10. Chapter 2
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Transcript of 10. Chapter 2
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Chapter 2
REVIEW OF RELATED LITERATURE AND STUDIES
The review of the literature for this study focuses on how accounts
receivable managementconcentrating on the efficiency of collection. The chapter
begins with the different definition of accounts receivable management, followed
by the findings of researchers. The research outcome will show how accounts
receivable management impacts the operation of the company.
Foreign Literature
Accounts Receivables are amount owed to the business enterprise,
usually by its customers. Sometimes it is broken down into trade accounts
receivables; the former refers to the amounts owed by customers, and the latter
refers to amount owed by employees and others (Robert N. Anthony, 2006). It
also can be classified as short-term receivables which are receivables that
converted into cash within a year or the operating cycle and long-term
receivables which are receivables cannot be converted into cash quickly; instead
cash will be received at some date in the future or over a period of time. If the
company has receivables, this means it has made a sale but has yet to collect
the money from the purchaser, most companies operate by allowing some
portion of theirs sales to be on credit. Accounts receivable are not limited to
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businesses – individuals have them as well
(http://www.investopedia.com/terms/a/accountsreceivable.asp, Retrieved August
20, 2013). Accounts receivable are integral part of doing business in a modern
economy. Sales may be increased by allowing customers to pay at a later date
since some customers may be unable to pay for their purchases immediately.
Accounts Receivable Management is a suite of integrated business
applications that extend a company’s accounts receivable and accounting
system to facilitate credit management, billing and invoicing, remittance
processing, dispute management, and collection process (Anytime Collect,
2008). Management of the receivables begins when all of the antecedent
functions are completed and a receivable is posted to the detailed accounts
receivable ledger. The receivables begin aging immediately, increasing the cost
of financing them and increasing the risk of nonpayment. Management of this
asset involves safeguarding the asset and accelerating cash inflow (John Salek,
2005).The objective of managing accounts receivable is to collect accounts
receivable as quick as possible without losing sales from high-pressure collection
techniques. Accomplishing this goal encompasses three topics: 1.) credit
selection and standards, 2.) credit terms, and 3.) credit monitoring (Lawrence
Gitman, 2012).
A common goal of accounts receivable management is to ensure debts
are collected within specified credit terms (Pike and Cheng, 2003). Another
common goal is the identification of delinquent accounts to reduce the total trade
credit which is written off as bad (Jackling et al., 2003, p. 384; Peacock et al.,
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2003). These two goals normally go hand-in-hand, as early identification of
delinquent customers reduces the size and age of accounts receivable and
reduces the probability of accounts defaulting (Peacock et al., 2003). Accounts
receivable efficiency measures indicate the performance of accounts receivable
processes and the success of policies applied.
In connection on our study about accounts receivable management, we
also considered the effect of credit policies. Glen Bullivant stated that granting
trade credit is a powerful selling aid, and is a fundamental foundation upon which
trading relationships are built. Both seller and buyer gain advantage from credit
facilities, but the risk of slow or non-payment is borne by the seller – risk in the
form of non-payment, and cost in the form of interest expense incurred from the
date of the sale to receipt of funds. The demand for trade credit requires: 1.) a
sound operating procedure to cope with continuous sales volumes; 2.) capital
fund the waiting time with a worthwhile return of the investment; and 3.)
regulation and enforcement, informally or by law, of credit agreements. In effect,
this means having credit policy.
A credit policy is necessary to show the company’s intended way of doing
business and avoids confusion and potential misunderstanding. The need for
company policies in respect of health and safety, smoking, employment etc., are
well founded and accepted as both normal and necessary, and this should apply
equally to the credit operation (Glen Bullivant, 2010). A credit policy should start
at the highest level, be agreed at all levels, and be inclusive of all those areas of
the business operation which leads to satisfying customer requirements. All
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companies extending and managing trade credit should establish a credit policy
which provides the framework for making consistent and well informed credit and
collection decisions which are compatible with the company’s strategic objectives
and the goals of the credit functions. The credit policy is a document that
specifies the course of action for granting credit and recurring credit activities.
The credit policy has to be understood by, and communicated to, all relevant
parties, particularly credit staff, sales staff,and customers.
