Accounts receivable risk includes slowing down the cash flow - or working capital - that sustains your business and allows you to grow. Effective debtor risk management lowers your risk by ensuring that invoice balances are paid on or before invoice due dates. While sales drive revenue, credit risk management reduces the chances of you getting paid late or not at all.
What are the risks of accounts receivable?
It is a normal course of business to extend trade credit and then have to manage accounts receivable. But this comes with inherent risks that can affect the quality of insight you have into your receivables and affect cash flow management. Typical accounts receivable risks include:
- 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.
- 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 The Risk
If a few clients represent the majority of your accounts receivable, you have an imbalanced receivable risk. This is called a high accounts receivable concentration and is a standard way to measure the riskiness of it.
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.
How your business can manage the risk
- Effective accounts receivable risk management steps you can take to reduce your exposure include:
- Maintain systems and standards: Establish a workable system and standards for managing accounts receivable, 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 accounts receivables to maintain a clear picture of your credit risk.
- 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 credit insurance: Another effective risk management strategy for debtors is credit insurance. This insurance covers your trade receivables and pays out a percentage of the outstanding debt when that debt turns into unpaid invoices.
What does healthy accounts receivable look like?
When measuring your accounts receivable risk and performance, here are specific KPI’s that gauge the health of your accounts receivable:
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 accounts receivable 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 accounts receivable risk.
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