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The Concept Of Account Receivables And Credit Sales Finance Essay

This chapter presents a comprehensive review of relevant literature concerning the subject under study. In other words this division deals with the theoretical and conceptual bases of this work highlighting on the empirical data relating to the important aspects of the study. It starts with an exposition on the concept of account receivables, followed by reviews of literature on the rationales and categories of credit risk management, credit policy, and credit billing and collection process as well as other concepts proposed by authorities and researchers in achieving good account receivables collection practices. However, in respect of debtors’ management by GWCL, empirical literature is limited. This demonstrates a need for further studies on this topic and provides the rationale for this dissertation. Much emphasis of this study therefore is placed on the relationship between the literature review and objectives as well as the research questions.

2.1 Concept of Account Receivables and Credit sales

Account receivable can be broadly defined as the amount due from customers or debtors as a result of selling goods on credit. Weygandt, Kieso, and Kell (1996) described accounts receivable as amount of cash receipts that have been recognized from offering service to customers but have not been collected. Account receivable can be categorized as one of the largest liquid assets of organizations, like GWCL and ECG and can amount to about 15% to 20% of their total assets, (Dunn, 2009). It is important for organizations to track accounts due (them) since receivables are vulnerable to bad debts and losses. This was substantiated by Talponen (2002), when he reported that huge receivables tie up working capital of business organizations and therefore impedes their smooth operation. An organization’s investment in account receivables will therefore depend on how much it sells on credit and for how long it collects its receivable.

An organization is said to have granted credit when it does not receive cash payment in respect of ordinary sale of its products or services immediately in order to allow buyers a reasonable period of time to pay for the goods they have received. Trade credit thus, gives rise to receivables or book debts that is expected to be collected by the organization in the near future. In other words, sale of goods on credit converts finished goods of a selling firm into receivables (Wood, 1953). Pandey, (2004) proposed that credit is a marketing tool for expanding sales. The main advantage of extending credit is that it will attract additional customers and increase sales volume. Many companies feel that it is necessary for them to offer credit to their customers because they wouldn’t survive if they operated only on a cash basis (The Entrepreneur Guide Book, 2001).

Grove (2005) therefore posits that credit is a vital means in financing the movement of commerce which helps to increase the buying power of consumers but concluded that an uncontrolled growth in credit sales could bring about an uncontrolled management of account receivables. To this effect, it is important for business organizations to monitor their credit sales regardless of the market share for their products or service. The importance of credit management cannot be over emphasized since ineffective credit measures can have a strong effect on the liquidity and cash flows of an organization.

2.2 Credit Policy Analysis

Credit policy is a guideline that addresses how a company evaluates its prospective consumers or customers who intend to buy on credit (Grove, 2000). Dinar (2000) purported that a company’s credit sales is always described by its credit policy under its terms of sales. The credit policy for larger businesses can be quite formal, involving things such as: specific documented guidelines, customer credit applications, and credit checks. Whiles the credit policy for most small business organizations tends to be quite informal and lacks the items found in the formal credit policy of a larger organization (Mostafa, 2005).

The primary objective of a company establishing credit policy is to avoid extending credit to customers who may not be able to settle their obligations when it falls due. Organizations want to achieve the highest level of profitable sales over the shortest time period with minimal bad debts; hence it is necessary to limit their sales to the unsafe financially insolvent customers. Miller (2008) lamented that there are at least four reasons why an organization should have a written credit policy which each add to the productivity of the entire organization:

Firstly, he was of the opinion that it is necessary to manage receivables due to its serious undertaking. The control of receivables result in limiting bad debts and improving cash flow, in this case outstanding receivables which can be considered as firm’s major assets should have good credit management processes.

Secondly, a credit policy assures a degree of consistency among organizations. By a written policy the arms of the organization will realize the common set of goals they have. In addition, a written policy can define each department’s functions so that replication of effort and needless friction can be avoided.

Thirdly, credit policy provides for a consistent approach among customers. With this decision making becomes a logical function based on predetermined parameters.

Finally, he posited that credit policy can provide some recognition to the credit department as a separate entity by been worthy of providing contribution into the overall strategy of a firm.

Edmonds (1996) was also of the same view that the purpose of designing a credit policy is to achieve certain objectives among which are: minimizing bad-debt losses, accounts receivable outstanding, maintaining financial flexibility, optimization of a company’s mix of assets and conversion of receivables to cash on a timely basis. Credit policy is thus a necessity and also an opportunity to improve the efficiency of an entire organization.

