Accounts Receivables Management | Corporate Finance | Part 2 | Section B | Episode 21 | CMA USA

Welcome back to CMA USA exam coach, your study companion. In this episode we are diving into next important component of working capital management, accounts receivables management. Receivables arise when a company sells goods or services on credit. Instead of receiving cash immediately, the company allows the customer some time to pay, usually 30, 60 or even 90 days depending on the agreement. This creates what we call accounts receivable, money owed to the business by its customers. Let's understand this through a simple scenario. Imagine a company sells office furniture to a client worth $10,000, but instead of receiving cash on the spot, the company gives the client 30 days to pay. At the time of sale, the company records this transaction as accounts receivable in the balance sheet. This is essentially an asset, money that the company expects to collect soon. The important point to understand here is that while credit sales can help boost sales volume and attract more customers, they also tie up the company's cash. The money is still not in the company's bank account and it may take weeks or months to arrive. That's why managing receivables effectively is critical to maintaining liquidity and ensuring that the business can meet its short-term obligations. In this episode we are going to understand how companies manage receivables, how they decide whom to give credit to and for how long. We'll also look at important performance measures like days sales outstanding and we'll explore tools like aging schedules and credit policies. But before we move into that, let's take a closer look at the concept of a credit policy because this is the foundation of receivables management. There are mainly two types of credit policies that companies may follow a liberal credit policy and a rigid or conservative credit policy. Let's first understand both and then we'll explore how each of them impacts the business differently. A liberal credit policy is when the company is generous with its credit terms. It allows more customers to buy on credit, possibly gives longer time for repayment and doesn't strictly screen customers based on their credit worthiness. On the other hand, a rigid credit policy is more conservative. The company only extends credit to carefully selected customers, often limits the credit period and tries to ensure a quick collection of dues. Let's begin by looking at what happens under a liberal credit policy. Under liberal policy, sales volume usually increases because more customers are encouraged to buy when they don't need to pay immediately. This can help the business grow, especially in competitive markets. But at the same time, the risk of bad debts also increases. When you give credit to more customers, especially without strict screening, some of them might not pay at all. Collection periods become longer, which means it takes more time to actually receive the cash. As a result, your average receivables, the amount of money owed to you at any given time, also increases. Now here's the financial impact. With more money tied up in receivables for a longer time, the opportunity cost goes up. Opportunity cost means the return the company could have earned if that money had been invested elsewhere. For example, in a short-term investment earning interest or in inventory to generate more sales. So while sales increase, profitability may be affected due to high bad debts and cash flow delays. Now let's look at the rigid or conservative credit policy. Under rigid policy, sales volume is usually lower because fewer customers qualify for credit and those who do may not be comfortable with shorter payment terms. However, the bad debt risk is also low since credit is only given to reliable customers. The company gets its money back more consistently. Collection periods are shorter, which means the company receives cash more quickly. This leads to lower average receivables and the company is less exposed to liquidity issues. And importantly, opportunity cost is also low because less money is stuck in receivables and more funds are available for other productive uses. So to summarize, a liberal credit policy boosts sales but also increases risks and costs, while a rigid credit policy limits sales growth but protects the company from losses and cash flow issues. The key is to strike the right balance depending on the industry, customer base and overall financial strategy of the company. Now let's understand a very important tool used in receivable management, the account's receivable aging schedule. The aging schedule is like a report card for your credit customers. It helps the company track how long its receivables have been outstanding. In other words, it shows which customers owe money and for how long that money has been due. Now how does it work? All receivables, meaning all the money customers owe to the company, are divided into time-based categories, usually called age brackets. These time buckets typically look like this. The first category is from 0 to 30 days, then 31 to 60 days, 61 to 90 days. And finally, over 90 days. Each group tells us how much of the total receivables fall into that time range. For example, let's say a company has total receivables of $100,000. When we prepare the aging schedule, it might look like this. $60,000 are current, meaning the customer is within the agreed credit period of 0 to 30 days. $20,000 are between 31 and 60 days. $10,000 are between 61 and 90 days. And the final $10,000 are overdue more than 90 days. Now what does this tell us? If the majority of receivables are in the current bracket, let's say 0 to 30 days, that means customers are paying on time. This is a sign of healthy credit management and good cash flow. However, if a large portion of receivables is sitting in the over 60 day or over 90 day category, that's a warning signal. It tells us that customers are delaying their payments. This can lead to serious problems like cash shortages, increased collection costs, or even bad debts. In addition to giving us an overview, the aging schedule can also help us identify which specific customers are overdue. With that information, the company can send reminders, stop future sales to those customers, or even begin legal recovery if needed. To summarize, the accounts receivable aging schedule is a simple yet powerful tool. It helps us monitor the health of receivables, understand customer behavior, and ensure that our credit policy is working properly. Let's continue our discussion on receivables management by learning how to measure how efficiently a company is collecting its receivables. The key metric we use for this is the accounts receivable turnover ratio, or simply ARTR. So what exactly is ARTR? The accounts receivable turnover ratio tells us how many times a company collects its average receivables during a year. It helps us measure the efficiency of a company's credit and collection policy. Let's go over the formula. ARTR equals annual credit sales divided by average accounts receivable. Where annual credit sales refers only to the total sales made on credit, excluding any cash sales. Average accounts receivable is