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Chapter 2

REVIEW OF RELATED LITERATURE AND STUDIES

The review of the literature for this study focuses on how accounts

receivable managementconcentrating on the efficiency of collection. The chapter

begins with the different definition of accounts receivable management, followed

by the findings of researchers. The research outcome will show how accounts

receivable management impacts the operation of the company.

Foreign Literature

Accounts Receivables are amount owed to the business enterprise,

usually by its customers. Sometimes it is broken down into trade accounts

receivables; the former refers to the amounts owed by customers, and the latter

refers to amount owed by employees and others (Robert N. Anthony, 2006). It

also can be classified as short-term receivables which are receivables that

converted into cash within a year or the operating cycle and long-term

receivables which are receivables cannot be converted into cash quickly; instead

cash will be received at some date in the future or over a period of time. If the

company has receivables, this means it has made a sale but has yet to collect

the money from the purchaser, most companies operate by allowing some

portion of theirs sales to be on credit. Accounts receivable are not limited to

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businesses individuals have them as well

(http://www.investopedia.com/terms/a/accountsreceivable.asp, Retrieved August

20, 2013). Accounts receivable are integral part of doing business in a modern

economy. Sales may be increased by allowing customers to pay at a later date

since some customers may be unable to pay for their purchases immediately.

Accounts Receivable Management is a suite of integrated business

applications that extend a companys accounts receivable and accounting

system to facilitate credit management, billing and invoicing, remittance

processing, dispute management, and collection process (Anytime Collect,

2008). Management of the receivables begins when all of the antecedent

functions are completed and a receivable is posted to the detailed accounts

receivable ledger. The receivables begin aging immediately, increasing the cost

of financing them and increasing the risk of nonpayment. Management of this

asset involves safeguarding the asset and accelerating cash inflow (John Salek,

2005).The objective of managing accounts receivable is to collect accounts

receivable as quick as possible without losing sales from high-pressure collection

techniques. Accomplishing this goal encompasses three topics: 1.) credit

selection and standards, 2.) credit terms, and 3.) credit monitoring (Lawrence

Gitman, 2012).

A common goal of accounts receivable management is to ensure debts

are collected within specified credit terms (Pike and Cheng, 2003). Another

common goal is the identification of delinquent accounts to reduce the total trade

credit which is written off as bad (Jackling et al., 2003, p. 384; Peacock et al.,
 16

2003). These two goals normally go hand-in-hand, as early identification of

delinquent customers reduces the size and age of accounts receivable and

reduces the probability of accounts defaulting (Peacock et al., 2003). Accounts

receivable efficiency measures indicate the performance of accounts receivable

processes and the success of policies applied.

In connection on our study about accounts receivable management, we

also considered the effect of credit policies. Glen Bullivant stated that granting

trade credit is a powerful selling aid, and is a fundamental foundation upon which

trading relationships are built. Both seller and buyer gain advantage from credit

facilities, but the risk of slow or non-payment is borne by the seller risk in the

form of non-payment, and cost in the form of interest expense incurred from the

date of the sale to receipt of funds. The demand for trade credit requires: 1.) a

sound operating procedure to cope with continuous sales volumes; 2.) capital

fund the waiting time with a worthwhile return of the investment; and 3.)

regulation and enforcement, informally or by law, of credit agreements. In effect,

this means having credit policy.

A credit policy is necessary to show the companys intended way of doing

business and avoids confusion and potential misunderstanding. The need for

company policies in respect of health and safety, smoking, employment etc., are

well founded and accepted as both normal and necessary, and this should apply

equally to the credit operation (Glen Bullivant, 2010). A credit policy should start

at the highest level, be agreed at all levels, and be inclusive of all those areas of

the business operation which leads to satisfying customer requirements. All

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companies extending and managing trade credit should establish a credit policy

which provides the framework for making consistent and well informed credit and

collection decisions which are compatible with the companys strategic objectives

and the goals of the credit functions. The credit policy is a document that

specifies the course of action for granting credit and recurring credit activities.

The credit policy has to be understood by, and communicated to, all relevant

parties, particularly credit staff, sales staff,and customers.

In measuring the efficiency of accounts receivables, it involves using

financial ratios, such as days sales outstanding and aging schedule. Days Sales

Outstanding (DSO) expresses the (aggregate) average time, in days, that

receivables are outstanding. It helps determine if a change in receivables is due

to change in sales, or to another factor such as change in selling terms, can be

computed by using the formula: ending total receivables multiplied by days in

period analyzed, divided by credit sales for period analyzed (Eugene F. Brigham,

2009). Aging schedule is a popular receivable tool and is widely referred to in the

normative literature (Arnold, 2005; Peacock et al., 2003). It comprises a

classification of outstanding balances according to the period of time they have

been outstanding. These are categories can be calibrated according to months,

weeks, or days, depending on the organizations requirements, and are

frequently expressed as a percentage relative to the total accounts receivable

balance. If debts are collected on time, most debts should be younger, and few

should be older. It is assumed that increased efficiency would reduce percentage

of debt in the older categories.