Van Horne (1989) stated that a firm should evaluate its credit policy in terms of returns (profits) and costs. He mentioned that the three types of costs involved in credit policy are: the selling and production costs, administration costs and bad debt losses. Organizations that deal in trade credit are therefore tasked by other researchers to deal with factors like cash discount offered for prompt payment, length of period offered for credit and assessment of debtor’s worthiness in their credit policy.

A very strict credit policy will turn away potential customers to slow sales, and in the end lead to a decrease in the amount of cash inflows of organizations. Also, a liberal form of credit policy by companies will promote slow paying and non paying customers to increase these companies’ average collection period for accounts receivable, and eventually lead to cash inflow problems. A good credit policy should assist to attract and retain good customers, in other not to have a negative impact on cash flow (Pandey, 1995 and Bhrat, 1993). Usually an organization’s typical credit policy which serves as a tool for monitoring account receivables contains the following variables: collection policy, cash discount, credit period and credit standards. For a company to have an effective credit policy, everyone in the company should be committed to the policy and be able to understand the consequences of not compelling to it. According to Szabo (2005) for a credit policy to be effective it must not be static, the policy must be reviewed from time to time regardless of how pragmatic it proves to be. He stated the review and adjustments of the policies is essential because of the dynamic nature of business organizations.

According to Pandey, (1993), credit policy involves the combination of three decision variables that is, credit standards, credit terms and collection efforts. Pandey therefore put it that, there is only one way in which the credit manager can affect the volume of credit sales, collection period and consequently, investment in accounts receivable and that through the changes in the credit policy at an optimum level.

2.2.1 Payment or Credit Term

Credit term is defined as the conditions under which a firm makes a sale (Kakuru, 1993). Typically these terms specify the period allowed to a buyer to pay off the amount due, and may demand cash in advance, cash on delivery, deferred payment period of 30 days or more (Van Horne, 1989).

Ross et al, (2010) also maintain that, from an accounting perspective, when credit is granted, an account receivable is created. Such receivables include credit to other firms, called trade credit, and credit granted consumers, called consumer credit. They are of the view that if a firm decides to grant credit to its customers, then it must establish procedures for extending credit and collection. Literally, the credit term is the term of payments for receivables. The credit terms of a sale are made up of the two (2) distinct elements: the period for which credit is granted (the credit period), and the cash discount (Dinar, 2000).

2.2.1.1 Credit Period

The credit period is the basic length of time for which credit is granted to customers. Credit period is not supposed to be too long, since longer credit terms increases the risk of a company as creditworthiness of customers may worsen before payment is made (Dolfe and Koritz, 1999, p 23).

According to Seidhen (1964), “Credit period is the duration of time for which trade credit is extended. The credit period varies widely from industry to industry, but it is almost always between 30 and 120 days. It is normally given without a discount, and stated in terms of a net date. A typical example is if an organization gives credit period of 30 days without discount then it is stated as “net 30”. In this type of credit period, the buyer is required to pay for the goods delivered within the agreed period of 30 days. The length of the credit period can directly affect the volume of investment in receivables and indirectly the net worth of companies (Seidhen, 1964).

Trade credit period is an important issue concerning cash management as it has a significant impact on a firm’s cash flow (Walker and Petty, 1986). Several factors have been known to influence the length of the credit period.

Studies by Paul and Boden (2008), Fafchamps (1997), and Giannetti et al. (2008) examined the relationship between the length of credit sales and the size of buying firms or customers. The studies explained that the length of the trade credit period depends on the bargaining power and size of buying firms and customers. They were of the view that due to the size of these larger firms and customers, they may have bargaining power over their suppliers to influence the credit period. Large firms have adequate financial resources; they can buy from other suppliers if a supplier refuses to give them a longer trade credit period. If these customers leave, the supplier’s sales may drop substantially. Consequently, the supplier may be forced to offer a longer credit period in order to continue the business relationship with these customers (Paul and Wilson, 2007). Fafchamps (1997 and 2000) has provided empirical work that supports this hypothesis. He found that large firms get longer credit period from their suppliers, which may negatively affect a supplier’s cash flow. In effect a longer credit period can blast sales but at the same time increase investment in receivables and lowers the quality of trade credit.

2.2.2 Credit Standards

Credit standard has an impact on credit sales and company’s receivables. Brigham & Ehrhardt (2005) defined credit standard as the acceptable required financial strength of credit customers. They were of the view that credit standards boost sales but also can increase bad debts. Dickerson et al (1995) also described credit standards as the strength and credit worthiness a customer must exhibit in order to qualify for a credit.