In measuring the efficiency of accounts receivables, it involves using
financial ratios, such as days sales outstanding and aging schedule. Days Sales
Outstanding (DSO) expresses the (aggregate) average time, in days, that
receivables are outstanding. It helps determine if a change in receivables is due
to change in sales, or to another factor such as change in selling terms, can be
computed by using the formula: ending total receivables multiplied by days in
period analyzed, divided by credit sales for period analyzed (Eugene F. Brigham,
2009). Aging schedule is a popular receivable tool and is widely referred to in the
normative literature (Arnold, 2005; Peacock et al., 2003). It comprises a
classification of outstanding balances according to the period of time they have
been outstanding. These are categories can be calibrated according to months,
weeks, or days, depending on the organization’s requirements, and are
frequently expressed as a percentage relative to the total accounts receivable
balance. If debts are collected on time, most debts should be younger, and few
should be older. It is assumed that increased efficiency would reduce percentage
of debt in the older categories.
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Credit monitoring is an ongoing review of the firm’s accounts receivable to
determine whether customers are paying according to the stated credit terms (L.
Gitman, 2012). When the customers are not paying in a timely manner, credit
monitoring will alert the firm to the problem. Slow payments are costly to a firm
because they lengthen the average collection period and thus increase the firm’s
investment in accounts receivable (L. Gitman, 2012).
Days Sales Outstanding (DSO) is a measure of the average number of
days a company takes to collect revenue after a sale has been made – in other
words, the average collection period. A low DSO means that it takes a company
fewer days to collect its accounts receivable. A high DSO shows that a company
is selling its product or service to customers or clients on credit and taking longer
to collect related revenues. As cash drives so much of a business’ operations
and opportunities, best practices dictate that a company collects outstanding
receivables as rapidly as possible. By quickly converting sales into cash, the
business can put the cash to use again – ideally, to reinvest and generate sales
(Sensiba San Filippo, 2010).
In line with the life cycle of a receivable, collection is one of the integral
parts of it. Bill Kuhn, 2006 stated the important steps to consider in collecting
receivables: 1.) Collection starts with timely billing; 2.) Determine the health of
your receivables by preparing a monthly aged trial balance identifying the
accounts and their status; 3.) Observe trend in the age of the receivables and re-
examine all accounts that are consistently past due; 4.) Establish a collection
program to ensure that regular, persistent follow-up begins soon after maturity; 5.
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Assign responsibility and authority, and keep sales people informed, notifying
them when no further orders will be accepted.
A good way to improve collection is to make the entire company away of
the importance of accounts receivable, and to make collections a top priority.
Invoice statements for each outstanding account should be reviewed on a regular
basis, and a weekly schedule of collections goals should be established. Tips in
the realm of accounts receivable collection include: 1.) Get credit references for
new clients, and check them out thoroughly before agreeing to extend the client
credit; 2.) Do not delay in making follow-up calls, especially with clients who have
a history of paying late; 3.) Curb late payment excuses by including a prepaid
payment envelope with each invoice; 4.) Know when to let go of a bad account;
5.) Collection agencies should only be used as a last resort
(http://www.inc.com/encyclopedia/accounts-receivable.html, retrieved September
16, 2013)
Local Literature
Receivables are financial assets because they represent a contractual
right to receive cash or another financial asset from another entity (Valix et al.,
2012). Receivables, in the broadest sense, represent any legitimate claims from
others for money, goods or services. In its narrower sense and as contemplated
in accounting, receivables represents claims that are expected to be settled by
the receipt of cash (P. Empleo and N. Robles, 2012).
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Accounts Receivables are open accounts or those not supported by
promissory notes (Valix et al., 2012). Receivables include the following: 1.)
Amounts collectible from customers and others, most frequently arising from
sales of merchandise, claims for money lent, or the performance of services.
They may be on open accounts or evidenced by time drafts or promissory note;
2.) Accrued revenue, such as accrued interest, commissions, rental and others;
3.) other items such as loans and advances to officers, employees, affiliated
companies, customers or other outside parties; legitimate claims against
suppliers and insurance companies; and other claims arising from nonrecurring
transactions such as calls for subscriptions receivables and disposal of property
(P. Empleo and N. Robles, 2012).
