Developing Receivables Policies

Policies on receivables formalize decisions on the extension of credit to customers. Rules should be established on various issues:

• How much credit will be granted to specific groups of customers?
• What are the credit terms that will be extended? That is, how many days will be the standard for payment of invoices or statements?
• Will discounts—called cash discounts—be granted for early payment? Will other types of discounts be offered?
• How will the company pursue slow and no payers? What mechanisms will be used, and what will trigger each action?
• What forms of financing will be used to assist our customers in making purchasing decisions?
• Should we use a financial intermediary to lend to us on our receivables while we await payment in a process called asset-based lending? Should we sell our receivables—called factoring?
• Are we monitoring our company's salespeople to prevent their making unauthorized credit promises to customers in order to generate sales?
• Should we use the services of a debt collection agency?

Written policies ensure consistency in decision making and avoid the possibility of discrimination against certain customers. In situations where preferential treatment is extended, the policy should specify the conditions for such treatment. These conditions could occur when a business relationship has existed for five or more years, or when a customer is consistently current on its payments.

Similarly, when punitive treatment is indicated, there should be a policy. For example, a customer consistently late in paying could be disciplined by requiring some cash in advance or by executing a lien (a legal claim to the property) on certain assets such as the inventory or equipment that was delivered.¹

Furthermore, policies establish required practice for all parties that cannot be modified except by senior management. This is important when a customer or a prospect asks for special terms, such as a longer time to pay or a smaller down payment. Any violation should be considered as a serious breach of behavior triggering appropriate penalties.

Getting to Know You—Getting to Know Your Company!²

Financial managers typically do not go on customer calls with their salespeople. As a result, it is impossible to have any idea of what they may be promising to win business. For example, are they offering pricing concessions, lenient credit terms, or a delay in payment? Salespeople are usually compensated by commission or a salary and a bonus for superior performance. Commissions and superior performance are driven by sales and not by concern for profits. Without adequate supervision, sales could be occurring at the expense of financial returns.

Incidentally, manufacturing often responds to the same motivation— production at the expense of efficiency and profitability. Unfortunately, these functional areas typically do not coordinate their decisions except at the level of the company president, and real turf wars can inhibit cooperation and appropriate procedure. Managers should leave the “friendly confines” of the finance office and go on a few sales calls or tour the factory floor. They may be surprised at what really goes on!

Calculating Receivables Float

The slippage or float lost between the target and actual due dates is 22 days. The value of the lost days, at an assumed 10 percent cost of capital, is calculated as $500 million × 22 lost days ÷ 360 calendar days × 10 percent cost of capital = $3.1 million. Research determined that the delay in invoicing was caused primarily by various scheduling issues within the information technology function, with invoicing cycles run at certain weekly intervals at the convenience of that department.

Once senior management became aware of the potential value of the lost float, it was a relatively simple matter to mandate the rescheduling of processing runs. Although some customers did notice the change in the timing of their monthly invoices and held checks until the usual release date, many paid once the bill was approved.

The various steps in the receivables cycle result in a loss of more than three weeks and $3 million a year, yet no one function is responsible. The rational CEO would demand that this situation be fixed, but who would he or she turn to? Unfortunately, the answer is a group of managers (probably vice presidents), each of whom could blame the others. What is needed is a dedicated senior manager (or committee) who can analyze the situation and initiate whatever changes are required, from earlier assembly of invoice data through the issuance of invoices.

The receivables manager/committee would also be responsible for specific activities that assist marketing, such as sales financing and cash or trade discounts; that trigger receivables, including invoicing; and that provide working capital to the company as it awaits payment, such as factoring. In the absence of a receivables manager, a company could establish a committee or task force on receivables with the power to examine and decide on possible changes in procedures.

Receivables Ratio Analysis

Ratios were discussed in Chapter 2 using receivables turnover (calculated as Credit sales ÷ Receivables) and a variation of that ratio, average collection period (calculated as 360 days ÷ Receivables turnover). In comparing ratios, we noted that we would measure the company's result to that of its industry using the interquartile range as normal. Our calculation for receivables turnover was 5.5 times and 66 days for average collection period.

Now let's examine an actual set of ratios using a standard source; as an example, we'll use plastics manufacturing (NAICS 326121–22).³ As reported by RMA for 2008–2009, receivables turnover (in turns) was 11 (3rd quartile), 9 (median), and 7 (1st quartile); average collection period (in days) was 32, 43, and 55. This means that results outside of the 11 to 7 turns or the 32 to 55 days should be reviewed for their inadequate performance.

