"Calculate average accounts receivable! That is very easy, Miss Dannison. I just wonder why you need this for our portfolio. Know anything about it?" asks Terry, Miss Dannison's assistant. "I need the amount for the financial analysis, Terry," Miss Dannison answers.
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What Is Going On in Mighty King Trading, Inc.'s Bulk of Accounts Receivable?
Miss Dannison, the accountant of Mighty King Trading, Inc., is not playing with Terry, her new assistant, when she says that 70% to 80% of the company's sales is on account. Mighty King's sales derive mostly from dealers. Miss Dannison, as instructed by the owner, has come up with formulas to be used in monitoring this bulk of accounts receivable. As noted above, she has told Terry that she needs the ratio for the financial analysis. She further tells Terry, "The amount will be used to compute the accounts receivable turnover so that the standard age of receivables will also be established. These variables are needed in order for us to create an efficient collection system for our receivables."
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What Is an Accounts Receivable? How Do We Record Accounts Receivable?
Receivables, in the broadest sense, represent any legitimate claim from others for money, goods, or services. In its narrower sense and as contemplated in accounting, receivables represent claims that are expected to be settled by the receipt of cash. Loans and receivables fall under financial assets that are within the scope of IAS 39. Generally, there are two kinds of receivables: current and non-current assets. Trade receivables, which are going to be used in the illustrations below, are current assets and are used in the application of the concept of the normal operating cycle. The normal operating cycle of an entity is the time between the acquisition of assets for processing and their realization to cash or cash equivalents. Thus, the normal operating cycle is the period required for cash to be converted into inventories through purchase and production, inventories into receivables through sale, and receivables back into cash or cash equivalents through collection.
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What Is the Common Problem Encountered in Granting Accounts Receivable?
A business handling a bulk of accounts receivable cannot avoid problems in collection. Also, the biggest problem in extending credit to customers is delinquency. Delinquency occurs when accounts are already matured and they are not collected. They are also called past-due accounts. There are many reasons why accounts become delinquent. The company might not have a strong collection system or there may be problems with customers. Because of these issues, companies must deal with customers' accounts seriously. Delinquency problems can be seen in reports like the aging of accounts receivable and the company's financial analysis on accounts receivables.
Miss Dannison is aware that with the bulk of accounts receivable the company has, some accounts might become delinquent if not managed properly. She knows her employer is right in instructing her to present formulas like the accounts receivable turnover and the age of receivables. The accounts receivable turnover indicates the number of times the accounts receivable are collected during the period. A high rate or above the standard rate inidicates efficiency in collecting the customer's accounts
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How to Compute Accounts Receivable Turnover and the Age of Receivables
In order for the accounts receivable turnover rate to be significant, it is compared with what is prevailing in the industry.
Let us take a look on how to calculate the accounts receivable turnover:
The formula is:
Account Receivables Turnover = Credit Sales divided by Average Receivable
Utilizing the data taken from Mighty King Trading:
Accounts Receivable, January 31, 2009, $30,000
Accounts Receivable, December 31, 2009, $10,000
Cash Sales $50,000
Credit Sales $160,000
To get the average receivables: Account Receivables, January 1, $30,000 - plus Accounts Receivables, December 31, $10,000 equals $40,000. $40,000 divided by 2 equals $20,000.
To get the Accounts Receivable Turnover: Credit Sales, $160,000 divided by the Average Receivables equals 8.
To get the average collection period: 360 days in a year divided by the accounts receivable turnover or 360 days divided by 8 times is equal to 45 days. This standard of days is compared to the number of days allowed in the company's credit term. If the credit policy allows only 30 days for credit accounts, then the company is performing below the standard. It means to say that the collection system is not efficient.
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What Is the Significance of the Average Accounts Receivable in Managing Customers' Accounts?
The average accounts receivable is important in calculating how many times a company collects its receivables in one accounting period. The number of times or the turnover rate can also be utilized to know the average age of receivables. The average age of receivables is compared to the usual credit term. If the age of receivables is bigger than the credit term, it means that the company is not efficient in collecting its accounts on time. Management should also compare the results with what is prevailing in the industry to determine how the company fares at the industry level. From this information, management can make moves to improve the collection system.
The tool above is practical to be used by a business that deals with a bullk of receivables, but management should be reminded that these standards only complement other techniques that are used in managing accounts. To properly manage customers' accounts, the company should start in its credit customer selection, and a strong credit investigation must be done in order to confirm what the applicants are stating in their application statement. Clear policies on credit must be established, too, and the approval on a credit application should also consider history of payment and the ability to pay.
To calculate average accounts receivable is the first step. It is also helpful to know how to induce customers to pay their accounts promptly. One strategy is to offer discounts for early payments or condonation of delayed accounts by foregoing the interests and paying only the fines. In our cooperative, the program on condonation of delayed accounts offers prompts to delinquent members to pay their long overdue accounts.
In the case of Mighty King Trading, the accountant should not only rely on these standards but should also consider the above-mentioned strategies in managing the bulk of accounts that the company has.
Book and Image Credits:
Intermediate Accounting Volume 1 by Robles and Empleo 2006