Accounts Receivable - PDF

ACCOUNTS RECEIVEABLE WEEK 1- WHAT IS ACCOUNTS RECEIVABLE? WHY IS IT IMPORTANT? AND APPLYING FOR CREDIT. WHAT IS ACCOUNTS RECEIVABLES? Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In m...

ACCOUNTS RECEIVEABLE WEEK 1- WHAT IS ACCOUNTS RECEIVABLE? WHY IS IT IMPORTANT? AND APPLYING FOR CREDIT. WHAT IS ACCOUNTS RECEIVABLES? Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established time frame, called credit terms or payment terms. The sales a business has made. The amount of money received for goods or services. The amount of money owed at the end of each month varies (debtors).The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the accounts receivable department. While the collections department seeks the debtor, the cashiering team applies the monies received. WHY IS ACCOUNTS RECEIVABLES MANAGEMENT IMPORTANT? It can be argued that revenue generation is the most critical function of a company. Every company expends substantial resources to generate increasing levels of revenue. However, that revenue must be converted into cash. Cash is the lifeblood of any company. Every dollar of a company’s revenue becomes a receivable that must be managed and collected. Therefore, the staff and processes that manage your receivables: Manage 100% of your company’s revenue. Serve as a service touch point for virtually all your customers. (Only Sales and Customer Service speak more with your customers.) Can incur or save millions of dollars of bad debt and interest expense. Can injure or enhance customer service and satisfaction, leading to increases or decreases in revenue. THE FIRST STEP: APPROVING THE CREDIT After this class you will be able to Understand the importance of accurately evaluating credit Evaluate the creditworthiness of customers Understand the different types of financial statements Identify the warning signs of customers in trouble THE FIRST STEP: APPROVING THE CREDIT There is an old adage in credit that says a sale is not a sale until the invoice is paid. Until that point, it is a gift. It is the primary responsibility of the credit department to make sure that the company converts all those gifts into sales. It is also the job of the credit department to make sure that sales are made to companies that have both the ability and the willingness to pay for the goods. WHY BUSINESS CREDIT IS IMPORTANT. Finding the right credit policy is a mixture of art and science. Many issues affect the policy. Corporate culture, the company’s margins, competition, existing inventory, and seasonality are just a few of the matters to be considered, in addition to the obvious financial analysis. When credit is extended to a company that cannot or will not pay, the impact directly impacts the seller’s bottom line. More insidious, when the seller pays late, there is a bottom line impact as well, although it is not as apparent. Similarly, when a buyer takes unauthorized deductions the action impacts the bottom line— sometimes to the point of making the sale unprofitable. OPEN ACCOUNT Credit would not be a problem if companies bought and sold goods the way individuals do. When most people need something, they go to the store and either pay cash or use a credit card. In either case, the store gets its money within a day or two. Businesses do not operate in that manner. The preferred way of operating (at least from the seller’s standpoint) is to order goods and pay for them at a later date. This is referred to as open account. When goods are sold on open account terms, the seller ships the merchandise and then expects to be paid at some point in the future, say 30 days after the buyer receives the goods. DISCOUNTS FOR EARLY PAYMENT In many industries, a discount is offered for early payment. The most common discount offered is 2% discount if the invoice is paid within ten days. You may remember seeing the term 2/10 net 30 in your old accounting books. If it is not paid within the discount period, then the full amount is due on the due date, which in the example here would be 30 days. Other terms sometimes seen include 1/7 net 10 or 2/10 net 11. The first allows the buyer to take a 1% discount if the invoice is paid in seven days, otherwise the total is due in ten days. The latter permits a 2% discount if the invoice is paid within the first ten days, otherwise the total is due in 11 days. In both of these examples, it is expected that the purchaser will take the discount unless it is experiencing financial problems. Those who have been in the profession for some time are probably aware that many buyers take the discount and do not pay within the discount period. This is referred to as an unearned discount. In some industries this is a massive problem. TERMS PREFERRED BY SELLERS Most sellers would like to sell on a cash-in-advance (CIA) basis. The problem with CIA terms is that, with very minor exceptions, few companies would purchase under those conditions. Thus, companies, and more specifically the credit staff, need to find ways to quantify risk and identify those customers who will pay if sold on open account terms. They also need to find ways to sell to those who don’t “qualify” for open account terms. VERIFYING THE COMPANY Small companies and those just starting out may not have credit reports. When trying to verify the business, do not use the phone numbers provided by the company. Look them up in the phone book or call information to get the information. Why? Check this information from third-party sources to avoid being taken by individuals looking to scam your company. The same is true when checking trade references. If the reference