Receivables are classified as trade receivables and non-trade receivables.
Trade receivables are receivables arising from sale of goods or services in the
normal course of business. Non-trade receivables are receivables that arise from
sources other than from sale ofgoods or services in the normal course of
business.
The discriminating nature of competition has made it an established
practice to offer credit terms to customers. Once credit sales are made, inventory
is already withdrawn from the warehouse and still no cash is available for
deposit. All you have is a “right” to collect money from customers. And the
precious right is based on a promise that you will be paid in the future. Ergo, the
whole point of selling your merchandise on credit is based on your trust to
customers (F. Agamata, 2012).
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Accounts Receivable Management refers to formulation and
administration of plans and policies related to sales on account and ensuring the
maintenance of receivables at a predetermined level and their collectability as
planned. The objective of this system is to have both the optimal amount of
receivables outstanding and the optimal amount of bad debts. This balance
requires the trade-off between: 1.) The benefit of more credit sales, and; 2.) The
cost of accounts receivable such as collection, interest, and bad debts cost (R.
Roque, 2011).
Salvador et al., (2012) stated that Accounts Receivable management
directly impacts the profitability of the firm. It includes determining discount policy
and credit policy for marginal customers, investigating ways of speeding up
collections and reducing bad debts, and setting terms of sale to assure ultimate
collection. As part of accounts receivable management, the company should
appraise order entry, billing, and accounts receivable activities to be sure that
proper procedures are being followed from the time an order is received until
ultimate collection.
There are several factors in determining credit policies. R. Roque, (2011)
gave the following factors such as: 1.) Credit standards, which are the criteria
that determine which customers, will be granted credit and how much. The credit
standard should not be too stringent or too tight which may eliminate the risk of
non-payment, but also eliminate potential sales to rejected customers; neither
should the standards to be loose or liberal, which may lead to higher sales but
also higher bad debts losses and collection cost. Such factors in establishing
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these standards are character, capacity, capital, conditions; 2.) Credit terms,
defines the credit period and any discount for early payment.
Foreign Study
Trade credit is considered as an essential marketing tool, acting as a
bridge for the movement of good through production and distribution stages of
customers.
A company grants trade credit to protect its sales from the competitors
and to attract the potential customers to buy its products at favorable and
competitive terms. When the company sells its products or services and does not
receive cash for it immediately, the company is said to have granted trade credit
to customer.
Trade credit means receivable or book debts which company is expected
to collect in the near future. The book debts or receivables arising out of credit
have three characteristics, first it involves an element of risk which should be
carefully analyzed. Cash sales are totally risk free, but not the credit sales as the
cash payments is yet to be received. Secondly it is based on economic value of
the goods or services which passes immediately at the time of sale, while the
seller expects an equivalent value to the received later on. Thirdly, it implies
futurity (J. Elangovan, April 2005).
Receivables management is a complex activity that is part art, part
science. Yet, the majority of A/R departments face significant human, process,
and technology barriers to becoming a best in class operation. The typical A/R
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department resource is mired at the transaction level, unable to move to more
strategic activities. This quagmire is caused first and foremost by the tremendous
percentage of paper-based invoices and payments which require significantly
more effort, time, and cost to send, manage, and clear. (Aberdeen Group, 2007)
Aberdeen (2007) research has shown that Electronic invoices cost
between 68% - 76% less to process. Another significant challenge facing a
majority of A/R organizations is the existence of numerous and disparate
financial systems to manage orders, billing, collections, and cash flow
management. The benefits of efficient A/R management includes: 1) Superior
cash flow management; 2) Better cash flow visibility; 3) Greater profitability; 4)
Lower credit risk and; 5) Improved customer relationships.
A study of M. Gofman, (2012) found out that average accounts receivable
constitute 16.5% of total revenues and 15.5% of total assets. The level of
accounts receivables is comparable to the level of total bank debt (15.7% of total
assets). Accounts payable for the firms constitute 10.9% of total assets.
Therefore, the levels of trade credit are significant comparing to other sources of
finance. The average firm has a large exposure to its customers and an average
60 days of credit. This is a suggestive evidence that trade credit is not just a loan
for a period required to deliver a good from a seller to a buyer.
