Companies routinely extend credit to customers to make purchases. Accounts receivable is a balance sheet account that includes outstanding credit invoices. Credit is convenient for customers because it helps them manage their cash flows. Economic weakness, inadequate management controls and soft business conditions could cause problems in the recording and collection of accounts receivable balances. Businesses need to detect and correct these problems before they hurt profitability and cash flow.
Review the accounts receivable aging report, which groups unpaid customer invoices by the number of days they are overdue. According to the AccountingTools website, a typical aging report lists invoices in 30-day buckets, starting with invoices that are less than 30 days old, followed by invoices that are 31 to 60 days old, 61 to 90 days old and invoices that are 91 days or older. The aging report reflects the payment record and financial health of customers. You should be concerned if a majority of accounts in the aging report are more than 30 days old.
Compute the average collection period, which is equal to the average accounts receivable divided by the average daily credit sales. The average accounts receivable is equal to the accounts receivable at the start of a period plus the accounts receivable at the end of a period divided by two. The average daily credit sales amount is equal to the annual credit sales divided by 365. The average collection period should be around your normal credit period, such as 30 days. If it is too much longer, you should review and consider changes to your internal controls and collection processes.
Calculate the accounts receivable turnover ratio, which is equal to the annual credit sales divided by the average accounts receivable. This ratio measures how well you are managing the credit approval and collection processes. A high turnover ratio means that you are able to convert a higher percentage of your credit sales to cash during the year, while a low turnover ratio means that some of your customers are not paying their invoices on time. However, if the ratio is too high, it could mean that your credit policies are too restrictive. This could lead to lost sales as customers shift their business to more accommodating vendors.
Monitor your internal controls. This means reviewing your credit approval process, verifying the accuracy of invoices, restricting access to account billing software and ensuring that you match cash receipts to the correct invoices.
Review the collection process. Strategies to speed up the collection of overdue accounts include offering discounts to customers who pay early, setting up electronic transfer and other online payment options and following up on delinquent accounts identified in the aging report.