Interpretation of Receivables Ratios

Certainly our results fall well outside of that range (at 5.5 turns and 66 days), but are they due to insufficient sales (the numerator) or poor receivables management (the denominator)? Because receivables directly result from sales, the culprit is certainly receivables management. But is the problem throughout receivables, or is it caused by a small subgroup, likely the slow and no-paying group of customers?

It should be noted that for most ratios we would have to carefully analyze every ratio among the significant ratios to draw firm conclusions about the source of a problem. For example, a poor current ratio can result from problems with current assets, current liabilities, or both. With receivables, summarized balance sheet data may mask collection problems with certain of our customers. The solution is to review an aging schedule.

Interpretation of the Aging Schedule

The result is an aging schedule that provides a reasonable estimate of doubtful accounts, which are subtracted from accounts receivable on the balance sheet to arrive at a net figure. In addition, payment patterns are revealed by customers and, when compared against previous results (say from last month), by aging group to show improving or deteriorating experience.

For example, the $150,000 in the 121 to 182 days group is about 8 percent of all receivables. If the previous report showed that group at 6 percent, we'd assume that the credit and collection manager was becoming less aggressive about pursuing overdues. And if similar statistics are found elsewhere in the aging schedules, that could be the source of the poor ratio performance.

Aging helps to determine if a company's credit analysis is being properly handled, or if exceptions have become too frequent. A credit report (to be discussed later in this chapter) may suggest that a good customer is becoming slow in paying others, but the marketing manager has not noticed a fall in its credit rating or may want to help the customer and not lose sales. However, a company may be shipping to a customer who will never pay if its business situation has deteriorated.⁴ Finally, aging identifies specific problems that are difficult to see in aggregated ratios.

Outsourcing Sales Financing

If this is too difficult, the sales financing process can be outsourced to a finance company or other lender in three possible formats:

1. Full recourse sales financing (allowing lowest interest rates), with the lender becoming the source of funds and offering advice on customer creditworthiness.
2. Limited liability or ultimate-net-loss, allowing a limitation on the extent of the recourse, with the seller and lender each absorbing some credit risk.
3. No risk, with the lender independently determining the creditworthiness of the customer.

When lenders assume some or all of the risk, approvals can be delayed up to a few weeks, depending on the information provided by the customer and on his or her credit rating.

While an outsourcing program avoids certain credit group and legal overhead, customer service could be adversely affected. Certain lenders focus on transaction activity, and may not understand the importance of service to the customers of the selling company. Problems might arise when questions are directed to the lender regarding such matters as the logistics and crediting of payments.

Reporting on Business Creditworthiness

Reporting data include a complete dossier on a company's credit and business history, and a credit score based on a complex proprietary statistical model. While the score simplifies the credit decision down to a single number, it is often too ambiguous to enable a simple “sell or don't sell” decision. In our illustration (Exhibit 6.3), the score is 55 (medium risk), making the “credit or no credit” decision a judgment call. However, the assemblage of data provided could not be accomplished by any company at any price, so many businesses subscribe to and use these services. Individual reports typically cost about $40, and subscriptions start at about $50 a month.

Fixing a Company's Credit Score

In Chapter 4 we discussed various sources of credit for a company. This chapter discusses customer credit scores. Just as a finance manager is vitally concerned about the credit scores of customers, he or she should pay attention to the credit scores of his or her company. Here are several recommended steps:

• Check the credit report of the business regularly and verify that the information in it is accurate and up to date.
• Establish credit with businesses that report trades. Not all business creditors report their trade information, so inquiries will have to be made of vendor practices.
• Pay creditors on time; past payment behavior with vendors plays a major role in calculating a business credit score.
• Remember that credit scoring uses several variables in its calculation, and none of the mathematics is disclosed. The finance manager should try to manage everything, but most particularly outstanding balances; payment habits; the extent of credit used; actions against a company for collection; and demographics such as years on file, NAICS codes,⁶ and business size.

Cash Discount Basics

Although many texts discuss cash discounts, actual experience today is that only about 10 percent of vendors offer such price reductions to their customers. The discount is specified as the amount of the discount and the last date on which the discount is offered. The cash discount “2/10” means that 2 percent may be deducted from the invoiced amount if the payment is received no later than 10 days after the bill is received. A full set of commonly used terms is “2/10, n30.” Terms are printed near the top of the invoice or statement.