is from ABC Company, call information and get a phone listing for ABC Company. Then use the phone number provided by information to check the reference. Why? A fraudster may provide you with the name of a very impressive company for a reference but actually have a friend or associate provide the reference. If you call using the number provided, you will be connected to the accomplice rather than a legitimate reference. TRADE REFERENCES Before extending credit on open account terms, most companies will check trade references to see how the potential customer pays its bills. Typically, the potential customer will provide the names of the references, along with the phone numbers. Now, like most people, they will only provide the names of companies that will give good references. Once the credit professional has contacted the trade reference using phone numbers obtained from information, he or she should try and ascertain other companies that the potential customer has done business with. Once the other companies have been identified, the credit professional can contact them, if possible. This needs to be done carefully. One of the best ways to find out about a potential customer is from credit industry groups. If you belong to such a group for your industry, check its latest reports to see how the potential customer has paid your peers. FINANCIAL STATEMENTS Financial statements are typically used to paint a picture of the financial health of the company. However, as credit professionals are well aware, numbers can sometimes be manipulated. Thus, it is important to have statements that are audited by an independent accounting firm. Financial statements come in three levels: 1. Audited statements are compiled by an independent accounting firm from company records. This is the preferred type of statement. The audit firm signs off on the statements when the audit is complete. They typically state that the accounting conforms to generally accepted accounting principles (GAAP). This is referred to as an unqualified and it is what credit managers ideally want to receive. FINANCIAL STATEMENTS 2. Reviewed statements are what they indicate. The audit firm reviews the numbers put together by the client, but the accountants have not audited the company’s procedures. 3. Compiled statements are put together on the basis of information provided by the company to the accountant. The accounting firm has no way of determining if the numbers are accurate or if the company has complied with GAAP. FINANCIAL STATEMENT- AGE The more current the statement, the more reliable the numbers will be to the credit manager using the information to complete a credit evaluation. Typically, the numbers may be as much as 18 months old. Here’s why. The accountants only audit once a year and this is done after the fiscal year-end. Thus, already some of the information is a year out of date. Then the company must complete the audit and prepare the financial statements. This can and usually does take several months. However, new statements should be available six to nine months after the end of the fiscal year. If they are not, it could be a sign of financial difficulties. Additionally, credit professionals are well advised to look twice at customers who change their fiscal year-end. Very rarely is there a good business reason for making the change, often the change is done to hide something. Thus, whenever a change is noted, question the customer for the reasoning behind the change. WHAT IS INCLUDED IN FINANCIAL STATEMENTS? Several important documents are included in the general term financial statements. Income Statement. The income statement is the starting point for most credit investigations. It tells the profit-and-loss story for the current fiscal year. Examine the statement closely for any unusual or nonrecurring items, such as the sale of a facility, a change in accounting methods, a large tax credit, or a write-off. If you find such items, recalculate the income statement, and then redo your ratio analysis based on the new numbers. After all, if the only reason a company showed a profit was that it sold a piece of real estate, this is a one- time gain that is unlikely to happen again. WHAT IS INCLUDED IN FINANCIAL STATEMENTS? Balance Sheet. The balance sheet, sometimes called the statement of financial condition, shows the financial condition of the company. It reflects both long- and short-term assets and liabilities. Cash Flow Statement. Although traditionally the cash flow statement was not deemed to be that important, increasingly it is seen as vital to those analyzing the financial condition of a company. It shows the cash inflows and outflows of the customer. It is especially important to credit professionals who are very concerned about making sure the customer has adequate cash flow to pay all its short-term obligations, especially vendor obligations. Some even call cash flow the lifeblood of any organization. Anything that adversely affects it needs to be examined closely. WHAT IS INCLUDED IN FINANCIAL STATEMENTS? Footnotes. Some of the most important information about a company is hidden away in the footnotes. Long and complicated footnotes deserve extra attention. Again, they do not necessarily mean bad news, but they do need to be inspected closely. Additionally, they may provide invaluable information that is not included elsewhere in the financial statements. What kinds of information might you find? Details about lawsuits pending against the company, use of tax credits, the condition of the pension plan, and the status of leases and mortgages or deferred compensation