Accounts Receivable Management II: Credit Evaluation, Collection and Average Collection Period
Course: Business Finance / Corporate Finance
Lecture: 6 – Accounts Receivable Management II
1. Learning Objectives
By the end of this lecture, students should be able to:
- Evaluate customer creditworthiness using standard techniques.
- Describe key elements of an effective collection policy.
- Calculate and interpret the Average Collection Period (ACP) for a firm’s receivables.
2. Credit Evaluation Techniques – The 5 Cs of Credit
Before granting credit, a firm should assess whether a customer is likely to pay on time. A widely used framework for evaluating creditworthiness is the Five Cs of Credit: Character, Capacity, Capital, Collateral, and Conditions. [web:45][web:49]
2.1 Character
Character refers to the customer’s reputation and willingness to pay. It is about trustworthiness and past behaviour, not financial figures alone.
- Past payment record with the firm and other suppliers.
- References from banks and other creditors.
- Stability and integrity of management.
2.2 Capacity
Capacity measures the customer’s ability to generate enough cash to meet payment obligations when due.
- Profitability and cash flow from operations.
- Existing debt obligations and leverage.
- Key financial ratios such as interest coverage and debt service coverage.
2.3 Capital
Capital reflects the financial strength of the customer as shown by its own investment and net worth.
- Size of owner’s equity and retained earnings.
- Solvency and long‑term financial stability.
- Ability to absorb losses without defaulting on suppliers.
2.4 Collateral
Collateral is any asset that the customer can pledge as security for credit. It gives the supplier an additional source of repayment if the customer fails to pay.
- Assets that can be pledged (property, equipment, inventory, receivables).
- Quality and marketability of collateral.
- Legal enforceability of security interest.
2.5 Conditions
Conditions refer to the broader economic, industry, and contractual environment that may affect the customer’s ability to pay. [web:46][web:52]
- General economic conditions (recession, inflation, interest rates).
- Industry trends and competition affecting the customer’s business.
- Specific terms of the sale (size of the order, purpose of the credit, seasonality).
In practice, the 5 Cs provide a structured checklist. The credit decision may be based on a formal scoring model or on management judgement after reviewing all five areas. [web:45][web:49]
3. Collection Policy and Procedures
Once credit has been granted, the firm needs an effective collection policy to ensure that customers actually pay according to the agreed terms.
A typical collection policy includes the following steps:
3.1 Reminder letters and emails
- Friendly reminders sent shortly before or just after the due date.
- Additional, firmer reminders for invoices that are slightly overdue.
- Statements summarising outstanding balances and due dates.
3.2 Phone calls and personal contact
- Calling customers when accounts are overdue by a set number of days.
- Discussing reasons for delay and agreeing a realistic payment plan if needed.
- Escalating contact from sales staff to credit control or finance staff for persistent delays.
3.3 Legal action and external collection
- Sending a formal demand letter when previous reminders are ignored.
- Engaging collection agencies or legal advisors if the amount and risk justify the cost.
- Pursuing court action in serious default cases, where appropriate.
A good collection policy is clear, consistent, and firm but fair. It should be communicated to customers in advance and applied systematically to maintain cash flow and discourage late payment. [web:51][web:54]
4. Average Collection Period (ACP)
The Average Collection Period (ACP) measures how long, on average, it takes a firm to collect cash from its credit customers. It is an important indicator of the effectiveness of receivables management. [web:50][web:53]
A common formula is:
Average Collection Period = (Average Accounts Receivable ÷ Net Credit Sales) × Number of Days
Where:
- Average accounts receivable = (Beginning receivables + Ending receivables) ÷ 2
- Net credit sales = Total sales made on credit during the period (excluding cash sales)
- Number of days = Usually 365 for a full year, or the number of days in the period being analysed
In simplified classroom examples, you may also see:
ACP ≈ Accounts Receivable ÷ Average Daily Credit Sales
Where average daily credit sales = Annual credit sales ÷ 365.
Interpretation:
- A shorter ACP means customers are paying faster, which is good for liquidity.
- A longer ACP may signal collection problems, overly generous credit terms, or weak enforcement.
- ACP should be compared to the firm’s stated credit period (e.g., 30 days) and to past trends and industry averages. [web:50][web:53]
5. Aging Schedule of Receivables
An aging schedule classifies accounts receivable according to how long they have been outstanding. It is a key tool for monitoring collection performance.
A typical aging schedule groups receivables into categories such as:
- Current (not yet due)
- 1–30 days past due
- 31–60 days past due
- 61–90 days past due
- Over 90 days past due
By examining how receivables are distributed across these time bands, management can:
- Identify emerging collection problems early.
- Focus collection efforts on the most overdue and risky accounts.
- Assess whether the credit policy and collection procedures are effective.
6. Numerical Exercise – Calculating ACP
Exercise (for students):
A company reports the following data for the year:
- Beginning accounts receivable: Rs. 120,000
- Ending accounts receivable: Rs. 180,000
- Annual net credit sales: Rs. 1,200,000
Required:
- Calculate the Average Accounts Receivable.
- Compute the Average Collection Period (ACP) in days using 365 days in a year.
- Interpret the result if the normal credit term of the company is 30 days.
Solution (for instructor):
- Average Accounts Receivable = (120,000 + 180,000) ÷ 2 = 150,000.
- ACP = (Average Accounts Receivable ÷ Net Credit Sales) × 365
ACP = (150,000 ÷ 1,200,000) × 365 ≈ 0.125 × 365 ≈ 45.6 days
Interpretation: On average, the company takes about 46 days to collect from its credit customers. If the stated credit term is 30 days, this indicates that customers are paying significantly later than expected, suggesting that the collection policy may need to be tightened or more actively enforced.
7. Homework – Lecture 6
Part A – Credit evaluation case
- Write a short profile (one paragraph) of a hypothetical customer asking for credit from your company.
- Using the 5 Cs of credit, briefly comment on each C (Character, Capacity, Capital, Collateral, Conditions) for this customer.
- State whether you would approve or reject the credit request and justify your decision in 3–4 sentences.
Part B – ACP and aging analysis
- Assume a company has a normal credit term of 30 days and an ACP of 55 days.
- Explain in 150–200 words what this difference suggests about its receivables management.
- List two actions the company could take to reduce its ACP and improve cash flow.
0 Comments