Credit standards therefore stipulate the minimum financial strength an applicant must demonstrate in order to be granted credit. Setting credit standards implicitly requires a measurement of credit quality (Campsey and Brigham, 1985).

Graham, (1990) emphasized that individual accounts of credit applicants need a great deal of scrutiny and that, for this reason, it’s important that standards be set based on the individual credit applicants. Pinches (1997) explained further that for the purpose of credit analysis, information on the creditworthiness and paying potential of customers is needed by organization. He was of the view that such information may be obtained from several sources like; accounting statements of customers or buying firms, credit ratings and reports, banks, trade associations, as well as company’s own experience.

Gitman, (1982) also added that credit standards provide guidelines for determining whether to extend credit to a customer and how much credit should be extended. Peterson and Rajan (1997) posited that suppliers and organizations have an advantage in acquiring information about their customers over financial institutions, because of several reasons. The first being a regular visit to customers’ premises to obtain information about them routinely at a low cost. Moreover if the buyer or customer is unable to take advantage of early payment discounts, this might serve as a signal for deterioration in buyers’ creditworthiness (Peterson and Rajan, 1997, p. 633).

Kakuru, (2001) noted that it is important that credit standards be set basing on individual credit applicants by considering credit information, credit analysis, and credit limit and default rate.

Campsey and Brigham further assessed that in determining credit quality of customers, the organization should first establish the character of their potential customer through credit analysis, credit limit, credit information and default rate.

2.2.2.1 Credit Analysis

In order to avoid unnecessary bad debts and costs related to late payments, it is important to assess the credit worthiness of a customer. Edwards (2004) argues that there are two main reasons for customers’ credit worthiness evaluation, profit reasons and sales reasons. By profit reasons, he means possible delays in payments or bad debts can affect the profits and by sales reason he means that it is also useful to know the ability of the customer to buy a product. Credit evaluation is therefore an important activity that needs to be carried by organizations to know the possibility of whether a customer will be able to pay debts at an agreed period of time. Customer’s creditworthiness can be judged by considering four basic criteria: Capital which is the status of financial resources of an individual or company as indicated in their financial statement, Character which deals with the reputation of customers in terms of fairness and honesty, Capacity is also the ability of the customer to pay debt on time and finally Collateral which represents the customer’s security in the form of assets (Anderson, 2000).

Ijäs (2002) in his book as well found out that financial statements of a customer are the single most important information source when assessing the credit worthiness of a customer. He was of the view that financial statements give very useful information on the customers’ profitability, liquidity and solvency, which are all indicators of customers’ financial state.

Credit evaluation can take the form of appraisal review; follow up, inspection and recovery and investigation to contact with customers. Picchkel, (1998) explains that credit analysis is an important aspect in designing a credit policy since it culminates into the seasons regarding the amount of loan granted to the applicants.

2.2.2.2 Credit Limit

According to Grove (2005) “Credit Limit is a threshold that a company or creditor will allow its customers to owe at any one time without having to go back and review their credit file”. It is the maximum amount of credit, which a firm can extend to customers at any point in time. Ijäs (2002) says that setting credit limits is not a way of managing credit risk but a way of controlling it. When a customer makes an order that if fulfilled, will exceed the customer credit limit, a decision needs to be made on whether to provide that particular customer with the additional limit required or not. In order to make this decision, it is necessary to evaluate the customers’ credit worthiness. (Ijäs 2002).

2.2.2.3 Average Collection Period

It refers to that period in which debts remain uncontrollable. It measures the number of days for which a credit transaction remains outstanding and thus determines the speed of payment by customers, (Pandey 1998).

2.2.2.4 Default Rate

Pandey (1993) explains that a default rate is the measure of the portion of the uncontrollable receivables that is bad debts loss ratio. The ratio indicates the default risk that is the unlikelihood that customers will fail to pay their credit obligation, Pandey, (1995). Basing on experience, the financial manager should be able to make a reasonable judgment regarding the chance of default.

2.2.2.5 Credit Information

Organizations need to have sufficient information about a customer before extending credit to them. This is done in a bid to minimize losses. According to Otero, (1994) reliable and timely information is critical to managing the credit process. If timely and useful information is available, management is much better equipped to direct and control prudent credit processes.

2.2.3 Debtor’s Collection Policy

Collection policy refers to the procedures used to collect past due accounts receivable that is letters, telephone calls, representatives and many others (Dickerson et al 1995). The goal of the collection policy or procedures is to reduce the net amount of outstanding accounts receivable, by stimulating, demanding and forcing payment from the customer no later than on the due date (Dolfe and Koritz, 1999, p.39). Dickerson et al, (1995) and Pandey (1998) also asserted that a collection policy is needed by firms because all the customers do not pay their bills on time. They added that some customers are slow payers while others are non-payers and therefore collection policy is aimed at accelerating collections from slow payers and reducing bad debts.

