Managing Accounts Receivable

When discussing how we manage our accounts receivable section, we’re trying to answer the question, “Are we receiving money quickly enough?” A common way we incentivize customers to pay more quickly is through offering a discount. For instance, if customers typically take 30 days to pay for their accounts receivable, but we offer a 2% discount if they pay in 10 days or less, they will only owe us $98 instead of $100.

As a business, how long we let customers wait to pay for their accounts receivable balance is important. Imagine having massive sales now, but our terms are 180 days; the customers wouldn’t pay us until six months from now.

The percentage discount that we choose is important too. If we make the discount too low, customers won’t feel incentivized, and they won’t pay us early. If we make it too high, the benefits of receiving the cash earlier are offset by the decrease in our discounts.

A company’s credit standards for customers matter as well. We shouldn’t let 100% of customers pay on credit. We should consider the customer’s credit score because a customer with poor credit may never pay us, causing us to write off the accounts receivable as a bad debt expense.

Sometimes a company has an immediate need for cash and can’t wait until the customers pay off their accounts receivable balance. In this scenario, a company has a few options.

First, a company could pledge its AR balance to get a loan. When a company takes out a loan, it has to provide collateral for the loan. Collateral is what the company would give the bank if it doesn’t make back its loan.

A company can pledge its AR balance as collateral, meaning that if the company doesn’t pay the bank back for the loan, then the bank has the right to all of those proceeds from the AR balance.

Study Tip: Pledging an AR balance means to use the AR as collateral for a loan.

There’s another option for using a company’s AR balance, which is called factoring or assigning. With factoring, a bank pays the company for its AR balance. Therefore, the company gets the cash right away instead of waiting for its customers to pay off their AR balance.

For example, let’s say a company has an AR balance of $100,000, but it needs cash right now. It factors its AR balance with a bank. The bank, let’s say, pays the company $80,000 in cash today for the rights to those future proceeds for the AR balance. Then when the customers eventually pay the AR balance, the proceeds of $100,000 go directly to the bank. The benefit is that the company receives cash for its AR balance right away. But the disadvantage is that they’re never going to recover the full amount because the bank’s going to charge a fee for the process.

Study Tip: Factoring an AR balance means receiving the proceeds early