Collections, aging and credit risk

Selling on credit turns a customer into a borrower. Some will pay late, a few will not pay. Lesson 5.1 shows the cost of waiting. This lesson deals with the cost of not being paid.

The aged receivables report

An aging report sorts every unpaid invoice by how long it has been outstanding, usually into buckets: current, 1 to 30 days past due, 31 to 60, 61 to 90, and over 90. It is the first report to read in a collections review because the probability of collecting falls as an invoice ages.

Two numbers come from it. The share of the balance that is past due shows how well terms are kept. The share past 60 days shows how much of the balance is at real risk.

Estimating the allowance

The accounts show receivables at the amount expected to be collected. The allowance for doubtful accounts is the deduction for those that will not be. A simple way to set it is a provision matrix: apply a loss rate to each bucket and add up.

The rates come from the business's own history: of the invoices that reached the 61 to 90 bucket in the past, what share eventually went unpaid? IFRS 9 allows a business to use a provision matrix like this for trade receivables when measuring expected credit losses. Aging-based estimates are used under other frameworks as well. The loss rates in the case are assumptions, and a real matrix needs the business's own figures.

Writing off an invoice and setting an allowance are different. The allowance estimates the loss in advance, the write-off removes a specific invoice once it is deemed uncollectible. The tax treatment of bad debts differs from the accounting treatment in many places, so check the local rules.

A measure of collection quality

DSO from lesson 5.1 mixes two things: how long customers are given and how late they are. Best-possible DSO separates them.

Best-possible DSO = Current receivables ÷ Revenue × 365

The difference between actual DSO and best-possible DSO is the days lost to overdue invoices.

The break-even test for selling on credit

Before offering terms to a new customer, compare the profit if they pay with the loss if they do not. Suppose an order has a selling price P and a cost of C. If the customer pays, the business gains P − C. If the customer never pays, it loses C, the cost of the goods. The break-even probability of payment p solves

p × P = C, so p = C ÷ P

The cost ratio is the break-even. A business with a cost of 66.7 cents per dollar of sales needs to be paid by 66.7% of such customers just to cover the cost. The thinner the margin, the more reliable a customer has to be.

Controls reduce the risk before the sale and speed up the collection after it.

• Before: check the customer's references and payment record, set a credit limit, ask for a deposit on large or first orders.
• After: send invoices promptly, state terms clearly, call before the due date, and follow up on a fixed schedule, such as day 1, day 15 and day 30 past due.