Managing credit and receivables is crucial for a company's financial health. It involves assessing customer through financial analysis and . This process helps determine appropriate and limits, mitigating potential losses.
Monitoring is equally important. Companies use aging schedules and financial ratios to track collection efficiency. Implementing clear credit policies and collection procedures helps maintain a healthy cash flow and minimize bad debt risks.
Evaluating Creditworthiness and Monitoring Receivables
Evaluation of customer creditworthiness
Gather comprehensive customer information through , financial statements, and credit reports from agencies (Experian, Equifax) to assess creditworthiness
Analyze customer's financial stability by assessing liquidity ratios (, ), evaluating profitability ratios (, ), and considering debt ratios (, ) to determine their ability to repay credit
Examine customer's payment history by reviewing past transactions with the company and checking references from other suppliers to gauge their reliability and promptness in settling debts
Determine credit terms based on risk assessment, setting credit limits, establishing payment terms (, ), and requiring or for high-risk customers to mitigate potential losses
Implement systems to objectively evaluate and rank potential customers based on their creditworthiness
Monitoring of accounts receivable
Maintain an that categorizes receivables by days outstanding (0-30, 31-60, 61-90, 90+) to identify delinquent accounts and prioritize collection efforts
Calculate and track key financial ratios such as Average Accounts ReceivableNet Credit Sales to measure how efficiently a company collects receivables and (DSO) Net Credit SalesAverage Accounts Receivable×365 to indicate the average time it takes to collect receivables
Implement a that establishes clear credit terms, communicates them to customers, follows up on past-due accounts promptly, and considers offering discounts for early payment to encourage timely collection and maintain a healthy cash flow
Monitor the to assess the effectiveness of credit policies and collection efforts
Accounts Receivable vs. Notes Receivable
Accounts receivable vs notes receivable
Accounts receivable arise from the sale of goods or services on credit, are short-term (typically due within 30 to 60 days), informal (not evidenced by a written promise to pay), and recorded at the original invoice amount
result from lending money or extending credit beyond normal terms, can be short-term or long-term (with specific maturity dates), are formal (evidenced by a written promissory note), recorded at the present value of future cash flows, and may bear interest at a stated rate (6% per annum)
Accounts receivable are used to manage short-term credit sales, while notes receivable are used for longer-term financing or special credit arrangements (extended payment plans)
Both accounts receivable and notes receivable can be used as collateral for borrowing (, ) or sold/securitized to improve liquidity and manage risk ()
Credit Policy and Risk Management
Establish a comprehensive that outlines the company's approach to extending credit, including credit terms, limits, and collection procedures
Assess and manage by evaluating customers' financial health, payment history, and market conditions
Implement an to estimate and account for potential uncollectible receivables
Record bad debt expenses to reflect the portion of accounts receivable that are deemed uncollectible, impacting the company's financial statements and profitability
Key Terms to Review (42)
2/10 net 30: 2/10 net 30 is a trade credit term that specifies the payment discount and due date for an invoice. It means that if the invoice is paid within 10 days, the customer receives a 2% discount on the total amount. However, if the invoice is not paid within 10 days, the full amount is due within 30 days of the invoice date.
Accounts Receivable: Accounts receivable refers to the money owed to a company by its customers for goods or services provided on credit. It represents the outstanding balance that customers have yet to pay for their purchases, and it is considered a current asset on the company's balance sheet.
Accounts receivable aging schedule: An accounts receivable aging schedule is a report that categorizes a company's accounts receivable according to the length of time an invoice has been outstanding. It helps businesses identify overdue payments and manage credit risk.
Accounts Receivable Financing: Accounts receivable financing is a type of short-term financing where a business uses its outstanding invoices or accounts receivable as collateral to obtain a loan or line of credit. This allows the business to access cash quickly without having to wait for customers to pay their outstanding invoices.
Accounts receivable turnover ratio: Accounts receivable turnover ratio measures how efficiently a company collects its outstanding credit sales. It is calculated by dividing net credit sales by the average accounts receivable during a period.
