Credit Analysis

and Lending
Management
CHAPTER 9: ACCOUNT RECEIVABLE MANAGEMENT

Outline:
Monitoring Account Receivable
Aging Account Receivable
Late Payment
Credit Limit

What are 'Accounts Receivable - AR'

Accounts receivable (AR) refers to money owed by customers (individuals or
corporations) to another entity in exchange for goods or services that have been
delivered or used, but not yet paid for.
Receivablesusually come in the form of operatinglines of creditand are usually
due within a relatively short time period, ranging from a few days to a year.
On a company'sbalance sheet, accounts receivable is often recorded as an asset
because this represents a legal obligation for the customer to remit cash for its
short-term debts

Why Monitor Accounts Receivable (A/R)?

Deviations from the expected levels of turnover and of bad debt can signal several
different problems. Three of these problems are Changing Customer Payment Characteristics the A/R manager deals with a
constantly changing portfolio of receivables as customers pay invoices, and sales
are made. Because of the rapid maturation of these assets in this portfolio,
changes in the firms customers or in economic and competitive conditions can
impact receivables with remarkable suddenness.
Inaccurate Policy Forecasts there is substantial uncertainty in estimating bad
debt, A/R turnover, and other relevant variables.
Improper Policy Implementation if the implementation is faulty, shareholder
wealth will not be maximized. Difficulties in the implementation of policies may
stem from problems in communicating the policies to employees, from
inappropriate evaluation of employees relative to these policies.

Methods for Monitoring Accounts Receivable

Two common methods of receivables monitoring are:
Days sales outstanding (DSO) and
Aging fraction statistics.
Unfortunately both of these approaches are seriously flawed. For example,
when sales vary over time, both days sales outstanding and aging
fractions will give inappropriate signals.

Methods for Monitoring Accounts

Receivable
Days Sales Outstanding (DSO)
DSO indicates the average length of time it takes the firm to collect for
credit sales.

A lowDSO number means that it takes a company fewer days to collect its
A/R.A high DSO numbershows that a company is sellingits product to
customers on credit and taking longer to collectmoney.

Methods for Monitoring Accounts Receivable

Days Sales Outstanding (DSO)
Due to the high importance of cash in running a business, it is in a
company's best interest to collect outstanding receivables as quickly as
possible.
By quickly turning sales into cash, acompany has the chance to put
the cash to use again ideally, to reinvest and make more sales.
The DSOcan beused to determinewhether a company is trying to
disguise weak sales, or is generally being ineffective at bringing money
in.For most businesses, DSOis looked at either quarterly orannually.

Methods for Monitoring Accounts Receivable

Aging Fractions
The aging fractions show the receivables by age of account. The longer
an account has been unpaid, the less likely it is to be paid.
The aging fractions are computed by dividing the outstanding
receivables of a particular age by the total receivables balance at the
end of that month.

This report typically lists each customer with its corresponding

receivable balance allocated horizontally into age categories.

Aging Schedule
Age of A/C

Percent of Total Value of

A/R

0 30 days

55%

31 60 days

10%

61 90 days

15%

Over 90 days

20%

Aging Summary

Better Tools for Monitoring A/R

Three OTHER MONITORING tools are:
Ratios of receivables outstanding to original sales
Customers payment proportions
Sales-weighted DSO
All these three methods do a much better job than aging fractions or
traditional DSO in monitoring payment behavior since they do not
give false signals when no deviations from the expected payment
pattern have occurred and do give proper signals when such
deviations have actually occurred.

Ratios of Receivables Outstanding to Original

Sales
Receivables outstanding at any particular time are compared only to
sales in the period during which the receivables were generated.
The ratios of receivables outstanding are computed by dividing the
receivables outstanding from a particular month by the sales from that
month.
This gives a true picture of receivables payment behavior.

Customers Payment Proportions

The payment proportions figures are computed as the proportion of a
months sales that are collected in the month being analyzed.
The payment proportions figures are calculated by comparing changes in
receivables balances with sales for the month during which the
receivables originated.

Sales-Weighted Days Sales Outstanding (SWDSO)

SWDSO allows for fluctuations in sales by weighting the receivables
balances by the sales incurred in the month during which the receivables
were generated.
The SWDSO can be calculated as:
SWDSO = (ARt/St) (30 days/month)
where t is the month of sale, n is the number of months for which
receivables are outstanding, ARt is the outstanding A/R balance from
month t, and St is the sales in month t.

Late payment
Alate paymentfee (alatecharge) is charged to a borrower
who misses paying at least their minimumpaymentby
thepaymentdeadline.

Credit limit
Acredit limitisthemaximumamountofcreditthatafinancialinstitutionorotherlenderwill
extendtoadebtorforaparticularlineofcredit(sometimescalledacreditline,lineofcredit,
oratradeline).
Forexample,itisthemostthatacreditcardcompanywillallowacardholdertotakeoutat
onceonacreditcard.
Thislimitisbasedonavarietyoffactorsrangingfromanindividual'sabilitytomakeinterest
payments,anorganization'scashflowand/orabilitytorepaythecreditcarddebtandisan
obligationoftheconsumertopayjustlikeallotherpartsofthebalance.

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