Cash Management in Accounts Receivable: Strategies & Best Practices

Cash Management: Accounts Receivable

Trade credit arises when a firm sells its products or services on credit and does not receive cash immediately. It serves as an important marketing tool for expanding sales and building customer relationships. By granting trade credit, a firm can safeguard its market share from competitors while encouraging potential customers to purchase its products under favorable terms.

Trade credit generates accounts receivable, or book debts, which represent the amounts the firm expects to collect within a specified period in the near future. Effective management of these receivables is vital for maintaining cash flow, ensuring liquidity, and supporting the overall financial health of the business.

Accounts Receivable Management: Why It Matters

Receivables constitute a substantial portion of the current assets of many firms. After inventories, trade debtors are often the largest component of current assets. Since there is usually a time gap between the date of sale and the date of payment, firms are required to finance this interval using their working capital. To bridge this gap, they often turn to banks or other financing sources.

Funds tied up in trade debtors represent a significant investment for the business. Because such large amounts are locked in receivables, careful analysis and effective management are essential. Proper receivable management ensures liquidity, minimizes financing costs, and safeguards the firm’s overall financial stability.

Credit Policy

A firm’s credit policy is shaped by three key decision variables:

1. Credit Standards – The criteria used to determine which customers are eligible to receive goods on credit.
2. Credit Terms – The duration of the credit period and the specific terms of payment extended to customers.
3. Collection Efforts – The methods and degree of effort applied to recover receivables. A shorter collection period reduces the firm’s investment in accounts receivable.

Types of Credit Policy

1. Lenient Credit Policy: Under this approach, firms extend credit liberally, granting longer credit periods even to customers with uncertain creditworthiness or weak financial positions. While this may boost sales, it increases the risk of bad debts.
2. Stringent Credit Policy: In this approach, credit is extended selectively and only to customers with proven creditworthiness and strong financial stability. Though it reduces the risk of default, it may also limit sales growth.

Costs Involved in Credit Policy

When evaluating its credit policy, a firm must weigh both the potential returns and the costs associated with additional sales. The main types of costs involved are:

1. Production and Selling Costs - If capacity is expanded to accommodate sales growth resulting from a more liberal credit policy, incremental costs will include both variable and fixed components.
2. Bad Debt Losses - These occur when the firm is unable to collect accounts receivable from customers who default on payments.
3. Administrative Costs
• Credit investigation and supervision costs related to assessing customers’ creditworthiness.
• Collection costs incurred in pursuing overdue payments.

Optimum Credit Policy

An optimum credit policy is one that maximizes the firm’s value. This is achieved when the incremental rate of return (also called the marginal rate of return) on investment in accounts receivable is equal to the incremental cost of funds (or marginal cost of capital) used to finance that investment.

• Condition for optimum policy:
• Incremental rate of return = Incremental cost of funds
• Marginal rate of return = Marginal cost of capital

The incremental rate of return is calculated as: 

Incremental Rate of Return = Incremental Operating Profit / Incremental Investment in Receivables 

The incremental cost of funds represents the return required by the suppliers of funds, given the level of risk associated with investing in accounts receivable.

As a firm loosens its credit policy, its investment in receivables typically becomes riskier due to an increase in slow-paying or defaulting customers. Consequently, the required rate of return rises, forming an upward-sloping curve. The optimum point is where the incremental return curve intersects with the marginal cost curve, ensuring maximum firm value.

Credit Policy Variables

The major controllable decision variables in a firm’s credit policy include:

1. Credit Standards and Analysis
2. Credit Terms
3. Collection Policy and Procedures

Credit Standards and Analysis

Credit standards represent the criteria a firm uses to select customers for credit extension. These standards directly influence the quality of the firm’s customer base. The quality of customers can be evaluated on two key aspects:

1. Average Collection Period (ACP): The time taken by customers to repay credit obligations. It measures the number of days credit sales remain outstanding. A longer ACP indicates a larger investment in accounts receivable and slower cash inflow.
2. Default Rate (Bad Debt Loss Ratio): The proportion of receivables not collected, representing the risk of customer default. A higher default ratio signifies greater credit risk.

To estimate the probability of default, finance managers consider the three C’s of credit analysis:

• Character: The willingness of the customer to pay.
• Capacity: The ability of the customer to pay, based on financial strength.
• Conditions: Prevailing economic or business conditions that may affect the customer’s ability to honour obligations.

