Accounts Receivable Management

Accounts receivable constitute a substantial portion of current

assets of several companies’ balance sheets, highlighting the

importance of the management and financing of this type of asset since

it plays an important role in a firm’s performance, risk and value

(Smith, 1990).

Accounts Receivable Management is the process of controlling and

collecting payments from customers (Fujo and Ali, 2016). It refers to

the activities that an organization is engaged in, such as issuance of

service, recording of transaction and analyzing and collecting

payments for services rendered to the debtors or to the customers.

Omondi (2014) further explains that it deals with a shortened

collection period, low levels of bad debts and a sound credit policy

that often improves business financial growth. Even though accounts

receivable is short term in nature, this has a long-term impact on the

organizations working capital and financial structure.

Accounts receivables management occurs when managers use

decisions in financial reporting and in organizing transactions to

modify financial information to either mislead some stakeholders

regarding the fundamental economic performance of the organization or

to influence contractual outcomes that depend on reported accounting

practices Healy and Wahlen (1999).

management. (1) Before a company grants credit to a customer it should

ensure, as far as possible, that the customer is worthy of that credit

and that bad debt will not result. Checks should continue to be

carried out by existing customers as a company would like to have

early warning of any problems which may be developing. This is

especially true for key customers of the company. (2) Once the

decision has been taken to grant credit, then suitable credit terms

must be set and the receivables that arise must be monitored

efficiently if the costs of giving credit are to be kept under

control. (3) A key area of the management of accounts receivable is

the final collection of cash from customers. Any company must have a

rigorous system to ensure that all customers pay in a timely fashion

as, without this, the level of receivables and the cost of financing

these receivables will inevitably rise, as will the risk and cost of

bad debts. Parrot further cited the importance of assessing

creditworthiness (such as band reference, trade reference,

credit/rating reference agency, financial statements, information from

financial media and visit), setting credit terms and monitoring

accounts receivable (such as explaining credit terms and conditions,

setting credit limit, monitoring of accounts receivable thru aged

analysis and credit utilization report), collecting cash (such as

giving customers invoice very quickly and accurately, sending monthly

statements, chasing letters, chasing phone calls, personal approach,

stopping supplies, legal action, and outsourcing external debt

collection from accounts receivable, and giving invoice discounting.

Managing accounts receivables involve five steps: determining to

whom to extend credit, establishing payment period, monitoring

collection, evaluating the liquidity of receivables accelerating and

eventually cash receipts from accounts receivable holder. Thus, the

critical part of managing accounts receivables is determining to whom

credit should be extended and to whom it should not. This forms the

basis of credit appraisal.

According to DeYoung, Glennon and Nigro (2006) most credit

decisions are frequently based on subjective feelings about the risk

in relation to expected repayment by the borrower. The first step in

limiting credit risk involves screening clients to ensure that they

have the willingness and ability to repay the credit sales extended to

them. Firms commonly use this approach because it is both simple and

inexpensive.

Credit Selection and Standards

Credit selection involves the application of techniques for

determining which customers should receive the credit. This process

evaluates the customer’s creditworthiness and comparing it to the

firm’s credit standards, its minimum requirements for extending credit

to a customer.
 Gitau, Nyangweno, Mwencha, and Onchagwa (2014) noted that the

credit control function is aimed at ensuring that the accounts

receivable are timely recovered before they become uncollectible

thereby becoming bad loss to the business. The credit managers needed

to consider these five Cs of credit on their credit issuance

decisions: capital, collateral, condition, character, and capacity

Kilonzo, Memba, and Njeru (2016).

Capital

The Applicant’s debt relative to equity. It is also known as

equity or net worth is the reserves a business has in the event of a

problem. Capital represents the funds retained in the company to

provide a cushion against unexpected losses. A strong equity position

will prove financial resiliency to help a firm weather periods of

operational adversity. Minimal or nonexistent equity makes a business

susceptible to miscalculation and thereby increases the risk of

default. A strong equity position is believed to ensure that the

owners of the enterprise will remain committed to the business to

mitigate moral hazards.

Collateral

The amount of assets the applicant has available for use in

securing the credit. The larger the amount of the available assets,

the greater the chance that a firm will recover funds if the applicant

defaults.
Condition

Current general and industry-specific economic conditions and any

unique conditions surrounding a specific transaction. It is also

business plan that considers the level of competition and the market

for the product or service, and the legal and economic environment.

Character

The applicant’s record of meeting past obligations. It refers to

the customer’s willingness and determination to meet a loan

obligation. This can be partially confirmed by determining how the

customer paid the previous obligations.

Capacity

The applicant’s ability to repay the requested credit, as judges

in terms of financial statement analysis focused on cash flows

available to repay debt obligations.

Through these five Cs, companies get to better understand their

customers leading to a decrease in the default rates. Some of the

sources where the data and information on the Cs could be obtained by

the credit managers include: the past experience of the firm with its

clients, financial statements from prior periods, and credit

reporting. Credit standards denote the needed financial strength of

admissible credit buyers. Therefore, the credit analyst uses financial

analysis and non-financial data to assess the suitability of every

standards have been linked to an increase in sales as well as the bad

debts. Both the credit period, which stipulates how long it should

take from the invoice date until the customer pays, and the cash

discount constitute the seller’s credit terms, and in most cases these

terms are very similar to those of other entities in its industry.