commitments. Information about certain contingent liabilities will also be buried in the footnotes. Most customers will not voluntarily offer this type of information to their creditors. You must find it. These facts can often have a negative bearing on a credit decision—provided you unearth them. NONFINANCIAL FACTORS THAT AFFECT THE CREDIT DECISION As virtually every credit professional knows, making a credit decision is as much an art as it is a science. The stark financial analysis may indicate that the customer should not be granted credit terms, but there are often other factors to be considered. Here is a brief look at some of the nonfinancial issues that affect the final determination: The 5 Cs of credit: character, capacity, capital, conditions, and collateral. One credit analyst revealed that his company routinely sold on open-account terms to a customer, whose numbers were awful. The reason was simply that this company always paid its bills and was never late. “I’d rather deal with this customer any day,” says the analyst, “than those large companies who continually string us along for payment even though they have the money.” NONFINANCIAL FACTORS THAT AFFECT THE CREDIT DECISION Relationship with the buyer. Oftentimes, if a long-term ongoing relationship with a customer exists, credit executives are more likely to allow the company to go over its credit limit. However, watch the payment patterns closely if this is allowed. Most credit professionals who follow this strategy do it with customers who have seasonal businesses. The customer’s payment history. If it is good, some credit professionals are apt to be more aggressive in finding ways to grant open-account credit terms. However, if it has been bad, most in the group indicated that they would be inclined to reduce the credit line if the sales force didn’t squawk too much. NONFINANCIAL FACTORS THAT AFFECT THE CREDIT DECISION Status of the product. Is it already manufactured and sitting in the warehouse? If so, the sales force is likely to bring this to credit’s attention, especially if the end of the season for the goods in question was approaching or if the product had been moving slowly. At this point, some credit professionals are more likely to get creative to find ways to make the sale happen. Status of sales goals. Is the sale needed to make the budget? Unfortunately, as the accounting period ends, many credit professionals find themselves being pressured to grant credit for sales that don’t meet credit standards. Several report that this happens with greater frequency if sales goals are not met. NONFINANCIAL FACTORS THAT AFFECT THE CREDIT DECISION Role of sales. Will sales be willing to get involved in collection efforts should the customer not pay? While most salespeople are reluctant to get involved with collection efforts, several of the credit professionals indicate that they are able to exact a promise to help in exchange for extending credit in marginal cases. However, most who were able to do this say that they did this mostly with customers who were late payers. The preference of the group was to tie the salesperson’s commission to the payment of the accounts receivable but few are successful on that front. Customer’s cooperation. Is it possible to obtain a partial payment up-front to cover costs? In cases where the credit of the customer is questionable and the margins on the product high, a number of credit professionals simply ask for cash in advance for the portion that relates to the out-of-pocket costs. Then if the final payment is not received, the company only loses its profits. This also demonstrates to the customer a willingness to work together. Several who have tried this approach with new customers say that they are ultimately able to convert these accounts into long-term quality customers. NONFINANCIAL FACTORS THAT AFFECT THE CREDIT DECISION Mean versus ends. Can this sale be used to leverage payment on an outstanding order? There is nothing more frustrating to a credit professional than to be approached by a salesperson to extend additional credit to a customer who is already late paying other invoices. However, should the customer really want the goods, it may be possible to make the sale if the customer agrees to pay the outstanding invoices. Ideally, such a customer should not only pay the outstanding invoices but make a partial prepayment on the new order. If, after taking all the factors discussed above into account, credit cannot be granted, credit professionals should look for another “creative” way to grant the credit even if the customer does not meet financial standards. Not only will the company get the sale and have a higher profit, the sales force will appreciate the efforts. HOW DIFFERENT COMPANIES REVIEW NEW ACCOUNTS Not all companies review credit in exactly the same manner. Depending on the nature of the business, the corporate culture, the resources devoted to the credit review process, and the amount of credit granted with open terms, companies set credit review guidelines. The range of what is done is quite wide. The following list includes just a few of the ways companies evaluate credit. Every new customer must complete a credit application. Have credit policies and procedures in writing and have them approved by senior management. This approval helps the credit department should sales try and bend some of the rules. HOW DIFFERENT COMPANIES REVIEW NEW ACCOUNTS Call all new customers and explain discount terms. Encourage customers to call before taking any deduction. New credit applications are reviewed thoroughly and questionable accounts