Based on this analysis, customers can be grouped into three categories:

1. Good Accounts
2. Bad Accounts
3. Marginal Accounts

Credit Terms

Credit terms are the stipulations under which a firm sells goods on credit. They consist of:

1. Credit Period: The length of time credit is extended, usually expressed in net days (e.g., net 30 means payment is due within 30 days).
2. Cash Discount: A reduction in payment offered to encourage early settlement of dues. For example, terms such as "2/10, net 30" mean a 2% discount is available if payment is made within 10 days; otherwise, full payment is required within 30 days.

Collection Policy and Procedure

Since not all customers pay on time, an effective collection policy is essential. The objectives of a collection policy are to:

• Accelerate collections from slow-paying customers.
• Reduce the likelihood of bad debt losses.
• Ensure regular and prompt cash inflows.

A sound collection policy should establish clear-cut strategies and procedures for following up on overdue accounts, balancing firmness with maintaining customer relationships.

Credit Policy Variable	Lenient Policy	Strict Policy	Impact on Sales	Impact on Risk	Impact on Liquidity
Credit Standards	Allows more customers, including marginal and doubtful credit risk	Allows only customers with proven creditworthiness	Higher sales volume	Higher default risk	Greater funds tied up in receivables
Credit Terms	Longer credit periods, generous cash discounts	Shorter credit periods, limited or no discounts	May boost sales	Increased risk of delayed payments	Reduced cash inflow speed
Collection Policy & Procedure	Less aggressive collection efforts	Strict and prompt collection efforts	May maintain better customer relations	Higher bad debt risk	Improves cash flow management

Monitoring Receivables

To ensure effective collection efforts and maintain healthy cash flow, a firm must continuously monitor and control its accounts receivable. Two traditional methods for evaluating receivable management are:

1. Average Collection Period (ACP)
2. Aging Schedule

Average Collection Period (ACP)

ACP measures the average number of days that accounts receivable remains outstanding before being collected. It is calculated as: ACP=( Debtors  ×360) / Credit Sales  

For example, if the stated credit period is 25 days but the actual ACP is 40 days, this indicates a lax collection system. ACP helps assess the quality of receivables by showing the speed of collection.

Limitation: ACP provides only an average figure and does not reveal the distribution or age of individual receivables, limiting its insight into the quality of outstanding accounts.

Aging Schedule

The aging schedule overcomes the limitation of ACP by breaking down accounts receivable according to the length of time they have been outstanding. This helps identify overdue accounts and assess collection risk more precisely.

For instance, if the firm's credit period is 25 days, but the aging schedule shows that 50% of receivables are outstanding beyond this period, it signals potential collection issues. An example aging schedule might look like this:

Outstanding Period (Days)	Outstanding Receivables (₹)	Percentage of Total Receivables (%)
0–25	200,000	50.0
26–35	100,000	25.0
36–45	50,000	12.5
46–60	30,000	7.5
Over 60	20,000	5.0
Total	400,000	100.0

This detailed breakdown helps firms identify slow-paying customers and take appropriate collection actions.

Factoring

A company can delegate its credit management and collection functions to specialized organizations known as factoring companies. Factoring is a widely used method for managing, financing, and collecting accounts receivable efficiently.

For example, subsidiaries of several major Indian banks, including State Bank of India, Canara Bank, Punjab National Bank, and Allahabad Bank, provide factoring services.

Nature of Factoring

Factoring is a unique financial innovation that combines both financial and management support for a client company. It transforms non-productive, inactive assets namely accounts receivable into cash by transferring them to a specialized firm that handles collection and administration.

A factor facilitates the conversion of receivables into immediate cash, thereby improving the firm’s liquidity.

Factoring Services

Factoring companies typically offer the following services:

1. Sales Ledger Administration and Credit Management
2. Credit Collection and Protection Against Default and Bad Debt Losses
3. Financial Assistance by Providing Advances Against Assigned Book Debts (Receivables)

FAQs 

What is factoring? How does factoring improve cash flow?

Factoring is a financial service where a business sells its accounts receivable to a specialized company (factor) to receive immediate cash and delegate credit management and collection. By converting receivables into cash quickly, factoring provides immediate working capital, helping businesses meet expenses without waiting for customer payments.

Is factoring a loan?

No, factoring is not a loan. It involves selling receivables. Thus, it does not create debt on the firm’s balance sheet.

What types of businesses benefit most from factoring? How much does factoring cost?

Businesses with long receivable cycles, fast growth, limited access to bank financing, or seasonal cash flow needs often benefit most from factoring. Costs include factoring fees and interest, typically higher than traditional loans. Fees depend on invoice amounts, customer credit, and contract terms.

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