How to Manage Risks Related to Accounts Receivable

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 trade credit insurance : Another effective accounts receivable risk management strategy is trade credit insurance. Trade credit insurance covers your business-to-business accounts receivable and can pay out a percentage of outstanding debt when that debt becoming  unpaid invoices.

When measuring your accounts receivable risk and performance, here are specific metrics 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.