Monitoring Accounts Receivable You can monitor how well accounts receivable are managed using finan-

Monitoring Accounts Receivable You can monitor how well accounts receivable are managed using finan-

cial ratios and aging schedules. Financial ratios can be used to get an overall picture of how fast we collect on accounts receivable. Aging schedules, which are breakdowns of the accounts receivable by how long they have been around, help you get a more detailed picture of your collection efforts.

You can get an idea of how quickly we collect our accounts receiv- able by calculating the Number of Days of Credit, which is the ratio of the balance in accounts receivable at a point in time (say, at the end of a year) to the credit sales per day (on average, the dollar amount of credit sales during a day):

Accounts receivable (20-4)

Number of days of credit = ---------------------------------------------------

Credit sales per day where credit sales per day is the ratio of credit sales over a period,

divided by the number of business days in that period. For example, averaging over a year:

Credit sales

Credit sales per day = ------------------------------ (20-5)

365 days

The number of days credit ratio, also referred to as the average collec- tion period and days sales outstanding (DSO), measures how long, on average, it takes us to collect on our accounts receivable.

Suppose that Whole Loaves, a wholesale bakery, has $1 million of credit sales per year and currently has a balance in accounts receivable of $80,000. Then:

Credit sales per day = $1,000,000 ------------------------------ = $2,740 per day 365 days

MANAGING WORKING CAPITAL

and Number of days of credit = --------------------------------------- $80,000 =

29 days $2,740 per day

This means the firm has, on average, 29 days worth of sales that have not been paid for as yet.

The firm can use this measure to evaluate the effectiveness of its col- lection policies, comparing the number of days of credit with the net period allowed in our with the credit terms. You can also use this infor- mation to help us in cash forecasting since it tells us how long before each credit sale turns into cash, on average.

But you need to consider certain factors in applying this measure. For example, if your sales are seasonal, which accounts receivable bal- ance do you use? Over what period do you measure credit sales per day? You must be careful when you interpret this ratio since both the numer- ator and denominator are influenced by the pattern of sales. For exam- ple, firms tend to select the end of their accounting year to be the low point of their operating cycle. This is when business is slowest, which means the lowest inventory level and, possibly, the lowest receivables. If you evaluate receivables at a firm’s year-end, you may not get the best measure of collections. It is preferable (though not always possible) to look at quarterly or monthly averages of receivables.

Firms also monitor receivables using an aging schedule. Preparing an aging schedule allows us to look at all our receivables and group them according to how long they were outstanding, such as 1 to 30 days, 31 to 40 days, and so on. For example,

Number of Days Outstanding Number of Accounts Amount Outstanding

$320,000 31 to 40 days

1 to 30 days

40 80,000 41 to 50 days

10 18,000 51 to 60 days

5 15,000 over 60 days

3 3,000 This schedule can represent the receivables according to how many

there are in each age group or according to the total dollars the receivables represent in each age group. The higher the number of accounts or the number of dollars in the shortest term groups, the faster the collection.

Looking at a breakdown of accounts receivable in an aging schedule allows you to do the following:

1. Estimate the extent of customers’ compliance with credit terms.

2. Estimate cash inflows from collections in the near future.

Management of Receivables and Inventory

3. Identify accounts that are most overdue. Keep in mind that the age of receivables may change from month to

month if credit sales change. For example, your 30–60 day old accounts receivable may increase from June to July simply because credit sales increased from May to June—not because collections of receivables became slower. 2