Accounts Receivable Turnover Ratio: The accounts receivable turnover ratio is a measure of how efficiently a company manages and collects its accounts receivable. It calculates the number of times a company's accounts receivable are converted into cash over a given period, providing insight into a company's working capital management and liquidity.
Aging Schedule: An aging schedule is a financial statement that categorizes a company's accounts receivable based on the length of time the receivables have been outstanding. It provides a detailed breakdown of the company's outstanding customer invoices, allowing for better management and assessment of credit risk.
Allowance for doubtful accounts: Allowance for doubtful accounts is a contra-asset account on a company's balance sheet that reduces the total amount of receivables to reflect those expected to be uncollectible. It helps in providing a more accurate picture of a company's financial health by anticipating potential losses from bad debts.
Allowance for Doubtful Accounts: The allowance for doubtful accounts is an estimate of the amount of accounts receivable that a company expects to be uncollectible. It is a contra-asset account that reduces the reported value of the accounts receivable on the balance sheet, providing a more accurate representation of the company's net realizable value of its outstanding receivables.
Bad debt expense: Bad debt expense is the cost to a company resulting from credit sales that are uncollectible. It represents an estimation of accounts receivable that will not be collected.
Bad Debt Expense: Bad debt expense is an accounting term that represents the estimated amount of accounts receivable that a company expects to be uncollectible. It is a cost recorded on the income statement to account for customers who are unlikely to pay their outstanding balances, reflecting the reality that not all credit sales will result in collected revenue.
Bankruptcies: Bankruptcies occur when individuals or businesses are legally declared unable to meet their debt obligations. This legal process helps manage the insolvency and provides a chance for debt restructuring or asset liquidation.
Collateral: Collateral refers to an asset or property that a borrower pledges to a lender as security for a loan. It serves as a guarantee that the borrower will repay the loan, and if they fail to do so, the lender has the right to seize the collateral to recoup their losses.
Collection Period: The collection period, in the context of receivables management, refers to the average amount of time it takes for a company to collect payments from its customers for goods or services provided. It is a critical metric in evaluating a company's cash flow and the efficiency of its credit and collection policies.
Contra-asset: A contra-asset is an account that reduces the value of a related asset on the balance sheet. It is typically used to account for depreciation, allowances for doubtful accounts, or accumulated amortization.
Corporate Finance Institute: The Corporate Finance Institute (CFI) is an online education platform offering courses and certifications in finance, investment banking, and related fields. It aims to provide practical skills and knowledge for finance professionals through a variety of online resources and tools.
Credit and Collections Policy: A credit and collections policy is a set of guidelines and procedures that a business establishes to manage its accounts receivable and ensure timely payment from customers. It outlines the company's criteria for extending credit, the process for collecting outstanding invoices, and the steps to be taken in the event of delinquent payments.
Credit Applications: Credit applications are the formal requests made by individuals or businesses to obtain credit, such as loans, credit cards, or other financing options. These applications provide lenders with the necessary information to evaluate the creditworthiness of the applicant and determine the appropriate terms and conditions for the credit extension.
Credit Limit: A credit limit is the maximum amount of credit that a lender will extend to a borrower. It represents the maximum amount of money that can be borrowed or charged on a credit card or other credit account before the account reaches its limit and additional credit is no longer available.
Credit period: The credit period is the length of time a seller allows a buyer to pay for goods or services purchased on credit. It typically ranges from 30 to 90 days depending on industry standards and the agreement between parties.
Credit Policy: Credit policy refers to the set of guidelines and procedures that a business or organization establishes to manage its accounts receivable and extend credit to customers. It outlines the criteria and terms under which the company will offer credit, as well as the steps it will take to collect outstanding payments.
Credit Reports: A credit report is a detailed record of an individual's credit history, including information about their credit accounts, payment history, and credit utilization. It is an essential tool used by lenders, creditors, and other financial institutions to assess a person's creditworthiness and determine the risk of lending to them.