In a model without bank loans, Bougheas et al.(2009) showed that, for a
given liquidity, an increase in production will require an increase in trade credit. A
higher production is associated with a higher production cost, which for a given
(insufficient) amount of liquidity, implies that firm will need to take more trade
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credit. So trade credit works as an alternative mean to finance production. Also
Cuñat (2007) argues that fast growing firms may finance themselves with trade
credit when other types of finance are not sufficiently available.
In the study of Fernando et al. in (2012) concluded that the use of trade
credit of a firm is a twofold process in which a firm can receive trade credit from
its suppliers (accounts payable) and, in turn, can extend trade credit to its
customers (accounts receivable). That shows, it is not just the accounts payable
or just accounts receivable that matter, but the sum of the two, which work as a
credit channel of trade.
Firms taking credit from their suppliers can simultaneously offer trade
credit to their customers. In fact, there are firms have higher amounts of accounts
receivable than accounts payable. Firms use trade receivables as a tool form
implicit price discrimination across suppliers, in cases where it is not possible, for
instance on account of legal restrictions, to discriminate directly on the bases of
prices (Meltzer, 2003). In such cases, firms with a stronger market position my
choose to make greater recourse to accounts receivable, selling to customers on
credit with a view to enhancing their competitive position in the market.
Accounts receivable are proven to be a useful tool when there is a
considerable uncertainty about the quality of a firm’s product among potential
customers. The firm can increase its sales by allowing delayed payments, such
that the customer can witness the quality before paying. Also, firms provide more
trade credit to customers that are in temporary distress. This also enhances their
sales, since otherwise the distressed customer would not be able to buy the
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goods. Firms will however only offer additional trade credit when they believe
there is a future surplus of having a long-lasting relation with that customer
(Cuñat, 2007).
Trade credit is the largest use of capital for a majority of business to
business (B2B) sellers in the United States and is a critical source of capital for a
majority of all businesses. For many borrowers in the developing world, trade
credit serves as a valuable source of alternative data for personal and small
business loans. The 1993 National Survey of Small Business Finance (NSSBF)
indicated that ethnic differences in the use of trade credit are present, especially
for Black-owned businesses, which research shows use less trade credit, are
less likely to take advantage of discounts for early payment, and are more likely
to have payments past due. There are many forms of trade credit in common
use. Various industries use various specialized forms. They all have, in common,
the collaboration of businesses to make efficient use of capital to accomplish
various business objectives. (Federal Reserve Bank of Chicago, Supplier
Relationships and Small Business Use of Trade Credit, December 2004).
In the study of the Federal Trade Commission in (2009), the credit
collection process commences when a company issuing credit to a consumer
(e.g., a credit card issuer of Telecommunications Company) determines that the
account is delinquent and that the consumer must be contacted about the deb. In
an effort to obtain payment, many credit issuers have their own collection
departments contact delinquent consumers via telephone calls, collection letters,
and other communication methods.
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Local Study
Accounts Receivable includes money due from customers. They are
substantiated by invoices and arise as a result of the operating cycle’s process of
selling products or services on terms that allow delivery prior to the collection of
cash. Normal transactions would be – product is sold and shipped, an invoice is
sent to the customer, and later cash is collected. The seller allows delivery of
goods or services to a customer prior to receiving cash payment. The receivable
exists for the time period between the selling of the product of service and finally
the receipt of cash.
Purpose of receivables is directly connected with the objectives of making
credit sales. The overall objective of committing funds to accounts receivable is
to generate a large flow of operating revenue and hence profit than what would
be achieved in the absence of no such commitment. Control of receivable is a
key element in macroeconomic and budget but it must be complemented by an
adequate system for managing commitment (Alvarez, 2004).
In the study of Parnada et al. (2011) states that management of accounts
is a process of making decision relating to the investment of funds in this asset
which will result in maximizing overall return on the investment of the firm. Thus,
the objective of receivable management is to promote sales and profits until that
point is reached where the return on investment in further funding of receivables
is less than the cost of funds raised to finance the additional credit. As the prime
role of receivable management is to manage effectively and provide clear
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fundamental guidelines, thus, the company needs to ensure both efficient
implementation of their budgets and good management of their financial
resources.