Credit Terms

These are payment terms mentioned on the invoice during the time

of purchase. This is an agreement between the buyer and seller about

the timings and payments that will be made for the goods that are

bought on credit.

Cash Discount

This is a way to speed up collections without putting pressure on

customers. It provides incentive for customers to pay sooner. By

speeding collections, the discount decreases the firm’s investment in

accounts receivable, but it also decreases the per-unit profit.

Additionally, initiating a cash discount should reduce bad debts

because customers will pay sooner, and it should increase sales volume

because customers who take the discount pay a lower price for the

product. Accordingly, firms that consider offering a cash discount

must perform a benefit–cost analysis to determine whether extending a

cash discount is profitable.

Credit Monitoring
 An ongoing review of the firm’s accounts receivable to determine

whether customers are paying according to the stated credit terms. If

they are not paying in a timely manner, credit monitoring will alert

the firm to the problem. Slow payments are costly to a firm because

they lengthen the average collection period and thus increase the

firm’s investment in accounts receivable. Two frequently used

techniques for credit monitoring are average collection period and

aging of accounts receivable. In addition, a number of popular

collection techniques are used by firms.

Average Collection Period

According to Gitman (2015), this is a measurement that is useful

to evaluate credit and collection policies and according to Brigham

(1995) it is the number of days sales remain with debtors. This means

that longer collection period indicates customer’s balance may become

uncollectible and can make a company unprofitable.

Aging of Accounts Receivable

An aging schedule breaks down accounts receivable into groups on

the basis of their time of origin. The breakdown is typically made on

a month-by-month basis, going back 3 or 4 months. The resulting

schedule indicates the percentages of the total accounts receivable

balance that have been outstanding for specified periods of time. The

purpose of the aging schedule is to enable the firm to pinpoint

problems. A simple example will illustrate the form and evaluation of

an aging schedule.
Benefits of Accounts Receivable Management

Accounts receivable is an interim debt arising through credit

sales and recorded as accounts receivable by the seller and accounts

payable by the buyer (Brigham 1986). Trade credit has been described

as the oil of commerce and is an indispensable catalyst in stimulating

production, selling and expansion in both small- and large-scale

businesses existing in private and public sector. The main reason why

firms sell on credit is to expand their sales and maintain the market

share. Credit policy helps to retain old customers and create new

customers by winning others from competitors.

If a firm expands its sales as a result of credit policy, it

incurs incremental production and selling costs, administration cost

such as credit investigation and supervision costs and collection

costs such as bad debts increases. According to Ross (2004) optimum

accounts receivable in a business is one that maximizes the value of a

firm when the incremental rate of return (marginal rate of return) of

an investment is equal to the incremental cost of funds (marginal cost

of capital) used to finance the investment. The incremental cost of

funds is the rate of return required by the suppliers of funds given

the risk of investment in Debtors. As the firm liberalizes its credit

policy its investments in debtors becomes riskier because of increase

in slow paying and defaulting debtors.

corporate finance since it directly affects the liquidity and

profitability of the company (Pandey, 2010). It is useful to think of

the decision to grant credit in terms of carrying costs and

opportunity costs. Carrying costs are the costs associated with

granting credit and making investment in accounts receivable. It

includes the delay in receiving cash, the losses from bad debts and

the costs of managing accounts receivable. Opportunity costs are the

lost sales from refusing to offer credit. In the sugar industry, this

involve insufficient raw material as farmers have land but may not

have the resources to develop the cane (Rose, Westfield, Jeff and

Jordan 2008). Finance manager can vary the level of accounts

receivable in keeping with the trade-offs between profitability and

risk. Economic conditions and the firm’s credit policies are the chief

influences of the level of accounts receivable to be maintained by a

firm at any given time (Horn 2007).

Accounts receivable is of importance to any organization which

has to attain its objective of profit maximization. Companies that are

able to manage their accounts receivable well will not need to borrow

funds from outside and can be able to sustain themselves.

As posited by Backman (1962) trade receivables arise from selling

of services and products on credit, and it requires efficient

management because there are risks relating to the future and, and

which has a greater economic value. These risks basically arise from

defaults in the future as the money is receivable at a future date

services are exchanged at a monetary value.

Under the class of total assets, the trade receivables are

considered third after the property, plant and equipment, and stock,

while second in class in reference to the current assets and come

after inventory. Additionally, in reference to the working capital

management, trade receivables are regarded a crucial element behind

cash and stock. Firms must institute efficient credit policy in order

to boost their profitability as well as the liquidity levels.

According to Foulks (2005) firms need to ensure proper accounts

receivable management to avoid situations of considerable strain of

their liquidity, and to remain profitable.

To attain maximum trade receivables management, a company is

required to consider these factors: volume of the credit trade, terms

and conditions for issuing credit, payment pattern of customers,

existing credit sales management practices and policies, and

collection policies. Receivables constitute large investments in an

entity’s assets making them like capital budgeting projects, which are

measured in reference to their net present value (Emery, 2004).

Receivables have been associated with stimulated sales because it

permits the customers to assess the quality of their purchases before

paying for them. However, debtors involve money that is an opportunity

cost to the company.

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