Value of Receivables Analysis
Receivables are unpaid customer invoices and they consist of: the original amount of the invoice, the customer identifier, a unique reference and the date of the invoice. Just like a good wine, receivables age, so when analyzing receivables it is best to consider a timeline rather than a snapshot at any point in time. This will provide supplementary information such as:
Let us consider each element and the supplementary information to see what can be analyzed and why. We shall use the term portfolio to describe the collection of receivables that make up accounts receivable.
A customer will purchase goods and services on credit via an order. The order should have a customer reference and this reference should be recorded against the receivable. When the goods are delivered and an invoice presented, the customer can note the order reference and reconcile the invoice quickly. While this alone does not validate the invoice, it does go a long way to minimizing disputes over quantities.
Recording the order electronically, so that the order can be displayed as the invoice is generated, will lower operational errors on details like the invoice amount and customer details. This will again minimize disputes over incorrect invoices. Consider employing a purchase-to-payment (P2P) system that allows electronic messaging between customer and supplier. Where the customer does not have infrastructure to support a P2P system, consider providing the customer with a portal. This may require the supplier to provide the customer with a standalone PC and an Internet connection.
Typically, an accounts receivable system will maintain a register of customer identifiers or codes that are linked to details like name, address and credit details. Companies can analyze the portfolio of receivables by this code. The main indicators are exposure and concentration. Exposure is simply the sum of receivables totalled by the customer at a certain date. A supplier should understand who their top customers are and the level of exposure. By expressing the customer total to the portfolio total as a percentage companies can get a measure of concentration.
There are other more sophisticated indexes like the Herfydahl Index that indicate concentration. Concentration indicates customer spread. If any one customer has a very high concentration, greater than 25 per cent of the portfolio, then there are risks involved. The two major risks are:
1. A customer with a high concentration defaults and therefore a significant proportion of the accounts receivable will default.
2. A customer with a high concentration moves to a competitor so sales will drop by the level of concentration.
Suppliers should understand their customer credit details and analyze receivables by credit terms for the portfolio. Consider ‘what ifs’ to determine the effect on cash as a result of any alteration of credit terms.
The invoice date is perhaps the most important element of the receivable. Combined with the terms of trade for each customer companies can calculate the due date, the day sales outstanding (DSO) and age the receivable. The DSO is an indicator of portfolio quality and companies can calculate the DSO for each receivable then average the DSO for each customer and the portfolio. Risk of default increases as DSO increases. The collection process revolves around the ageing of receivables. Procedures should be documented and adhered to with respect to collections and statements, e.g. overdue letter to customers at 60 days or cross ageing and suspension of credit for a customer with receivables in 90 days.
Measuring the DSO for a customer over time is a good risk indicator, e.g. if a customer’s DOS is increasing significantly from one period to the next, then perhaps the customer is in trouble and may not be able to pay. Combine this information with the customer’s exposure and concentration and you may be in serious trouble. If on the other hand the DSO is steady and the customer’s exposure is increasing, then the customer is purchasing more, therefore a good payer, and so deserves some extra attention to keep the relationship positive.
Companies need to allocate payments to a receivable so that the outstanding amount reduces. When the outstanding amount has reduced to zero and the receivable is fully paid you can record the payment date. Analysis of the payment date and the date of the receivable provides the payday’s indicator, i.e. the number of days from the receivable date to pay date. This is an indicator of collections performance.
Companies want the paydays to be as small as possible so they get their cash sooner rather than later. They should therefore endeavor to send invoices electronically because posting paper invoices adds two to three business days to paydays.
Analyzing this indicator over time and averaging by customer allows companies to accurately forecast cash collections. This information is essential for corporate treasurers who may need to liquidate an investment because of the need for cash for payroll or inventory. Attention to part paid receivables is important. After allowing for early payment discounts, if you allow them, part paid receivables usually indicate some sort of dispute. Companies should consider suspending credit to customers who they presume to be in dispute through part payment, until they understand the reason for part payment.
Disputes can be costly to resolve both in time and effort. Providing the customer with an electronic dispute mechanism can ease this problem. The sooner a company knows what the dispute is, the sooner it can react and resolve the issue to protect the relationship. Disputes can be resolved by issuing a credit note. Analysis of credits and the underlying dispute provides a lot of useful information. Companies need to understand which receivables credits apply to and why.
Disputes arise for two main reasons: either something is wrong with the invoice or there is something wrong with the product. In either case the customer will not pay the full amount of the invoice. A credit to a receivable is called a dilution as it ‘dilutes’ the value of the receivable. The time from the receivable date to the credit note being issued is called the dilution horizon. Companies should endeavor to keep this horizon as low as possible. Unresolved disputes tend to pollute other indicators like DSO.
Analysis of credits over time by customer provides some insights to the company. If a single customer is responsible for all credits then this indicates that the relationship is not sound. If the customer is a small customer then you can suspend credit for this customer as they are causing more work. If all customers are disputing quality of the product then there is something wrong with the product. If credits are related to operational issues, incorrect data on invoices or statements, then companies should perhaps consider a P2P system that would overcome purchase order or invoice errors.
Once the basic analysis as detailed above is performed, it is then possible to conduct more sophisticated analysis. Companies can look at the indicators over time and compare movements in the current period with previous periods, e.g. average DSO current period with average DSO for the same period last year. These aggregated indicators reflect growth and seasonal issues. They also allow for ‘what if’ calculations, e.g. if a market situation arises whereby your company can grow its business by 100 per cent, you need to increase inventory by 100 per cent and this will require cash. If the average payday remains the same, what will the forecasted cash position be?
It is important to monitor indicators over time as rapid movements of DSO and paydays from customer and portfolio averages can indicate fraudulent schemes. Analysis of the origin of payments will disclose such schemes. Generally, electronic accounts receivable systems with electronic delivery of invoices, electronic dispute resolution and the recording of order details along with appropriate indicators and procedures will minimize the opportunity for staff fraud.
Companies should maintain a corporate timeline where internal and external events can be recorded on the timeline. The timeline can then be cross-referenced against all of the indicators and may provide the reason behind any odd movements within indicators, e.g. a sudden increase in global oil price may explain a sudden increase in the DSO of a transport customer.
Basic analysis of receivables will allow companies to better understand their customers and also provide an overview of the risk and opportunities. Basic analysis of receivables need not be time consuming or expensive though and implementing an electronic P2P system, while providing benefits to the accounts receivable department, can also make analysis of receivables easier.