In the Study of Torres-del Valle, 2012 stated that accounts receivable
management is not simply a collection function; it is an integral part of working
capital management that is linked to a company’s entire business process,
including invoicing, collection, credit, operations, accounting, and treasury, and
supply-chain management. Most often, additional benefits in the context of
improved cash flow and cost savings may be attained from modifying the
accounts receivable process. For instance, a company could opt to redesign its
invoicing pattern and customer credit arrangement to shorten the accounts
receivable cycle. Alternatively, the company could work with its bank to structure
a more efficient collection solution and implement an integrated account
management system to facilitate more effective cash flow management. In
addition, outsourcing of non-core accounts receivable management activites,
such as reconciliation and information capturing would create additional value
through cost reduction and increased efficiency.
Managing the turnover of accounts receivable is an integral part of
working capital management. Accounts receivable is one of the core elements of
current assets and is directly linked to a company’s cash flow, inventory, credit
risk, and liquidity positions. Given its importance, companies are constantly
seeking ways to enhance effectiveness in receivables management and, most
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often, attention is focused on expediting fund availability though shortening the
collection and clearing cycles (Torres-del Valle, 2008).
The collection process is an important component of receivable
management, but it can only represent a subset of its underlying value (Torres-
del Valle, 2008). Essentially, receivables management may impact on every part
of a company’s business process and, if applied effectively, can offer vast
opportunities for a company to revamp its operational arrangements and
business strategy to gain a competitive advantage.
Proper management of accounts receivable coordinated with appropriate
implementation of company policies may improve cash flow and promote cost
efficiency of the company, which may eventually result to better financial position.
Accounts Receivables and Claims Management policies of the SOM
Division of XYZ marketing were in place and were found to be generally
adequate to ensure protection o company’s resources by mitigating risks caused
by aging and uncollected accounts receivables. Though there were many strong
points on the existing ARCM policies, there is still a necessity to review the
current policies. Enhancement of the existing policies to better protect the
company’s resources is indispensible, more importantly; the commitment of the
whole team in resolving the problem is essential (Torres-del Valle, 2008).
An Improper management of cash flow components such as, accounts
receivables, accounts payables, and inventory will result in difficulties in the firm’s
continued operations. Cash flow problems can cause operational problems,
which will ultimately results in real costs to business. These cost can be direct
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cash costs such as bad debt losses caused by failing to follow up on overdue
receivables, storage and carrying costs of excess inventory, operating and
insurance costs associated with excess fixed assets, and interest cost on
borrowings necessitated by the cash flow problems (Aguilar, 2012). But
sometimes it is not the company that causes the inefficiency of collection; it may
also due to the customers pay their amount dues (Li, 2011).
A key requirement for effective sales and accounts receivables
management is the ability to intelligently and efficiently manage the entire credit
and collection process. Greater insight into a customer’s financial strength, credit
history, and trends in payment patterns is paramount in reducing the exposure to
bad debt.
Synthesis of the Reviewed Literature and Studies
The literature and studies, cited in this chapter, provided relevant insights
and gave a clear direction to the conduct of the study. The researchers were
convinced that the related literatures and studies, both local and foreign which
were chosen and assessed are vital in the conduct of this research.
The researchers had come to identify the similarity of our study to a
graduate thesis entitled “Cash and Receivable Management of Selected
Branches of Rizal Commercial Banking Corporation”, by Parnada, et al (2011),
cited in the local study, where the author tackled the purpose of receivable
management, as well as its objective. It signifies that there is a relationship on
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the efficiency of the collection of receivables and with a proper receivable
management.
Related literatures written continue to emphasize the impacts of receivable
in a company, its positive and negative effects, and how the efficiency of
collections of these receivable can help the company maximize the return and
minimize the cost of handling these receivables which found by the researchers
relevant to the current study being conducted.
The review materials which include foreign and local books and theses
support the notion presented in this study. Information obtained from these
related literatures and readings stimulated the researchers to conduct and
pursue the study as they sought to confirm the efficiency of collection of the
receivables of the company.