The selling company and its customer should be aware of the value of the cash discount in order to make appropriate decisions. Terms of “2/10, net 30” calculate to 36 percent of value annually, determined as follows:

• Calculate the “nondiscount” days in the credit cycle; e.g., 30 days less 10 days = 20 days.
• Divide the result into 360 days; e.g., 360 days ÷ 20 days = 18 annual payment cycles.
• Multiply the number of cycles times the cash discount; e.g., 18 cycles times the 2 percent cash discount = 36 percent,⁷ which is the annual value of the discount.
• Compare the annual discount to the cost of capital; e.g., 36 percent (the value of the discount) vs. 10 percent (the cost of capital we've used throughout this book).
• If the discount exceeds the cost of capital, accept. Otherwise, reject.

Cash Discount Decision Factors

In this situation, we would take the discount if we were customers, as it is more than 3½ times the cost of capital. On the other hand, the selling company possibly should not offer such a generous incentive, as its financial cost is likely far greater than any sales benefit. Another consideration is that a customer regularly taking the discount and then passing it might be suspect to the vendor, who might assume that the customer's financial situation has deteriorated.

Cash discounts create a dilemma for companies when their customers take the discount but pay after the discount period. Should the customer be billed for the discount or should the policy infraction be ignored? If this is ignored once, the customer will simply repeat its action with each invoice. If the customer is billed for the discount, bad feelings could result.

Other Discounts

The most common types of discounts offered to induce customer sales are noted in Exhibit 6.4. However, none of these improve working capital management, and, in fact, may result in reduced cash collections.

Invoice Design

Simplifying the invoice or statement eliminates unnecessary verbiage and multiple addresses. A bill should be easy to read and pay, with a clean look. A single return address forces the customer to mail payments to the proper address rather than to a location that may delay processing. (One company had four addresses on each bill—the home office, the regional office, the office of the sales representative, and the lockbox address! Little wonder that many items were sent to the incorrect location.)

Invoice design may involve developing formats readable by automated equipment, including those in MICR and OCR fonts.⁸ MICR and OCR characters are printed in special ink at designated positions on checks and remittance documents, usually at the bottom of the page.

Invoice and Statement Timing

Research has been conducted over the past decades to examine alternative invoice or statement mailing dates and the resulting payment “receive” date for both corporate and retail payments. For most industries, the optimal time for the customer to receive a monthly invoice or statement is 25 days prior to the due date for receipt of funds by the date due.

However, many companies are sending bills 10 to 15 days later than optimal, say two weeks prior to the due date, with the result that their days' sales outstanding (DSO) is longer than average for their industry. Equivalent relationships hold for industries billing on cycles other than monthly.

There are several factors that drive this situation:

• The invoice or statement must be received at the correct location (see the previous section on “Invoice Design”) and forwarded to a payables clerk.
• The payables clerk must verify that the invoice or statement is correct. Although we defer discussion of the payables cycle to Chapter 8, it is sufficient to note that time is required to gather the necessary purchase order, receiving report, and other documents or approvals.
• Any disputes must be manually entered and deducted from the net payment.
• The approved invoice or statement must enter the disbursement cycle, which runs only once or twice a week in many companies.

The total time that has elapsed can be longer than two weeks. By the time the check is received and the collected funds are credited, three weeks may elapse, meaning effective payment is one week later than the due date.

Invoices versus Statements

Some companies issue both invoices and monthly statements (or other types of bills). Unless requested by customers, delivering multiple types of bills can confuse accounts payable clerks, particularly when there is a disagreement in the documents, and may provide an excuse for delaying remittances. Choose one of these forms of billing, probably basing the decision on industry practice and customer preference, and drop the other type.

Receivables Factoring

Factoring involves the sale of accounts receivable.⁹ By selling invoices for future payment, cash is generated sooner than waiting to collect cash from customers. The factor that purchases a company's receivables takes title to the invoices and directs that payment be made to a post office box (usually a lockbox) when due. Factoring is expensive, because the cash paid for a receivable is discounted by about 5 percent.

Aging is important in receivables financing, as the older the account, the less value it has. For example, lenders may lend 80 percent of the face value for outstandings less than 45 days old but only 50 percent on older receivables. A monthly interest rate on receivables is calculated by applying a daily percentage rate to the receivables outstanding each day.

As in sales financing, a possible consideration in factoring is the harm to customer relations, as any collection actions taken may endanger an ongoing business relationship with customers. There may be situations where a company would compromise a debt, extend payment deadlines to a preferred customer, or employ a more lenient collection approach for a specific customer. A factor has little interest in preserving a future relationship with the debtor. See Exhibit 6.5 for a list of factors.