According to Mishra, “A collection policy should always emphasize promptness, regularity and systematization in collection efforts. It will have a psychological effect upon the customers, in that; it will make them realize the attitude of the seller towards the obligations granted.”

Kakuru (2000) opined that organizations should follow a clear cut sequence of collection procedures to be able to collect slow paying accounts. To keep receivables flowing smoothly, companies should employ the use of phone calls and series of letters to persuade customers to pay. The form of communication must start out friendly, and progressively should be considered more serious and persistent as payments of receivables become overdue. (National Association of Credit Management, 2009).

Anderson (2010) in agreement with Kakuru (2000) stated that collection policy is a very essential element which can lead to an efficient system of debt collection. He was of the view that for an organization to have a good accounting system it must invoice its customers promptly, and must follow up disputed invoices speedily, there should also be issuance of reminders and statements to debtors at the right periods. Organizations have to generate their management reports like the aged analysis of debtors regularly. Anderson (2010) further concluded that there should be a clear policy which is devised of overdue accounts, with the appropriate procedures for charging interest on overdue amounts as well as withdrawing future credit.

According to Kumar (2010) the following five steps are also very useful in Debt Collection Process:

Monitoring the state of receivables,

Dispatch of letters to customers whose due date is near.

Telegraphic and telephone advice to customers around the due date.

Threat of legal action to overdue accounts, and

Legal actions against overdue accounts.

Khare (2007) also identified some methods for collecting overdue loans from debtors as: Charge interest for late settlement, send out reminder letters, make telephone calls to the debtor, employ the services of a debt collection agency, send an authorized person from your credit control department to visit the customer and request payment, take legal action.

The DebtCollectionSteps.Com (2008) stated some collection policies for organizations that deal in provision of service like GWCL. The collection of receivables by utility companies has become a greater priority, and it is necessary for these companies to improve their collections activities. There is then the need for some of these companies to employ improved strategies to help combat rising utility collections (www.debtcollectionsteps.com).

Some of the effective steps of collecting debt suggested by the DebtCollectionSteps.Com (2008) to the utility organizations are the following:

Payment arrangements to delinquent customers should be offered early, before ordering service disconnections. In this case there can be a reduction in the cost and labor involved with implementing shut-off orders and subsequent follow up reconnects. In effect the reduction in the number of disconnection orders can offer existing field staff the opportunity of money-generating duties, like installing appliances.

There should be improvement in the processes of collection of an organization’s receivables before the final default bill accounts can be entrusted to third party agencies for collections. Customers must be called early and often, before they default in their payments. Payment extensions or provision for accounts in arrears need to be considered, this can lower the number of accounts that need to be outsourced to debt recovery agencies.

Finally extension periods should not be allowed to go past 60 days, since the longer the period the difficult it becomes to recover debts. (www.debtcollectionsteps.com).

They concluded that the collection process is the art of knowing the customer and the psychological understanding of the customer which give insights into what method to use in collecting the accounts. Therefore legal actions should be a last resort.

2.2.3.1 Relationship between Credit Policy and Debt Collection

Credit policy and collection policy have to be actively managed because they affect the timing of cash inflows, sales, profits and account receivable risks (Chambers and Lacey, 1994). The relationship between effective credit policy and the extent of debt collections is very necessary; since more effective systems require less detailed credit structures and compliance regulations (Ricchuite, 1982). Moss and Stine (1993) examined that any changes in credit and collection policy have a direct impact on average outstanding accounts receivable balance maintained relative to an organization’s annual sales.

Pandey (1995) stressed that organizations need to intensify their collection efforts to be able to collect outstanding bills from financially less sound customers. John, (1980) then emphasized that debt collection performance needs to be strengthened to make timely debt collections possible through timely realization of payments from debtors.

Hampton (2001) in his book financial decision making “noted that for a firm to ensure efficient and effective debt collection it must control the amount of credit to individual customers as well as total credit outstanding so as to avoid bad debts losses arising in the business. He was of the view that credit limits is crucial to a firm offering credit facilities to avoid excessive credit sales to individual customers and total sales as well.

