information Verification
Information on credit applications must be verified to ensure
that it is correct, current, and complete. A good place to begin
is the place of employment to verify that the applicant is
employed and that income and time on the job have been reported
accurately.
Bank references should also be verified. While laws restrict
the amount of information that banks can disclose, checking on
this information can protect you from obvious fraud and may give
you some indication of the applicant's ability to pay. Most
banks will confirm the existence of an account and disclose a
broad idea of the average balance. The bank may also indicate
whether or not the account has been satisfactory.
Credit Bureaus
An important source of information for retail credit is the
local credit bureau, which generally provides information on
credit applicants to firms that are bureau members. Annual
membership fees usually depend upon the size of the business.
Besides the membership fee, there is a nominal charge for
each inquiry on a credit applicant. Your local credit bureau
will provide you with details about services and costs.
Stability
In situations where the time or cost of a comprehensive
credit check is prohibitive, professional credit managers have
often found that a quick evaluation can be made based upon the
applicant's stability. Stability is determined by the length of
continuous employment and residence. This assumes that the
person who has been employed for several years on the same job
will most likely continue to be employed and therefore will be
able to pay. Similarly, continuous residence indicates a desire
to maintain standing in the community.
Summary
There are no hard and fast rules that can tell you who is a
good credit risk and who is not. There are cases where the
poorest of people pay their bills promptly, while the wealthy
ignore them. As the owner of a small business, you must combine
facts about the applicant with common sense to determine those
risks that appear reasonable.
Commercial Credit
Commercial accounts should complete an application similar to
that used for personal credit. Unlike individual credit
applications, it is often difficult to verify information on
income and expenses for businesses. It is also more difficult to
make estimates of these factors for commercial accounts. There
are situations where it may be reasonable to request a financial
statement from the commercial account before extending credit,
but these situations are not typical. Instead, you must rely
more heavily upon references such as banks and suppliers with
whom the applicant does business, the applicant's reputation in
the industry, identity of officers, and so on.
The application should note the names of individuals who are
authorized to purchase for the account so that fraudulent
purchases can be detected. There should also be an indication of
purchase order requirements so that you will be protected in the
event of an unauthorized purchase.
Frequently, the commercial applicant with a marginal credit
rating will list only those suppliers with whom a satisfactory
relationship has been maintained. However, you can often use
your own judgment and knowledge of your industry and locale to
determine other suppliers with whom the applicant may have done
business. If there is any doubt in your mind as to the credit
worthiness of the applicant, it is always a good idea to contact
these other sources to find out what their experience has been.
Commercial Credit Services
Commercial credit services maintain financial information and
credit services for large and small companies throughout the
country. The cost of this service varies with the detail and
depth of information requested on any applicant.
Problem
Detection
A successful credit
and collection policy requires that all problems be detected and
acted on as early as possible. The sooner a problem is detected,
the sooner it can be corrected. This is particularly critical in
receivables management where the sheer passage of time can
aggravate any problem that may exist.
An important indicator of the effectiveness of your credit
and collection policy is your average collection period. The
average collection period is a ratio that expresses the total
amount of receivables outstanding in terms of an equivalent
number of average daily credit sales.
Figuring the Average Collection Period
The average collection period is calculated as follows:
Accounts Receivable
_____________________
Average Daily Credit Sales
Or, viewed another way, the total amount owed by customers is
equivalent to 45 days' credit sales, on the average.
For example, if a business had average monthly credit sales
of $6,000 and outstanding accounts receivable of $9,000, the
collection period would be calculated as follows:
Average Monthly Credit Sales
6,000
Average Daily Credit Sales = _____________________ = ________ =
200
30
30
Accounts Receivable
9,000
Average Collection Period = ______________________ = ______= 45
days
Average Daily Credit Sales $200
This indicates that, on the average, customers are taking 45
days to pay their accounts. (Some formulas for calculating the
average collection period consider only net credit sales. These
are determined by subtracting an estimated allowance for bad
debts from total annual credit sales. While the result is
mathematically more precise, it is being ignored here and the
simpler formula, based upon total credit sales, is being used
for instructional purposes.)
Comparisons
The average collection period can be compared with any of the
following bases to determine whether or not a problem exists:
- Payment terms. If your terms of sale specify
payment within 30 days and your average collection period is
greater than this, it indicates that creditors are not
complying With your terms and a problem exists.
- Past history. Comparison with your experience in
previous periods indicates whether or not collections are
improving or declining.
- Industry averages. Comparison with the experience
of other companies in your industry will determine whether
or not your credit and collection policies are as effective
as those of your competitors. (Industry averages are usually
available at your library or trade association.)
