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How to Calculate Investment in Accounts Receivable (AR)?
What is Accounts Receivable?
Although many professionals do not know, accounts receivable is a part of working capital, and it is shown in the balance sheet in the current assets. As this is an investment, AR should be counted as a net realizable value. We get the net realizable value when the AR is adjusted for all costs and deductions from the gross AR itself. These deductions may include, but are not limited to sales discounts, uncollectible balances, allowances, and sales returns.
Accounts receivable is an outcome of operations, but many entrepreneurs lose money due to a lack of knowledge of the effect of AR on their businesses. In some cases, the business owners may lose money without knowing it when the AR of the business is mismanaged. Therefore, it is of optimum importance to know about AR while conducting a business, especially when the sales are made on credit.
Investment in Accounts Receivable
It is a common query as to how much amount of funds should be invested in AR. Firms often seek to learn what could be an optimal balance while considering the investments in accounts receivables. In fact, it is a trade-off between the opportunity to make maximum sales and the loss due to uncollectible. It is an analysis of costs and benefits where benefits should be more than the costs.
The benefits may include the potential increase in sales and a competitive piece advantage while the costs may include admin costs to manage outstanding payments, bad debts, write-offs, revenue loss due to restrictive credit policies, etc. Applying this policy requires consideration of different factors.
For example, the industry norm is an important external factor. A retailer which requires customers to pay for the products right at check-out will have zero AR while a manufacturer may have to wait for months to collect the prices.
The most used measurement of AR management is the following −
$$\mathrm{AR\: Turnover\: in\: days =\frac{Number\: of \:days}{receivables \:turnover}}$$
Where,
$$\mathrm{Receivables \:turnover =\frac{Net \:credit\: sales }{Average\: net\: receivables }}$$
The AR Turnover in days represents the average number of days required to collect the receivables. It is also known as Daily Sales Outstanding (DSO). On the other hand, the receivables turnover ratio represents the success of the firm in the collection of outstanding receivables.
Using the formulas given above, one should find the theoretical DSO and match it with the practice DSO of each month. It is better to decide a range for the calculation of DSOs rather than using them randomly. The best possible DSO can be found while forming the annual budget of the company. The process can also be reviewed using cost-benefit analysis as mentioned above. While processing ahead, the range can be adjusted if business requirements have to be addressed after completing the cost-benefit analysis.
Fixing the levels of each division, region, and customer segmentation can be handy in making monitoring and controlling the process more effective. This can be applied further down the hierarchy of the business model to get a dependable idea of investments in accounts receivables.
Having such results in hand can go a long way in minimizing losses arising due to mismanagement of accounts receivables.
Conclusion
The notable fact to observe is that the AR is not vetted as systematically as other capital investments. Start-ups and emerging businesses are the ones who fall mostly in this category. The financial managers must know that AR is a valuable part of businesses and it can offer large pay-offs.
The most important fact to consider while taking note of AR is that the right strategy for collecting AR is quantifiable but mishandling AR is often found to go without any notice.
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