Samuels et al, (1989) and Brigham (1985), concludes that the inefficient monitoring and follow up procedures on slow payments are a major principle cause of accounts receivable accumulation. Brigham acknowledged the need for an aggressive collection since a small number of customers are always willing to pay their debt on time. He said a high rate of customer default will occur when the customers know that an organization has no strength of power to enforce repayment. Thus an organization needs to take special efforts to monitor both credit granting and credit collection processes (Chang et al., 1995).

2.2.3.2 The effect of Follow up Measures

Effective follow-up measures put in place by a company can help track prompt payments from customers and keep the borrowing unit under constant vigil. Casu et al (2006) and Khare (2007) view that many discrepancies or default rate can be monitored through such follow-up measures by ensuring the alertness of debtors and guiding them to make prompt payment to avoid higher default rate.

Usually the lack of follow up measures cause consumers not only to ignore payments of their dues to companies but also allow them to stride on wrong path much to the disadvantage of their own financial health and the companies providing the credit. Naturally, such follow-ups prevent the consumers from going contrary to the terms and conditions of a credit and also from redirecting any fund for purpose other than those assigned in sanction letters to keep the financial strength of the units in good order (Khare, 2007).

2.2.3.3 Debtors Collection Follow-up Systems

Factoring:

Factoring is the process of selling account receivable to another firm at a discount off of the original sales price, (Adelman and Marks, 2007). Factoring companies offer a range of services in the area of sales administration and the collection of amounts due from debtors. A factor can take over the administration of sales invoicing and accounting for a client company, together with collecting amounts due from debtors and chasing up any slow payers.

Accounts Receivable Report

Organizations can monitor their timely collection of receivables by the use of accounts receivable report. Fueser (2001) and Lewis (1992) asserted that the analysis of payment performance of debtors is a consistent and precise review by staff as well as internal and external reviewers. The account receivable report is therefore a monitoring tool for checking outstanding accounts of organizations.

Computer and Credit Management

Lewis (1992) stated that computers should be able to offer an opportunity to track an automated defection of bad accounts. He also noted that an evaluation of customers’ payment performance can be based on an internal data. Computer is an important devise that helps in providing essential up-to-date information like summary of billings, payment discount taken, and receivables.

Ledger Plan or Card Tickler System

The ledger plan is used to specifies information regarding the amount, terms due date, collection actions at length in details.

2.2.3.4 The constraint of ineffective Collection Effort on Receivables build-up

Pandey (1995) affirmed that organizations need to be very cautious in taking steps in order to collect their accounts due from their slow paying customers. Pandey identified that firms that are strict in their collection policy, will get their customers offended and they may shift to competitors. Because of this, the firm may lose its permanent business. He continued that if there is also leniency in collection, receivables could increase and thereby reducing organizational profitability.

Campsey and Brigham (1985) noted that fairness is needed in collection efforts to prevent any undue lengthening of the collection of receivables to minimize losses through bad debts. Van Horne (1994) therefore suggested that an organization’s overall debt collection policy should be such that the administrative costs and other cost incurred in debt collection must not exceed the benefits derived from incurring those costs and that some extra spending on receivables collections procedures can reduce bad debt losses and the average collection period.

2.3 Debtors Payment System

Bruun-Jensen (2009) speculated that companies should include clear instructions on their preferred means of payment channels to their customers. The payment instrument or collection channels by companies must reside on these two opposite sides. Firstly, the company should offer as many collection channels as possible to be able to provide customers with different payment option to assist with easy payment. Secondly a balance should be made between shortening the collection cycle, adjusting to customer needs and streamlining the accounts receivable management process when the company is choosing the means and channels of payment (Tunon, 2008, Yiu, 2004 and Cunningham, 2007).

2.3.1 Debtors Payment Channels

Direct Debit- Direct debit is the process where money is transferred from a customer’s account to a company’s account on instructions from a selling company (Dolfe and Koritz, 1999). Belpaire (2009) examined that direct debit presents benefits to both the selling company and its customers. Belpaire asserted that direct debit serves as a cheap form of collection instrument, and can considerably reduce the operational costs and speeds up collection process.

Collection through Outsourced Agents- Myres and Brealey (2003) maintain that debt collection is a specialized business that calls for experience and judgment, which means that, it is prudent for a company to rely on an experience agent to collect receivables where the company is small such that it cannot employ or train specialized credit manager. This method increases flexibility and convenience to the customer which may lead to improvements in the rate of payment.

Integrated Voice Response - A system which combines the use of human operators and a computer based system to allow customers to make payments over the phone, generally by credit card; this system has been proved highly successful in organizations which process a large number of payments regularly (Commonwealth Auditors Report, 1997).