Determining the Extent of the Problem
The extent of the receivables' excess can be measured by
comparing your actual receivables with a target level. For
example, assume that your terms of sale specify payment Within
30 days, and your industry average collection period is
approximately 30 days: A suitable target for your receivables
Would then be 30 days' average credit sales.
If your average daily credit sales are $200, you could then
calculate a target for receivables as follows:
Average daily Sales x Collection Period = Receivables
$200 x 30 = $6,000
If your actual receivables were $9,000, you would then know
that you had an average of $3,000 ($9,000 - $6,000) in
receivables that require attention.
Corrective Action
A relatively high average collection period indicates that a
problem exists and corrective action must be taken. Prompt
attention should reduce the collection period, speed conversion
of receivables to cash, minimize your capital tied up in
accounts receivable and, at the same time, reduce the risk of
uncollectible accounts.
Aging of Receivables
Analysis of your average collection period will help you
identify and measure receivables problems in total. However,
immediate corrective action requires identification of
individual problem accounts.
Problems in individual accounts can be detected through
analysis of your receivables by aging. A receivables aging
divides each customer's account into amounts that are 0-30 days
old, 31-60 days old, 61-90 days old, etc.
The longer an account is past due, the more serious the
problem. These can be identified quickly by aging, and
corrective action can be initiated promptly.
For example, examine the receivables aging below. The first
account shown, L. Brown, has a total outstanding of $775.02. Of
this amount, $317.91 is 0-30 days old, $222.63 is 31-60 days
old, $156.32 is 61-90 days old, and $78.16 is over 90 days old.
Some prompt action seems required.
Totals are entered for each age group. It is often useful to
calculate the percentage of total receivables in each age group
to alert you whenever overdue receivables become excessive. For
example, if you knew from past experience, or from industry
averages, that receivables more than 90 days past due were
seldom more than 5% of total receivables, the 19.9% would
instantly alert you to a dangerous situation that requires
immediate correction before you are faced with possible serious
losses.
Internal
Collection Procedures
The fundamental rule of sound receivables management is
to minimize the time span between the sale and collection. Any
delays that lengthen this span cause receivables to build to
unnecessarily high levels and increase the risk of uncollectible
accounts. This is just as true for delays caused by your billing
and collection procedures as it is for delays caused by the
customer.
Invoices
Proper collection procedures begin with invoice preparation.
Invoices should be prepared promptly and accurately. Promptness
eliminates one possible source of delay. Accuracy prevents those
delays that occur when the customer disputes the invoice and
returns it for correction, triggering a chain of events that is
time-consuming and often costly.
Invoices should clearly state payment terms. Is payment due
within 10 days? Thirty days? Are the days measured from the
receipt of goods? Receipt of invoice? End of the month?
Cash Discounts
When selling to large accounts such as commercial,
industrial, institutional, and governmental buyers, collection
is often accelerated by the offer of a cash discount. The
discount, usually 1% or 2%, is offered for payment within 10
days. Most large organizations take advantage of all such
discounts. In so doing, they can sharply reduce your commitment
of capital to accounts receivable. If your competitor offers
cash discounts, it may be necessary for you to include the same
provision to maintain your competitive position.
Specifying Payment Terms
Payment terms normally include discount terms and dating
terms. Discount terms describe the discount available, if any,
for prompt payment. Dating terms specify the time when payment
is due.
Discount terms are usually described as follows: 2/10
The number before the / is the discount percentage, in this
case 2%. The number following the / is the number of days within
which payment must be made in order to take advantage of the
discount. In the example, the customer can take a 2% discount
for payment within 10 days.
This leads to the next question, 10 days from when? And, if
the customer lets the discount period pass, when is the net
amount due? The answers to these questions are specified in the
dating terms. Extending our previous example a little further,
the terms might be expressed as follows:
2/10 - n30
The "n" is an abbreviation for net. The
"30" indicates that payment is due within 30 days. If
no other date is specified, the 30-day period begins with the
invoice date. For example, if the terms above appeared on an
invoice dated September 2, the customer would be entitled to a
2% cash discount for payment by September 12. If the customer
does not pay within this period, the net amount is due within 30
days, or by October 2.
Special Conditions
Large accounts often specify certain requirements for invoice
preparation. They may require reference to a purchase order,
proof of delivery, or a certain number of copies. Be certain
that these conditions are met when the invoice is first prepared and submitted in order
to avoid delays and duplication of effort.
Statements
To keep customers advised of their account balances, monthly
statements should be submitted to all open accounts. The
statement should summarize the amount owed and any activity in
the account within the month.
Abbreviations are used to specify the beginning of dating
periods that are different from the invoice date. Two common
abbreviations are "EOM," End of Month, and "ROG,"
Receipt of Goods. In the first case, EOM, the discount and net
periods begin at the end of the month, regardless of the invoice
date. In the second case, ROG, the periods begin when the
customer receives the goods, regardless of the invoice date.