put on cash-on-delivery (COD). Use multiple sources of information, including the Internet, to obtain factual data on companies. Sales and credit review customer programs in detail. Profitability analysis, capacity, and other key factors are all part of the credit line granting process. HOW DIFFERENT COMPANIES REVIEW NEW ACCOUNTS Have the board of directors revise and clarify credit policy and terms. Divide the credit application into two parts: the credit agreement and the application for credit. Streamline the new account set-up process. Assign one person to set up new accounts, send out credit applications, and process them once they are completed and returned. Have all customers complete an application and a customer profile so the credit analyst can see the big picture. Redesign the credit application so it is easier to fill out. Eliminate any meaningless requirements and add slots for e-mail addresses and customer Web sites. Require bank/trade references with completed credit application. Work with sales on the credit application process. Make sure they get a signed contract and authorization rather than just a verbal commitment. HOW DIFFERENT COMPANIES REVIEW NEW ACCOUNTS Make the credit approval for all new customers consistent. Require the same information from all before credit is granted. Once the process is standardized, the sales reps know what will be required and make sure the customers supply it. Automatically give new accounts a small credit line with minimal credit checking. Then reevaluate based on financial information and payment habits. Formalize a thorough process involving pulling credit reports, reviewing the customer’s completed credit application, and accessing financial information over the Internet. Have a training program for the existing credit staff to make sure they all understand the nuances of credit and are using the same corporate standards. Hire a full-time credit administrator to monitor the credit approval process. EXISTING ACCOUNTS Just because a rigorous credit evaluation was completed when a company first becomes a customer does not mean that analysis is good forever. Most in the field would recommend that credit reviews of all accounts be done at least once a year. However, the reality is that ongoing credit reviews are one of those things that get pushed back when the credit staff does not have enough time to do all the work that it has on its plate. This is too bad because long-term customers do run into financial difficulties and it would be nice if you were able to cut your firm’s exposure before the customer can no longer pay. Here’s a sampling of how you can review the credit limits of their existing customers: Each month, you can generate a list of all customers that are up for their annual review. Review current credit limit and past payment history to determine if higher credit limits should be granted to each customer once a year. Review existing accounts with controller once a year and discuss the status of each. EXISTING ACCOUNTS Depending on the level of activity in the account, each customer is reviewed annually or semi-annually. Only review the top 25 customers each year. Customers with large balances or changes in their payment habits are reviewed each year. Continually monitor largest customers. Any customer who has not done business with the company in over a year is forced to go through a new credit check. Accounts are all set up for annual review by placing an indicator in the sales system. The list is printed monthly and the accounts updated. Depending on the credit limit, the update may consist of obtaining new financial statements, updating credit reports, and trade and bank references. EXISTING ACCOUNTS If a customer consistently bumps up against its credit limit but pays within acceptable limits, the limit is reviewed. If the payment history is not acceptable, “the whole enchilada” is done again. Update data by mail and phone. Run reports to show which accounts have orders that will exceed their credit limits. These accounts are then reviewed. Evaluate current payment patterns, and update trade references and financial information for a formal review of the credit limit. Maintain a monthly analysis of all customer credit lines and sales and payment methods. Conduct a thorough analysis two to three times a year with upper management and monthly meetings with the department staff. EXISTING ACCOUNTS Credit professionals should try to review existing accounts at least once a year not only because it is a good business practice but also to protect themselves. When the credit review is done, the documentation should be put in the file and any recommendations should also be filed. If management overrides you, it is imperative that at a minimum a note to this effect be put in the file. Ideally, the override would be in writing—but that is often difficult. The reasons for this are fairly simple. When one of these marginal accounts goes bankrupt and ends up owing your company thousands (or more) of dollars, management is going to point a finger at credit and ask “why wasn’t credit on the ball to see this trouble coming.” If you have a notation in the file that you warned management and sales, and they decided to ignore your advice, you will avert the blame. They still won’t be happy with you, but at least credit won’t shoulder the full responsibility for the loss. WHAT SHOULD BE IN THE CREDIT FILE? When taking legal action because of nonpayment or bankruptcy of a customer, some credit managers find they do not have the information they need. If the facts and figures were not collected when the