Use of Payment Incentives- Discounting can be used as an incentive for prompt payment by customers upon receipt of services. Cash discounts may encourage early payment, but the cost of such discount must be less than the total financing savings resulting from lower debtors balances any administrative or financing savings arising from shorter debtors’ collection period, and any benefits from lower bad debts (Levy et al, 1998).

The commonwealth Auditor’s report (1997) established that in addition to developing a range of incentives for early payment agencies and organizations should also consider the imposition of penalties on late payment. In designing penalties agencies should be aware of legislative and policy considerations which may reduce the potential for major penalties such as removal of service.

The report also asserted that other payment methods such as the use of data kiosks by customers in public use areas and payment for goods and services via the Internet should be encouraged for early payment.

2.3.2 Causes of Default of Payment

Ghana Water Company is being handcuffed by the fact that the sort of services it provides is of necessity and for that matter the government always take interest in what the company does. It is by this reason that the company’s activities or operations are being regulated by the PURC. In the light of this, it is quite obvious that the company cannot choose its own customers neither can the company select customers to whom credit should be extended in respect of the services provided by GWCL. This goes contrary to what Anderson, (2000) suggested, that before extending credit to a customer the supplier or the service provider should consider the 5Cs of credit worthiness. These are:

Capacity: He suggested that it is incumbent on the provider or the supplier to find out whether the customer will be able to pay his or her amount within the agreed credit period.

Character: To assess the reputation of customers in terms of honesty and fairness

Collateral: It is the scope of including appropriate security in return for extending credit to the customer.

Capital: What is the status of financial resources of an individual or company as indicated in their financial statement

Conditions: Anderson lamented that conditions are the prevailing economic and other conditions that are likely to impact the customers’ ability to pay promptly.

Anderson (2000) emphatically makes it known that if the points are not considered with all due importance, the probability of customers defaulting payment would be invariably very high. On the point why people default in payment, he has the following to say: “In your own debt reduction journey, you may discover that finances get tight occasionally. And during those times, it is helpful to know which bills are okay to pay late and which are not.

2.3.3 Billing System

Billing System tracks customer usage of services and calculates the impact on a customer’s account, based on the price of the service. Billing System has come to include noncore functionality such as customer management, integration with payment gateways and statistical systems (www.hyperdictionary.com).

Jana (2011) is of the view that the day to day billing operations of companies will require one to manage ones client information, record their goods and services usage , invoice accordingly, collect payment from client, reconcile those payments, and dealing with overdue account.

Grover (2000) also analyzed the following process to be used by organizations to aid in proper billing system:

An effective invoice must be created: organizations should make sure that their invoices are accurate, clear, in depth and very simple to interpret. The invoice should include the purchase order number, amount due, customer name and address, and the organization’s address and ID number. More importantly the name and phone number of employees can also be added to allow easy access or contact when there is any questions to be answered. There should also be a clause in the invoice that can give the customer the right to contact the company if there is any problem with their services or a comprehensible outline of late charges.

There should be prompt mailing of Invoices: There is a notion that the earlier invoices get out; the sooner payments will come in. Grover was of the view that some organizations distribute invoices out monthly, but was considered a mistake since it can impede the payment of some receivables by two to three weeks. He then opined that organizations should try to send out invoices within a day or two of delivery of product or completion of a project.

Organizations should bill the right persons: The process of billing the wrong person can shove payment off as much as 60 or more days. There is the need of interacting directly with the customer to know whom or where to send their bills.

Follow up measures: It is necessary to follow up an invoice with a phone call to check on its status. A quick check-in can confirm that an invoice was received and processed.

The billing system should therefore provide service to the user, collect user usage records, and generate invoices of each credit expire, each billing cycle depends on the billing type, collect payments and adjust customers' balances (Ofrane, 2003).

2.4 Monitoring of Accounts Receivable

Pandey (1995) investigated on how a company can continuously monitor and control its receivables to ensure the success of its debtor’s collection effort. Pandey identified the two traditional methods for monitoring receivables as:

Average Collection Period (ACP)

Aging Schedule

By maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients. A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient (Investopedia, 2009).

2.4.1 Average Collection Period (ACP)

Average collection period also known as the Day Sales Outstanding (DSO) at a given time, is the number of days debts remain outstanding or the ratio of receivable outstanding at the time to average daily sales (Stone, 1976). According to this method account receivable is considered to be in control if ACP is equal to or less than a certain norm; which means it takes a company fewer days to collect its account receivable. If the ACP exceeds the specified norm, collections are also considered to be slow (Arnold, 2005). In effect, if credit sales increase, a proportional increase will arise in the accounts receivable balance, and the ACP ratio will remain the same. If collection efficiency was to increase, then the balance of accounts receivable relative to credit sales would decrease, and the lower ratio would reveal greater efficiency (Benishay, 1965, Birth et al., 2005, Bazley et al., 2004).