Credit risk: Credit risk is the possibility of a borrower failing to repay a loan or meet contractual obligations. It affects lenders and investors as it impacts the expected returns on investments involving debt instruments.
Credit Risk: Credit risk is the risk of loss arising from a borrower's failure to repay a loan or meet contractual obligations. It is a fundamental consideration in the context of bonds, trade credit, and receivables management, as it can significantly impact the value and performance of these financial instruments and transactions.
Credit Scoring: Credit scoring is a system used by lenders to assess the creditworthiness of a borrower. It involves the use of statistical models to evaluate an individual's credit history and predict the likelihood of future loan repayment. This information is crucial for lenders in the context of receivables management, as it helps them make informed decisions about extending credit and managing outstanding accounts receivable.
Credit terms: Credit terms specify the conditions under which a seller will extend credit to a buyer. These include the payment due date, any discounts for early payment, and the interest rate applied for late payments.
Creditworthiness: Creditworthiness is a measure of an individual or entity's ability to repay debt and meet financial obligations. It is a critical factor in determining the risk associated with lending and is a key consideration for lenders when evaluating loan applications or extending credit.
Current ratio: The current ratio measures a company's ability to pay short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities.
Current Ratio: The current ratio is a financial metric that measures a company's ability to pay its short-term obligations using its current assets. It is a key indicator of a company's liquidity and financial health, providing insights into its short-term solvency and operational efficiency.
Days Sales Outstanding: Days sales outstanding (DSO) is a metric that measures the average number of days it takes a company to collect payment from its customers for sales made on credit. It provides insight into the efficiency of a company's accounts receivable management and the overall liquidity of the business.
Debt-to-Equity: Debt-to-equity is a financial ratio that measures a company's financial leverage by comparing its total liabilities or debt to its shareholders' equity. It indicates the proportion of equity and debt a company uses to finance its assets.
Factoring: Factoring is a financial transaction where a business sells its accounts receivable to a third party (called a factor) at a discount. This provides the business with immediate cash flow and transfers the risk of collecting the receivables to the factor.
Factoring: Factoring is the process of converting accounts receivable into immediate cash by selling them to a third-party at a discounted rate. It is an alternative source of financing that allows businesses to improve their cash flow and liquidity without taking on additional debt.
Interest Coverage: Interest coverage is a financial ratio that measures a company's ability to meet its interest payment obligations. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses, indicating how many times the company can cover its interest payments with its available earnings.
Net 30: Net 30 is a payment term that specifies the total amount owed for a transaction must be paid within 30 days of the invoice date. This term is commonly used in the context of accounts receivable management, as it establishes the timeline for when a customer must remit payment to the seller.
Notes Receivable: Notes receivable are formal written promises to pay a specific sum of money on a certain date in the future. They represent a company's right to receive cash from customers or other parties who have borrowed money from the company.
Personal Guarantees: A personal guarantee is a legally binding promise made by an individual to repay a debt or fulfill an obligation if the primary borrower or obligor fails to do so. It is a common practice in business financing and credit arrangements to mitigate risk for the lender or creditor.
Pledging: Pledging refers to the process of offering or committing an asset, typically a receivable, as collateral to secure a loan or other financial obligation. It involves using a receivable as a form of security to obtain financing or credit from a lender.
Quick ratio: The quick ratio measures a company's ability to meet its short-term obligations using its most liquid assets. It is calculated as (Current Assets - Inventory) / Current Liabilities.
Quick Ratio: The quick ratio, also known as the acid-test ratio, is a liquidity ratio that measures a company's ability to pay its short-term obligations using its most liquid assets. It provides a more stringent assessment of a company's liquidity compared to the current ratio by excluding inventory from current assets, as inventory may be more difficult to convert into cash quickly.
Return on Assets: Return on Assets (ROA) is a financial ratio that measures a company's profitability and efficiency in utilizing its assets to generate net income. It is calculated by dividing a company's net income by its total assets, and is expressed as a percentage.
Return on equity: Return on Equity (ROE) measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. It is calculated as Net Income divided by Shareholders' Equity.