Account Receivables

Collecting Receivables

Collecting accounts receivable is the final step in the credit extension process and arguably the most difficult. When dealing with collections, a firm needs to start by monitoring its accounts receivable to determine whether its policy is working to the company's advantage. Accounts receivable days and an aging schedule are the most common monitoring tools.

Accounts Receivable Days

Accounts receivable days are the average number of days a firm takes to collect on its sales. By comparing this number to the number in the credit policy, a business can determine whether its policy is effective.

Accounts receivable days are important because investors use this measure to evaluate a firm's credit management policy. However, this method has weaknesses. Seasonal sales patterns may cause accounts receivable days to change depending on when the calculation occurs. Therefore, management can potentially manipulate accounts receivable days to hide important information.

Aging Schedule

The other commonly used method is an aging schedule, which categorizes accounts by the number of days they have been on the books. It can be constructed using the number of accounts or the dollar amount of the outstanding accounts receivable. If the percentages in the lower half of the schedule begin to increase, the firm needs to evaluate the effectiveness of its credit policy.

Payment patterns provide information on the percentage of monthly sales the firm collects each month after the sale. This information can be used to forecast the business's working capital needs.

Receivable Turnover Ratio

Another way to evaluate a credit policy is to examine the receivable turnover ratio. This financial ratio measures the average number of times receivables are collected.

Collecting Receivables

Collection Letter This is an example of a letter from a collection agency offering to settle a debt.

Companies can use several methods to collect their outstanding receivables. Some do nothing, some send reminders notifying customers of late payments, and some take legal action – sometimes at the first late payment. If firms so choose, they can use a collection agency. A collection agency is a business that pursues payments of debts owed by individuals or businesses.

Most collection agencies operate as agents of creditors and collect debts for a fee or percentage of the total amount owed. There are many types of collection agencies. First-party agencies are often subsidiaries of the original company to whom the debt is owed.

Third-party agencies are separate companies contracted by a business to collect debts on their behalf for a fee. A company may protect against bad debt losses by purchasing trade credit insurance. This is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their accounts receivables from loss due to credit risks like protracted default, insolvency, or bankruptcy.