Thu, Apr 4, 2024

Every time a business offers credit to its customers, it assumes an accounts receivable risk. These risks include slowing the cash flow that sustains your business and allows your business to grow. If your business is seeing slower cash flow, you are not alone. According to the 2022 Atradius Payment Practices Barometer, 47% of all U.S. B2B invoices are paid late, while more companies are devoting resources to chasing unpaid debt: 42% of the companies polled, up from 37%.

Effective accounts receivable management must include a strong risk management program, which should be a part of any company’s accounts receivable procedures.

What Is Accounts Receivable Risk Management?

Accounts receivable risk management is the identification, assessment and mitigation of the risks associated with extending credit to customers purchasing goods or services. Payments for these goods or services that will be received in the future are considered receivables as they have not been realized. Typically, the credit period for these receivables is short, ranging from a few days to months.

Invoices that go unpaid past the credit period can have a significant impact on your business operations, which can include:

  • Higher operating expenses due to your billing and finance employees spending more time working with clients to obtain payment or sending cases to collections
  • Free money for customers who do not pay on time (During periods with high interest rates, customers who do not pay are borrowing from you at a 0% interest rate. If your company is paying a high interest rate on its debt, there will be losses.)
  • Limiting growth, which results from a slower cash flow (Slower cash flow may mean less investments in new equipment, better computer systems, or employee development and promotion.)

With all of these impacts in mind, it is critical to take the necessary steps to mitigate or reduce the impact of accounts receivable risks.

Accounts Receivable Risk Assessment

Assessing your customer’s credit history and understanding the factors that impact your outstanding invoices will help mitigate accounts receivable risk. These activities should occur regularly as a part of an accounts receivable risk management program.

Segment Your Customers

Placing your customers into segments will help you see patterns that will help identify riskier cases. Groupings can include geography (e.g., domestic vs. foreign), industry (manufacturing, transportation, etc.), product or service category, and size, such as the percentage of your overall receivables the customer represents.

Note whether a small number of customers are failing to pay their invoices on time and the percentage of the receivables they represent. If they represent a high percentage of your receivables, you may be taking on more risk if that income is lost.

Analyze Your Loss History

Analyzing the history of losses when customers cannot pay their debts will help in several ways. First, patterns may emerge that will trigger immediate risk mitigation — for example, if insolvencies are clustered in a particular industry or geography, there may be a greater need for more security arrangements in those groups.

In addition to identifying groups that you will need to be more cautious with, look for ways to improve your company’s accounts receivable procedures and accounts receivable tools, such as reviewing how credit checks are performed and if credit limits are set.

Identify All Security Arrangements and Guarantees

Once you understand which customers pose greater risks, identify and list security measures and guarantees that are in place for those customers, as well as for all of your customers, to limit any losses. Security arrangements and guarantees may include letters of credit, liens, bonds, asset transfers and credit insurance.

For those customers who pose a greater risk, are there sufficient arrangements or guarantees in place to limit potential losses? When all security arrangements and guarantees are identified, take the opportunity to review payment terms for all of your customers.

Take a Close Look at Your Accounts Receivable Aging Report

The accounts receivable aging report categorizes a company’s accounts receivables into the amount of time invoices remain outstanding. The columns in the report capture the number or dollar amount of receivables that are due and those that are past due in 30-day increments (e.g., 1-30 days, 31-60 days, 61-90 days, etc.). In addition to capturing those receivables that are late, add a column that includes current receivables. This way, you can sum up a running total.

As a tool, this report can indicate if certain customers are becoming credit risks. If customers have unpaid invoices, determine what next steps should be taken, such as discontinuing business with them or requiring them to pay in advance.

Identify Future Risks to Your Cash Flow

Once you have a better understanding of your current customer’s credit risk and outstanding invoices, strengthen your accounts receivable procedures by planning for how future growth will impact your company’s receivables risk:

  • New customers: Establish proper due diligence for all new customers before credit is lent. Consider each one individually as opposed to viewing them as risky because they are in a risky industry or geographic location. Obtain letters of credit and ensure that your credit insurance is updated to reflect any increase in credit lent.
  • Entering new markets: Assess each new market individually based on economic risk. Note the track record of the county’s credit rating and economic news that indicates unwillingness to pay. Consider any rules on imports and tariffs you may need to pay.
  • Expanded sales: As your business experiences growth in sales, consider if the risks are any higher. Ensure that your company’s sales team is operating with due diligence and performs routine credit assessments on those clients who are purchasing on more credit.

Key Performance Indicators

To maximize the performance of your accounts receivable procedures and tools, your accounts receivable team needs the right data, and they need to know how to act on that data. To do this, most companies use a specific set of key performance indicators (KPIs) to identify strengths and weaknesses. Some of the more popular KPIs include:

  • Days Sales Outstanding (DSO): Also known as the average collection period, this indicator tracks the average number of days it takes for a company to get paid after making a sale on credit. The lower the number of days, the shorter amount of time is being taken to collect from customers.
  • Average Days Delinquent (ADD): This indicator tracks the average number of days that invoices are delinquent or past due. A lower ADD indicates customers are paying more quickly, whereas a higher ADD indicates customers are slower to pay.
  • Accounts Receivable Turnover Ratio: This indicator shows how quickly your company is collecting revenue. It tells you the number of times during a specific period (e.g., a month or a year) that your company collected the average of its receivables. A higher number is preferred, as it indicates that collection is happening faster (collection is occurring more times in a given period).

Other KPIs include the collection effectiveness index (CEI) and expected cash collections, which measure the amount of cash a company can anticipate having at a given time.

When reviewing KPIs, do so regularly as a part of your accounts receivable risk management program. Don’t look at KPIs in a silo; compare the data with your competitors and how others in the industry are doing.

Accounts Receivable Best Practices

To ensure that your company’s collections workflow and credit lending procedures are optimal, consider implementing some of these accounts receivable best practices:

Strengthen Your Credit Acceptance Procedures

Carefully review credit acceptance procedures before extending any new credit. Consider making a rule that all past-due customers must start purchasing on a cash-only basis for two business quarters before extending more credit. Make sure the sales team is aware of any changes so they understand what customers must do to become qualified for credit.

Communicate With Past-due Customers Sooner and More Often

When collecting overdue amounts, timely action is critical. Consider acting as soon as one day after an invoice goes unpaid by sending late notices via several methods: email, text and phone. Continue to send regular notices and make phone calls until the matter is resolved. Set up a clear process for referring delinquent accounts to collections or notifying an attorney if accounts go unpaid.

Make Payments Easy for Customers

Review options available for customers to pay as well as the user experience. Remove any unnecessary steps in the payment process, perhaps by completing information for the customer so they are not doing a lot of typing at the point of sale. If your company does not already have a way for customers to pay electronically or via mobile, such methods should be considered. Modern payment systems are safe, fast and accessible via a mobile device.

Learn more about managing accounts receivable risk by exploring these related resources on KnowledgeLeader:

Topic Spotlight: Accounts Receivable
Internal Audit and Risk Management: The Basics
Must-Have Tools for Accounts Receivable Risk Management