When you make the business decision to offer credit to customers, you should also develop a collections policy. Doing so will help you manage the inherent risks associated with extending payment terms to customers. One important element of the collections policy is to monitor accounts receivable through an aging schedule.
Smart businesses will develop a schedule of accounts receivable to monitor amounts and due dates for each customer that receives products or services on credit. Typically, the aging schedule will include customer name, balanced owed and a breakdown of which amounts are past due or current.
Accounts Receivable Aging Methods
Accounts receivable aging is a technique used to estimate bad debt expense when a company extends credit to customers. Basically, accounts receivable are classified based on the length of time each invoice remains outstanding. An estimate of the non-collection probability for each category is also part of the aging process. Classification of accounts in the aging schedule will help identify customers that usually take longer to pay. Sales restrictions will be placed on those customers to reduce further bad debt risks.
Typically, receivables are categorized into multiple payment term periods. For example, your company might have a net payment term of 30 days. The most common classification for a 30 day payment term in an aging schedule would be 0 to 30 days, 31 to 60 days, 61 to 90 days and so on.
The next step in this method would be to calculate the probability of not collecting for each aging schedule category. That number is multiplied with the sum of accounts receivable in each category. So, you would multiple the total amount of invoices in the 30 to 60 day category. The return represents the amount of receivables that you expect to become bad debt in that category.
A second aging schedule method is to categorize receivables by the number of days each have been on company books. Basically, you could construct this method in one of two ways. The first is to take the total number of accounts; the second is to use the dollar amount. If percentages in the lower half of the schedule increase, you might need to evaluate how effective your current credit policy is for securing payments.
Using payment patterns is a good way to determine the percentage of monthly sales your company collects each month after making a sale. With payment patterns, you can forecast how much working capital is needed to run the company efficiently.
Why it is Important to Have an Aging Schedule
An aging schedule is important for your company to determine how well – or poorly – your credit policy is working. Your company loses cash flow every day that a customer is late making a payment. Therefore, setting up an aging schedule and acting on collections policy procedures is important to having a financially healthy company.
If customers are paying their invoices within the prescribed credit period, the policy is working to meet your financial needs. If the aging schedule highlights a large percentage of customers that are not paying, or consistently pay late, you might need to make some changes to the current policy.
How to Analyze an Aging Schedule
Properly managing your company’s cash flow requires analyzing several components that affect the timing of cash inflows and outflows. One of those components is the aging schedule, which lists credit accounts and customer paying habits. A good analysis will highlight problem accounts that have a direct link to the cash flow gaps your company experiences. Narrowing or closing those gaps is key to better cash flow management. Analyzing the aging schedule will point out problems early before they become major cash flow problems.
Essentially, you will use the aging schedule to identify customers that have extended your payment collection terms. If one customer holds the bulk of overdue amounts, you can take necessary steps to collect promptly. If multiple customer accounts are overdue, you will need to revisit your credit policy for new and existing customers.
Additionally, analysis of the accounts receivable aging schedule can identify recent changes in accounts on a monthly basis. In other words, a customer’s account that was current last month might have an overdue balance this month. If they are in the 31 to 60 day range, you could send a friendly reminder for payment.
As you analyze each credit account, you want to have several questions in mind to get the most out of the aging schedule. Is the change due to a billing problem, or was there a change in your credit policy? Will the change affect next month’s cash inflows? Analyzing the aging schedule can provide early answers to protect your company.
You will recognize patterns of delinquency and know where to concentrate collection efforts. An aging schedule helps in evaluating whether your cash reserves are adequate to carry bad debt. The longer customer accounts go unpaid, it becomes less likely that you will collect. You will also avoid financial losses on future sales, since most customers who fall behind usually look for new supply sources.
Setting Up Accounts Receivable with a Collections Policy
Whatever approach you decide to take in setting up an aging schedule, you must have a supportive collection policy. Simply put, a collections policy is a set of procedures used to ensure your company receives payments on accounts receivable. A written policy serves as a blueprint for your company’s philosophy and treatment of credit and debt. Having a clear collections policy at the outset is the best way to lay the groundwork for collecting on established customer accounts.
Even with the best accounts receivable practices, every business has at least one customer that never keeps up with payments. You may want to give late payers the benefit of the doubt, but you also have a fiduciary responsibility to your company’s bottom line. Your collections policy should be written down, followed strictly and accessible to all employees involved with customer accounts.
Furthermore, strict compliance with the collections policy allows you to streamline processes for collecting accounts receivable efficiently. Time is never wasted on how and when to respond to a situation with a customer account. Systemized steps in the policy may help you recover monies owed without initiating costly litigation procedures.
In general, the policy should detail when and how a delinquent customer is contacted. There should be guidelines for resolving invoice disputes. Sometimes, a customer has not paid because they believe they were not invoiced properly.
Similar to other business policies, your collections policy should not be a boilerplate, off-the-shelf document. Instead, you want to draft a policy that addresses unique circumstances and needs related to your industry. For instance, you might have government contracts, which are notorious for extending beyond the 90 day payment window. You would not step up collection efforts when you know the government will pay – eventually. You would simply make other arrangements to fill the gap.
Aggressiveness and strategy for collecting will also depend on your company’s mission and long-term customer relationships. Where one customer receives escalated collection efforts, another customer might receive an extra courtesy phone call before the account is written off as a bad debt or placed with an outside collection firm.
In the end, you want a collection policy that works with your accounts receivable system. Having a structured environment will help to safeguard your accounts receivable, which is one of your most precious business assets.
Source: New feed