calculated as the opening balance plus closing balance of accounts receivable divided by two. This gives us a realistic picture of the receivables balance during the year. Now let's understand what this ratio means. If the ARTR is high, for example 10, it means the company collects its receivables 10 times in a year. That's once every 36 days. This is considered efficient collection. On the other hand, if the ratio is low, say 4, it means the company is collecting only four times a year or once every 90 days. This could be a red flag indicating weak collection efforts or very lenient credit terms. Now to make this information even more useful, we can convert this turnover ratio into the average collection period, also called days sales outstanding or DSO. The formula for that is average collection period equals 365 divided by ARTR. This tells us how many days on average it takes to collect receivables. So if your ARTR is 10, then 365 divided by 10 equals 36.5 days. This means it takes the company on average 36.5 days to collect payments from customers. If the ARTR is 4, then 365 divided by 4 equals 91.25 days, which means customers are taking around three months to pay. That's a long time and it might require some action to improve collections. So in summary, a higher ARTR means faster collection and better liquidity. A lower ARTR means slower collection, higher investment in receivables, and possibly a risk of bad debts. And using 365 divided by ARTR gives you the average collection period, which is an easy and intuitive way to understand your collection timeline. Now let's apply what we learned with a This type of question is very typical in your CMA exam and will test your understanding of the impact of receivables on working capital. A company plans to tighten its credit policies. The new policy will decrease collection period from 75 to 50 days. The ratio of credit sales will also decrease from 70 percentage to 60 percentage. The total sale also will be 5 less if the new policy is implemented. The projected sale for the coming year is 50 million. Calculate the impact of account receivable if the new policy is implemented. All right, now let's take a moment to understand what this question is really saying. The company is thinking about tightening its credit policy. That means they want customers to pay faster and reduce the number of customers who get credit. Let's break the data down. First, the collection period, which is the number of days customers take to pay, is currently 75 days. Under the new policy, this will reduce to 50 days. That's good for cash flow, but it may affect sales. Second, the credit sales ratio, which tells us what portion of total sales are given on credit, is currently 70 percentage. This will go down to 60 percentage under the new policy. That means fewer customers will be allowed to purchase on credit. Third, due to the stricter credit terms, the total expected sales will also go down by 5 percentage. So even though the projected sales are 50 million, if the new policy is implemented, it will be reduced. So, to summarize, the company is tightening its credit policy, which will reduce sales and credit terms, but also help bring in money faster. Now, we are asked to calculate how this new policy will affect the accounts receivable, that is, the amount of money tied up in unpaid customer bills. Now let's take a closer look at the relationship between the average collection period and the accounts receivable turnover ratio, or ARTR. As we already discussed, the equation to calculate average collection period is 365 divided by ARTR. That means if we rearrange this formula, we can also find ARTR using 365 divided by the average collection period. Now, let's use this to calculate ARTR before and after the company's policy change. Before the policy, the collection period was 75 days. So ARTR equals 365 divided by 75, which gives us approximately 4.8 times. After the policy, the collection period will be reduced to 50 days. So ARTR equals 365 divided by 50, which gives us approximately 7.2 times. So what does this mean? This means the company will be collecting its receivables more frequently during the year if it tightens its credit policy. This higher turnover ratio indicates improved efficiency in collecting credit sales. Now, let's move forward and calculate the average accounts receivable before and after the credit policy change. As we know, the formula for average accounts receivable is annual credit sales divided by accounts receivable turnover ratio, or ARTR. Step one, before the policy change, we are told that total projected sales for the year are 50 million dollars, and 70 percent of those are expected to be credit sales. So annual credit sales equals 50 million multiplied by 0.7 equals 35 million dollars. Now divide this by the ARTR we calculated earlier, which was 4.8. So 35 million divided by 4.8 equals approximately 7,291,666 dollars. That is the average receivable before the policy change. Step two, after the policy change, now the company expects that total sales will fall by 5 percent. So new projected sales equals 50 million minus 5 percent, which is 50 million multiplied by 0.95 equals 47.5 million dollars. Also, the new credit sales ratio is expected to be 60 percent. So annual credit sales equals 47.5 million multiplied by 0.6 equals to 28.5 million dollars. Now divide that by the new ARTR, which we calculated as 7.2. So 28.5 million divided by 7.2 equals approximately 3,958,333 dollars. That is the average receivable after the policy change. Step three, calculate the impact. Let's find the difference in average receivables. Before the policy equals 7,291,666. After the policy equals to 3,958,333. Now subtract 7,291,666 minus 3,958,333 equals approximately 3,333,333 dollars. So the impact of implementing the new tighter credit policy is a reduction in average accounts receivable of about 3.3 million dollars. This means less capital will be tied up in receivables, improving liquidity and possibly reducing the need for external financing. All right, before we wrap up, let's take a quick look at what we covered in this episode on accounts receivable management. We started by understanding what accounts receivable is and how it arises from credit sales. Then we explored the two main types of credit policies a company can follow, liberal and rigid credit policies. We looked at how each of these affects sales, bad debts, collection periods, and opportunity costs. Next, we discussed the aging schedule, which helps companies monitor overdue receivables and take timely action. After that, we moved into analyzing the key ratios, especially the accounts receivable turnover ratio or ARTR, and how it connects with the average collection period. Finally, we worked through a detailed example problem where we saw how a change in credit policy can affect the average receivable balance and how to calculate the financial impact step by step. I strongly encourage you to practice more questions from your question bank and make sure to read your study material to reinforce what we've learned today. That's it for now. See you in the next episode where we'll continue building your expertise in working capital management. All the best and keep learning!