Accounts Receivable

Accounts Receivable (A/R) is a total amount that your clients owe your company for products and services that they received but have not yet paid for. Essentially, A/R is an instrument of trade credit or customer credit with which your company finances your customers (more accurately, their purchases of your goods and services).  

A/R represent short-term (definitely less than one year, but usually less than three months), no-interest financing. That differentiates it from long-term customer financing common in sales of cars or expensive industrial, computer or other equipment. In the latter case your customer gets the goods in exchange for a long-term note payable on which an interest must be paid (which goes to Interest Income account on your P&L). I will cover notes payable in more detail in the Capital Assets section.

 

Why would you want to finance your customers with A/R? To sell more of your products and make more money, of course. In our credit-driven world (both in B2C and in B2B sectors), attractive financing terms is a major competitive advantage.

In some industries (e.g. auto industry or computer equipment industry) you simply can not compete if you do not offer comfortable financing. Which becomes an important dimension in customer decision-making in addition to ‘classic’ functionality, quality, price and service.  

But there is a significant downside. First, cash that is tied up in your A/R, can’t be used to pay your bills (which increases your liquidity risks) or make investments (which reduces financial value generated by your company). Second, some of your customer debt will inevitable go bad and will have to be written off. Which means that you will definitely lose some money.

Therefore, your key objective in A/R management is two-fold: (1) identify and maintain an optimum balance between cash/credit/prepayment sales – with some customers you might have to do the latter and (2) build an optimal portfolio of you’re A/R – with different maturities. You will need to accomplish this objective to maximize NPV and ROIC from your investment in your accounts receivable.

To accomplish this vitally important objective, you will need:

1.      A highly efficient system of performing customer credit checks and calculating credit scores (which requires a detailed and comprehensive customer database)

2.      A no less efficient system for offering credit terms based on these scores

3.      Highly efficient consumer debt collection system

Which, in turn, requires solid methodologies, highly efficient business processes, highly competent customer credit managers, a competent and experienced collection agency and a good working relationships with this agency.