account was first opened, the customer will probably not provide them when the account gets into financial difficulty. This information is not difficult to obtain when the account is first set up. The customer is interested in putting on a good face with the vendor. While amassing these reports for each new customer may seem a waste of time, the credit professional will be paid back many times over for this effort when the account goes bad. So, exactly what should you keep in debtors’ credit files? WHAT SHOULD BE IN THE CREDIT FILE? Basic Information- The data listed in this section are usually needed to prepare documents. While it seems elementary, some credit professionals report it missing from their files. It includes: The identity of the debtor, including its correct name, form of business, and whether it is one entity or multiple entities Locations of the debtor Locations of the debtor’s assets Value of collateral Form of debt (invoices, statements of accounts, promissory notes) WHAT SHOULD BE IN THE CREDIT FILE? Other Sources of Information In addition to the details listed above, miscellaneous intelligence—such as information from banks, other creditors, or competitors—should be included. Much of the material kept in the credit files needs to be updated regularly. New financial reports and sales contracts should routinely be included in the credit files. Similarly, new credit reports should be pulled periodically to make sure your customer’s financial standing is as good as (or better than) it was when the account was first opened. In the current environment it is imperative that credit professionals do everything to protect their companies against nonpayment. Some companies actually have the information discussed above but cannot find it when it is needed. The importance of having all relevant documents in one place should not be underestimated. CHECKING OUT NEW CUSTOMERS The old adage, “if something looks too good to be true, it probably is,” is especially pertinent to credit professionals when they check trade references on new clients. A potential customer gives you the names of three companies and contacts there. You reach all the contacts, who respond that the customer pays bills on time and is no problem. What could be wrong with that? In some instances, a lot. You should be suspicious if a reference uses only superlatives to describe the customer and doesn’t need to look up the customer’s records. The following are some suggestions on checking on references before you rely on them to support the potential customer: CHECKING OUT NEW CUSTOMERS Check with the Yellow Pages or other outside sources to confirm that the reference company actually exists. Call information and ask for the phone number of the reference company. See if it’s the same as the number the potential customer gave you. Make sure the person you speak to really works for the reference company and is in a position to speak for the company. Ask to speak to the credit manager instead of the person whose name was provided. Make sure the reference is in a business in which the customer could logically be expected to work. Will these steps guarantee that a phony reference won’t sneak past you? No, but following these simple procedures certainly will make it more difficult for someone trying to pass bogus references. SETTING A CREDIT LIMIT Some companies use a simplistic approach offering customers 10% of the customer’s net worth capped at some level. For example, most vendors with annual sales of $100 million will never offer a customer a line of more than $10 million. The reason is simple —the vendor simply cannot handle the limit no matter how good the company, and it is also a very poor idea. Most companies like to limit their exposure to any one company, never allowing one company to represent more than 10% of its annual business. Others use a formula based on the customer’s financial numbers. WARNING SIGNS Alert credit professionals will find signs of potential trouble in their day to- day operations. The following are some signs that might signal trouble: A normally prompt paying customer begins to take longer and longer to pay its invoices. A small customer suddenly places a much larger order than normal. Other credit managers report late payments at industry group meetings. Sales finds a new customer that must have a large order quickly. A customer that took minimal deductions suddenly starts taking large deductions. INTERNATIONAL CUSTOMERS One of the biggest mistakes companies make when they first dip their toes into the international arena is to assume that business overseas runs the way it does locally. That simply is not the case and proceeding using that assumption is likely to get a company into big trouble. The second biggest mistake made by more than a few companies is to throw credit considerations right out the window. These companies decide that evaluating international credit is very difficult and therefore they won’t even bother. Thus, they end up granting credit to every customer that shows up including those that they would never offer open account terms to had they been a domestic customer. Selling to companies in other countries requires different approach than when selling domestically. SUMMARY As you can see, there isn’t only one way to analyze credit. The approach selected by each company will match its industry needs along with the resources it is willing to devote to the credit process. By evaluating the discussion above and reviewing some of the techniques used by different companies, you will be able to devise the best credit approach for your company.