Extended collection period delays cash inflows, impairs firm’s liquidity position and increase chance of bad debts. This method of average collection period has got two limitations; provides average picture of collection experience and it is based on aggregate data (Pandey, 1995).

According to Bazley et al (2004) and Birt et al (2005) ACP ratio can be calculated using this formula:

ACP = r/s (.365)

Where

ACP = Average Collection Period in days.

s = credit sales (The total credit sales for previous 12 months ‘yearly’ calculation or can be monthly calculation)

r = The “r” represent the balance of account receivable (that is the total balance of outstanding credit sales.)

This ratio therefore measures the quality or worthiness of an organization’s debtors or customers. A shorter collection period entails prompt payment by these debtors. In that effect ACP ratio reduces the chances of receivables from falling into bad debts. Likewise, a longer collection period implies that credit collection performance is too liberal and inefficient. It is difficult to provide a standard collection period of debtors (Brigham and Houston, 2003).

The use of ACP as a monitoring tool for accounts receivable is an important credit-granting policy that can indicate the effectiveness of company’s receivable collection policies and the capability of staff in charge of executing these policies (Jackson and Sawyers 2001).

On the contrary, Lewellen and Johnson (1972) argued that ACP can provide misleading indications of collection efficiency when credit sales are not constant. With the direct relationship between ACP and credit sales, an increase in credit sales will trigger an increase in ACP, falsely implying a decrease in account receivables collection efficiency. The same way a decrease in credit sales will lead to a false idea of an improvement in account receivable collection efficiency (Cotter, 1973).

2.4.2 Aging Schedule

The aging schedule according to Pike and Cheng (2001) is a popular account receivable tool. It is the classification of all outstanding balances according to the period of time they have been outstanding. The aging of accounts receivable method consider older accounts receivable which are usually less likely to be collectible. For instance, a receivable due in 30 days that has not been paid after 60 days is more likely to be collected, on average, than a similar receivable that still remains unpaid after 120 days (Libby and Short, 2001). Zeune (1991) asserted that the age categories can be standardized according to months, weeks or days depending on an organization’s requirement. If debts are to be collected on time, most of it should be younger and few must be older,this is because the older the debt the harder it becomes to collect. It is assumed that increased collection efficiency would reduce the percentage of debt in the older categories (Leitch and Lamminmak, 2011).

According to Fabozzi and Peterson (2003), aging analysis of company’s account receivables are classified into 30 days categories based on when they are past due after sales such as 1 to 30 days, 31 to 60 days, and 61 to 90 days thereby helping managers to get a more detailed picture of their collection efforts to prevent cash flow problems.

Arnold (2005) and Peacock et al (2003) propounded an equation for calculating the aging schedule of outstanding balances:

Pt = rt /Σr

This is stated in 30 days categories

Current = r1/Σr

30 days = r2 / Σr

60 days = r3 / Σr

90 days = r4 / Σr

Arnold and Peacock et al established that:

Pt = the proportion of accounts receivable in the past.

rt = the total accounts receivable sourced from credit sales issued t financial periods in the past.

In spite of the importance of aging schedule in debtor’s collection effort, it also has some deficiencies. It can be influenced by pattern of sales and payment behavior of customers. Rising credit sales will result in a schedule exhibiting increasing values in the younger categories, and a misleading suggestion of increased collection efficiency for the older categories (Zeune, 1991). Lewellen and Johnson (1972) concluded that the Aging Schedule produces an incorrect analysis, and false warning patterns can be raised by normal sales fluctuations.

2.5 Ratio Analysis to Control Account Receivables Collection

Financial statement is an important document that presents desirable sources of information to organizations regarding the financial position of their customers for credit control. On the contrary, a single number from a financial statement is of little use except in relation to comparative ratios. Financial ratio according to Reilly Brown (2006) is an important catalyst to conquer the little meaning of typical numbers thereby providing meaningful relationship between individual values in a financial statement.

2.5.1 Receivable Turnover Ratio

Receivable turnover ratio can be use to analyze how often accounts receivable are rolled over during a year (Keown, Martin, and Petty, 2008). White, Sondhi and Fried (2002) also established that receivables turnover measures the effectiveness of firms’ credit policies and the level of investment in receivables that is needed to maintain a firm’s sales level. It indicates the relationship between company’s sales and its accounts receivables.

