Accounts receivable (AR) risks include slowing the cash flow – or working capital – that sustains your business and allows you to grow. Effective lowers your exposure by ensuring that invoice balances are paid on or before the invoice due date. While sales drives revenue, credit risk management mitigates the potential of receiving or not getting paid at all.
What Are the Risks of Accounts Receivable?
- Overstatement of revenue: When revenue is overstated, more receivables are recorded than what customers actually owe. This can happen when accounts receivable record keeping is disorganized or if potentially uncollectible accounts are purposefully not excluded from the accounts receivable total in order to make it look like profits are higher than they actually are.
- Unenforced cutoffs: Cutoffs ensure that financial transactions are accurate and accounted for in the correct accounting period. Without proper cutoffs, accounts receivables and revenue can be overstated.
- Understatement of revenue: When revenue is understated, fewer receivables are recorded than what customers actually owe. This can happen due to an accounting error or when done purposefully to lower taxable income.
- AR Concentration: When only a few customers represent your accounts receivable, you have a greater risk to your revenue when those receivables are not paid on time or not paid at all.
How to Quantify Accounts Receivable Risk?
If a few clients represent the majority of your AR, you have an imbalanced receivable risk. This is called a high AR concentration and is a standard way to measure the riskiness of your AR.
With a single large customer or a few large customers representing a majority of your accounts receivable, you face a cash flow risk if those receivables become uncollectible. Learn more about the risks involved with a high customer concentration.
How Your Business Can Manage Accounts Receivable Risk?
Effective AR risk management steps you can take to reduce your exposure include:
- Maintain systems and standards: Establish a workable system and standards for managing AR, including segregation of duties.
- Analyze the risk of extending credit : Before you take on a new client, do some research into the prospect’s creditworthiness to learn if that new client is likely to default on payment. Then, conduct monthly or quarterly reviews of your AR to maintain a clear picture of your .
- Establish an enforceable credit policy: Fully stipulate your credit terms, including the amount of credit you are willing to extend and for how long. Discuss these terms with new clients before you extend credit.
- Lower your customer concentration: Diversify your client base by focusing sales on different business segments or industries.
- Invest in trade credit insurance : Another effective AR strategy is . Trade credit insurance covers your business-to-business AR and can pay out a percentage of outstanding debt when that debt becoming .
What Does Healthy Accounts Receivable Look Like?
When measuring your AR risk and performance, here are specific metrics that gauge the health of your AR:
- Days Sales Outstanding: Each industry has different averages for Days Sales Outstanding (DSO) or how quickly money is collected after an invoice is issued. Typically, a healthy DSO does not exceed your terms by half. In other words, if your payment terms are net 30 days and you typically receive payment no more than 45 days after invoice issue, you can consider your account receivables healthy.
The calculation is: (average accounts receivable ÷ billed sales) x days
- Best Possible DSO: Best Possible DSO considers only current accounts receivable, so it shows the lowest possible number of days accounts receivable are unpaid. The closer the DSO and Best Possible DSO numbers are, the healthier your accounts receivable.
The calculation is : (current accounts receivable ÷ billed sales) x days
- Average Days Delinquent: While DSO looks at the history of your accounts receivable, Average Days Delinquent (ADD) gives you an at-a-glance look at how effective your company is at collecting accounts receivable on time. It measures how long an overdue invoice takes to be paid. The lower your ADD score, the better.
The calculation is : DSO – Best Possible DSO
- Turnover Ratio: Your receivables turnover ratio shows how well you manage the credit you extend to your clients and how efficient you are at collecting payment. The higher the ratio the better.
The calculation is : total sales for the period ÷ ((receivables at the beginning of the period + receivables at the end of the period) ÷ 2)
- Collection Effectiveness Index: You can understand how strong your accounts receivable management is by calculating the Collection Effectiveness Index (CEI). Then closer the CEI is to 100%, the better your processes. The calculation is: (beginning receivables + monthly credit sales – ending total receivables) ÷ (beginning receivables + monthly credit sales – ending current receivables) x 100
Using these metrics and reevaluating your credit collections policies and procedures on a regular basis can help decrease your AR risk.