While there are different reasons for non-payment, the focus of this article is on the company extending credit.
The first step in extending credit is to approve the credit application for the person, or company, applying. This should be done by a credit manager who understands how credit is reported, and who can make a reasonable determination based on the amount requested and the income to debt ratio of the person making the request. While it is impossible to be 100% accurate, in terms of those that will pay their balance in a timely manner, you can limit the amount of defaulted collections by making smart decisions based on financial considerations.
After credit is granted and the purchase made, an aging accounts receivable balance should be prepared at the end of every month. This will give the company an idea of which account is in danger of default. This gives the creditor a chance to make arrangements with the debtor before turning them over to collections and possibly hurting someone’s credit for something that could be avoided.
Normally, accounts receivable is aged every thirty days and sent off to collections at 120 days. Before the 120 day mark, an attempt should be made to work out an arrangement with your customer to ensure their credit is not ruined and you can collect on the account. This should be done regardless if you use the allowance for bad debt method or the direct write off method. (Note: If you “write-off” a debt, it can still be turned to a third party to attempt collections. Any money recovered at this point is generally credited to “Other Income”, but you should seek the advice of your accountant.)
One of the ways to determine the effectiveness of your collection efforts is to use the Accounts Receivable Turnover Ratio. To determine, use the following formula:Net Credit Sales / Average Accounts Receivable Balance
The formula to determine the Average Accounts Receivable Balance is:
(Beginning Balance + Ending Balance) / 2
*IMPORTANT: If you use net total sales, instead of net credit sales, your turnover ratio will not be representative of how often you turn over your accounts receivable.
Things to remember when calculating your accounts receivable turnover:
- · A high turnover ratio may indicate your credit manager is being too selective on credit decisions and you are losing sales to competitors.
- · There is never a set number you should strive for. You should use your company's past history and the industry standard to determine the effectiveness of your accounts receivable department.
- · Remember, this ratio is an average. This means that it may hide any past due receivables and some may be offset by accounts collected faster.
Therefore, it is important to have a credit manager who can make reasonable decisions based on numerous factors. The SBA (www.sba.gov) has a series of guidelines for making credit decisions. These include running a credit check on all customers, developing clear and concise payment plans, and determining how you invoice customers (in house vs. outsource). Determine how you will collect late payments, lay out the penalties for late payments and how unpaid bills will be handle. All of this information is important in the case of fraudulent or delinquent accounts.
Using these tips, along with experience in your industry and hiring well qualified people, will help you develop practices to increase efficiency within your accounts receivable collections. This will allow more time to serve your customers and less time developing invoices and attempting to collect on delinquent accounts.