Receivable turnover ratio can be calculated as:

Receivables Turnover Ratio = Net Sales

Average Accounts Receivable

Where

Average Accounts Receivable is also calculated as:

Opening + Closing Receivables

2

According to Spiller and German (), the turnover of receivables provides information on liquidity of receivables by indicating the speed or slowness with which receivables can be converted into cash. It is therefore serves as a tool for analyzing whether there is laxity in a company’s credit policy or problem in its collection policy.

2.5.2 Receivables to Sales Ratio

This ratio holds considerable importance in indicating the credit and collection policy adopted by a company. A higher ratio indicates greater investment in receivables and slackness in credit collection policies. While a lower ratio points out that a company is practicing strict credit and collection policy resulting in effective receivables management control (Diane White, 2008).

Receivables to sales ratio is calculated as:

Receivables to Sales Ratio = Receivables × 100

Annual Credit sales

Nelgadde (2010) asserted that receivables can be expected to fluctuate in direct relation to the volume of sales, provided that sales terms and collection practices do not change. The tendency of slackening of collections due to more lenient credit extension and an increase in the number of slow paying accounts needs to be detected by investigating the relationship of receivables to sales.

2.6 Empirical Evidence of Related Studies on Account Receivables

This section summarizes the main results obtained from studies on accounts receivable and its collections.

A study on tracking the credit collection period of Malaysian Small and Medium-Sized Enterprises undertaken by Zainudin (2008) indicates that profits of a company depend upon its frequency of reinvestment, or turnover, of its capital. However, frequent turnover would not be possible if debtors’ collections are slow as they deny the company the use of its own capital. Credit collection period is, therefore an important factor that may influence a company’s overall performance. His findings were that there is a negative correlation between collection period and financial performance. Companies that collect their debts faster seemed to generate better returns and also collection period is negatively associated to company size, with smaller-sized companies facing the greater delay. In his conclusion, he said his study is supported by empirical evidence in a sample of 7250 Italian firms.

Asselbergh (2004) conducted a research “A Strategic Approach on organizing Accounts Receivable Management: An empirical study” in this paper an organizational behavior in managing accounts receivable was studied. The research paper developed a conceptual framework which aimed on the recent surge of interest in trade credit management from both academics and practitioners emphasizing; the rather permanent character of these short term but continuously renewed investments, and their strategic potential due to the existence of financial, tax-based, operating, transaction and pricing motives. The study therefore focused on a search for sources of such a strategic value and for the determinants of its risk.

Notably, he concluded that this potential strategic value is said to create a need for flexibility and control in managing accounts receivable. It will induce a need for internalization of its management. This therefore results in a revision of the existing decision-making processes since, the extension of trade credit becoming a strategic asset, investments in accounts receivable cannot be judged by the financial needs incurred as measured by the traditional DSO-rate anymore. More specifically, a transaction cost theoretic approach is used to explain the decision whether or not to internalize the firm’s accounts receivable and its risk.

Also, in Omiccioli (2005) a study was designed to examine trade credit as collateral. He additionally studied how “a remarkable feature of short-term business finance is the widespread use of trade credit as collateral in bank borrowing, especially by small and medium-sized firms. His paper models the incentives for a firm to collateralize accounts receivable as a trade-off between the benefit from lower interest rates and the implicit cost from the disclosure of private information associated with this form of collateral. The model showed that the share of receivables pledged as collateral is larger: When the borrowing firm is riskier (and the difference in interest rates between secured and unsecured lending is larger), also when an information disclosure costs for the firm is lower (example, when the information is dispersed among many banks and the firm assets are mostly made up of tangibles. Furthermore, when the default correlation between sellers and buyers is lower and the legal protection of creditors is weaker and suppliers have a stronger advantage over banks in monitoring and enforcing loan contracts”, (Omiccioli, 2005).

2.7 Conclusion

From the foregoing it is evidently clear that a change in accounts receivable can be a major determinant of a company’s cash flow from operations. Collection of accounts receivable often represent a company’s largest and most consistent source of cash receipts. Therefore, the monitoring of its collection is an important part of efficient cash management. A company’s ability to generate the cash needed for routine business operations often depends upon the amount collected and the maturity dates of its receivable (Meigs, 1996). Franks, Broyles and Carleton (1985) has also examined that there is the need to develop cost effective measures for identifying credit worthy customers and the process for monitoring the status of customer accounts with overdue bills.

Effective credit administration w

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