Knowing how good you manage your accounts receivable is critical in managing the whole company’s financial. It could be meant: how good you pay your bills on one side; and how good you retain the customers and increase sales on the other side. In other words, knowing how good you manage accounts receivable answers how good company’s financial management on supporting its operation.
When coming into managing accounts receivable, bad-debt is a nightmare and slow cash-in is another big problem that all companies try to avoid in all ways.
With that in mind, companies often put most of their focus on preventing such situations and go way too much in speeding the collection of the receivables up; (a) a tightened credit policy; and (b) aggressive collection. Until several loyal customers start leaving the company—because of uncomfortable experience they get as an excess of the new, tightened, credit policy and the aggressive collection approach. An effective management of accounts receivable is a balance between: (a) extending credit to increase your sales; and (b) collecting cash quickly to reduce your need to borrow. So, how do you know if your accounts receivable management is effective or ineffective?
Information from the financial statements can be used to evaluate a company’s performance. An important element of overall company performance is the efficient use of its assets.
With regard to accounts receivable, inefficient use means that too much cash is tied up in the form of receivables; OR extremely tight credit policy that slowing down the sales—or even pushing loyal customers out of the door because of uncomfortable experience with aggressive collection, but they don’t say—just leaving in silent.
A company that collects its receivables on a timely basis has cash to pay its bills. Companies that do not do a good job of collecting receivables are often cash poor, paying interest on short-term loans to cover their cash shortage or losing interest that could be earned by investing cash. That is on the first side.
On the other side, aiming to have a zero accounts receivable balance could be dangerous too. During today’s economic slowdown, making sales isn’t easy. Unless your product is incredibly loveable (such as Apple’s) having cash sales is almost impossible in the current competitive market. Everyone try to hold up their cash for future use. Unless they get good credit offerings they won’t buy. Sure, there could be some sales but not much. You may, actually, be loosing the opportunity to increase your sales.
A short credit term may work well for certain commodities, but may not for others. So this is tricky. The point here is: how you know if your accounts receivable management is “too tight” or “too loose”.
There are several methods of evaluating how well you’re managing your accounts receivable. The most common method involves computing two ratios:
- Accounts receivable turnover; and
- Average collection period
Next, let’s have a look at the ratios. Read on…
Using Accounts Receivable Turnover
Using “accounts receivable turnover ratio” means you’re attempting to determine how many times, during the year, your company is “turning over” or collecting its receivables. It is a measure of how many times old receivables are collected and replaced by new receivables.
Accounts receivable turnover is calculated as follows:
Accounts Receivable Turnover = Sales / Average Accounts Receivable
Notice that “Sales” here is total sales in a certain period, Jan 1 until Dec 31, 2011 for example, quiet straight forward. “Average Accounts Receivables” is average of your accounts receivable balance for the period. This could be tricky.
In calculating average accounts receivable balance, one may attempt to use only beginning and ending balance and then divide by two. Such way could end up with wrong calculation. The best way to calculate average accounts receivable, is by totaling all accounts receivable balances, and then divided by total months (12 months if the company adopts annual reporting.)
Your company, in 2011, made sales $250,000 with the following accounts receivable balance breakdown:
As you can see, by using only beginning and ending accounts receivable balance ends up with ‘average accounts receivable‘ of $5,500 which is not correct. And, totaling all accounts receivables resulted in $8,875 which better reflects the actual condition.
Based on the above information, you can calculate the accounts receivable turnover:
Accounts Receivable Turnover = Sales / Average Accounts Receivable
Accounts Receivable Turnover = $250,000/$8,875
Accounts Receivable Turnover = 28
28 in accounts receivable turnover means that, on average the company’s accounts receivables turned over 28 times during the year 2011.
Converting Your Accounts Receivable Turnover into Average Collection Period
If you’re not familiar with ‘turnover’ numbers (many others aren’t either,) you can convert the turnover ratio into number of days it takes to collect receivables by computing a ratio called “average collection period.”
The average collection period ratio is computed by dividing 365 (or the number of days in a year) by the accounts receivable turnover, as follows:
Average Collection Period = 365/Accounts Receivable Turnover
Using the previous case example, your average collection period in 2011 is approximately 13 days (=365/28), means it takes you about 13 days on average to collect its receivables in 2011.
“Is an accounts receivable ratio of 28 good? Is an average collection period of 13 days good?” You may ask.
The easiest way to determine whether your current ratio is good or bad is by comparing it to the previous period. If you find the accounts receivable turnover ratio was 12 in the year 2010 for example (or about 30 days on average collection period), that means your current turnover is much often and faster.
“Is more often or faster, better for my company?” you may ask again.
Well, the convention says “YES”—the more often or faster is the better. But as I said in the preface, an extremely more often accounts receivable turnover (or faster average collection period) is often achieved by either a tightened credit policy or an aggressive collection approach—and those could result in unhappy customers. To make it sure, you would need to have a look at your sales account and compare it to the previous sales, see the trend; are they the same, increased or decreased?
If your sales account is looking good, then your current accounts receivable management is great—as you see that your accounts receivable turnover is much improved. Congratulation! But if it is the exact opposite, then there are some more works you need to do. The reason for sales decreased is not always anything to do with credit or payment term, however. Check these out:
- Quality of your products/services – is it decreased or not?
- Quality of your delivery time – is it decreased or not?
- Quality of your customer service – is it decreased or not?
- Quality of competitor’s product – is it increased or not?
- The macro economic situation
And, your credit policy or collection approach could be one among those possible reasons. Again, proper receivables management involves balancing the desire to extend credit in order to increase sales with the need to collect the cash quickly in order to pay off your own bills. Another good way to determine whether your accounts receivable turnover ratio and average collection period ratio are good or not, is by doing what is called ‘accounts receivable turnover benchmark’—comparing your accounts receivable turnover to the average for other companies in the same industry.