Assume that an invoice issued on September 15 had the
following terms:
2/10 - n30 EOM
The customer would be entitled to a 2% discount for payment
by October 10. If the discount is forfeited, the net amount
would be due October 30.
Your choice of payment terms will often depend upon customary
practices in your business. In order to stay competitive, it is
often necessary to offer payment terms that are equivalent to
those offered by your competitors.
Delinquency Charge
In some businesses, a delinquency charge for late payment is
used to discourage customers from allowing their accounts to
become long past due. The delinquency charge normally involves a
finance charge or service charge of 1% to 1.5% per month on all
balances more than 30 days past due. For example, if a
customer's statement at the end of June indicates a total
balance due of $630, of which $417 is more than 30 days past
due, the finance charge for June would be calculated as follows
(assuming a 1% delinquency charge):
$417 x .01 = $4.17
Most people recognize that a charge of 1% per month
represents an annual interest expense of 12% (12 x .01). A
charge of 1.5% per month represents an annual interest charge of
18% (12 x.015).
Follow-up
The best time to initiate pursuit of outstanding balances is
immediately. As an account gets further behind, the balance
often increases, while the chances of collection decrease. The
person who owes a few hundred dollars today is not likely to be
in better shape to pay next week or the week after than right
now. Now is the time to start enforcing a rigid collection
policy, making whatever arrangements are necessary to be sure
that you receive the money due to you in a reasonable period of
time.
Don't Be Reluctant
Many businesses are reluctant to enforce strict collection
procedures. The reasons for this are several, and none of them
are valid. Some people simply are embarrassed to ask for money
even though it is owed to them. Others express concern that they
might alienate a "good customer" and perhaps lose an
account. The opposite is true. How good is an account if the
bills are not paid? Even more important, the customer owing you
a large balance may be reluctant to do more business with you
until the account is cleared. You have not only lost your money,
you have also lost a customer.
Some companies feel that rigorous enforcement of a collection
policy can damage their reputation. Viewed logically, would you
conclude that a person who owes you money is likely to spread
this news around town?
Credit
Cards
Many problems
associated with credit can be avoided through the use of credit
cards. In many businesses, particularly in the retail and
consumer service fields, credit arrangements for customers are
available through the use of these cards. Under these plans,
there is little or no commitment of the business' own capital,
and the costs and risks of administration and collection are
almost entirely the responsibility of the credit card company or
bank.
Credit card service is available from your regular commercial
bank. Receipts from bank credit card purchases can be deposited
daily and are immediately credited to your checking account. The
bank assumes all credit risks provided that you follow
instructions for approval of credit card purchases. Typically,
these instructions require that you check the validity of the
card against a master list of canceled cards and contact the
credit service before accepting the customer's card for purchase
above a certain limit.
Credit card services are particularly vital for businesses
with a large number of relatively small accounts. They eliminate
the need for credit approval, invoice preparation, record
maintenance, and collections. They also minimize your commitment
of capital and virtually eliminate the risk of un-collectible
accounts. From a marketing standpoint, the availability of
instant credit could often encourage a customer to buy
immediately, rather than postpone the decision to a later date
or bypass it completely.
Credit cards are most often used for retail accounts.
However, they have also been used successfully in selling to
small commercial accounts. Businesses such as repair shops,
supply firms, and stationery stores, which have a mixture of
consumer and commercial accounts, often find it convenient and
economical to extend credit card service to small commercial
accounts.
Credit And
Collection Policies
The establishment and execution of credit and collection
policies can minimize problems associated with accounts
receivable. As with all policies, they must be reevaluated from
time to time in order to determine their effectiveness. If your
business already has policies for receivables management,
evaluate them according to the check list on the following
pages. If you do not presently have credit and collection
policies, you can use the check list as a guide in establishing
policies.
Your answer to all questions should be "Yes" or
"Not Applicable." If you have any "No"
answers, you should consider revising your policy or have a
strong and valid reason for not doing so. For example, you may
have a "No" answer to the question, "Do you offer
a cash discount?"
If your accounts are primarily personal, this might be a
valid answer. If your accounts are primarily major industries, a
"No" answer would suggest that you consider the
possibility of offering a cash discount.
CREDIT AND COLLECTION
POLICIES CHECK LIST
Credit Approval
SUMMARY
Sound policies for credit and collection can eliminate many
problems before they occur and minimize those that do occur. In
this module, you have learned the techniques of receivables
management. If you apply these techniques to your own business,
your profit will improve and your cash position will be
strengthened. Profit will improve through fewer credit losses
and lower costs of credit administration. Capital will be freed
so that you will be able to meet your own obligations promptly
and invest in those assets that offer a significant profit
potential.
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