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Credit monitoring is an ongoing review of the firms accounts receivable to

determine whether customers are paying according to the stated credit terms (L.

Gitman, 2012). When the customers are not paying in a timely manner, credit

monitoring will alert the firm to the problem. Slow payments are costly to a firm

because they lengthen the average collection period and thus increase the firms

investment in accounts receivable (L. Gitman, 2012).

Days Sales Outstanding (DSO) is a measure of the average number of

days a company takes to collect revenue after a sale has been made in other

words, the average collection period. A low DSO means that it takes a company

fewer days to collect its accounts receivable. A high DSO shows that a company

is selling its product or service to customers or clients on credit and taking longer

to collect related revenues. As cash drives so much of a business operations

and opportunities, best practices dictate that a company collects outstanding

receivables as rapidly as possible. By quickly converting sales into cash, the

business can put the cash to use again ideally, to reinvest and generate sales

(Sensiba San Filippo, 2010).

In line with the life cycle of a receivable, collection is one of the integral

parts of it. Bill Kuhn, 2006 stated the important steps to consider in collecting

receivables: 1.) Collection starts with timely billing; 2.) Determine the health of

your receivables by preparing a monthly aged trial balance identifying the

accounts and their status; 3.) Observe trend in the age of the receivables and re-

examine all accounts that are consistently past due; 4.) Establish a collection

program to ensure that regular, persistent follow-up begins soon after maturity; 5.
 19

Assign responsibility and authority, and keep sales people informed, notifying

them when no further orders will be accepted.

A good way to improve collection is to make the entire company away of

the importance of accounts receivable, and to make collections a top priority.

Invoice statements for each outstanding account should be reviewed on a regular

basis, and a weekly schedule of collections goals should be established. Tips in

the realm of accounts receivable collection include: 1.) Get credit references for

new clients, and check them out thoroughly before agreeing to extend the client

credit; 2.) Do not delay in making follow-up calls, especially with clients who have

a history of paying late; 3.) Curb late payment excuses by including a prepaid

payment envelope with each invoice; 4.) Know when to let go of a bad account;

5.) Collection agencies should only be used as a last resort

(http://www.inc.com/encyclopedia/accounts-receivable.html, retrieved September

16, 2013)

Local Literature

Receivables are financial assets because they represent a contractual

right to receive cash or another financial asset from another entity (Valix et al.,

2012). Receivables, in the broadest sense, represent any legitimate claims from

others for money, goods or services. In its narrower sense and as contemplated

in accounting, receivables represents claims that are expected to be settled by

the receipt of cash (P. Empleo and N. Robles, 2012).

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Accounts Receivables are open accounts or those not supported by

promissory notes (Valix et al., 2012). Receivables include the following: 1.)

Amounts collectible from customers and others, most frequently arising from

sales of merchandise, claims for money lent, or the performance of services.

They may be on open accounts or evidenced by time drafts or promissory note;

2.) Accrued revenue, such as accrued interest, commissions, rental and others;

3.) other items such as loans and advances to officers, employees, affiliated

companies, customers or other outside parties; legitimate claims against

suppliers and insurance companies; and other claims arising from nonrecurring

transactions such as calls for subscriptions receivables and disposal of property

(P. Empleo and N. Robles, 2012).

Receivables are classified as trade receivables and non-trade receivables.

Trade receivables are receivables arising from sale of goods or services in the

normal course of business. Non-trade receivables are receivables that arise from

sources other than from sale ofgoods or services in the normal course of

business.

The discriminating nature of competition has made it an established

practice to offer credit terms to customers. Once credit sales are made, inventory

is already withdrawn from the warehouse and still no cash is available for

deposit. All you have is a right to collect money from customers. And the

precious right is based on a promise that you will be paid in the future. Ergo, the

whole point of selling your merchandise on credit is based on your trust to

customers (F. Agamata, 2012).

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Accounts Receivable Management refers to formulation and

administration of plans and policies related to sales on account and ensuring the

maintenance of receivables at a predetermined level and their collectability as

planned. The objective of this system is to have both the optimal amount of

receivables outstanding and the optimal amount of bad debts. This balance

requires the trade-off between: 1.) The benefit of more credit sales, and; 2.) The

cost of accounts receivable such as collection, interest, and bad debts cost (R.

Roque, 2011).

Salvador et al., (2012) stated that Accounts Receivable management

directly impacts the profitability of the firm. It includes determining discount policy

and credit policy for marginal customers, investigating ways of speeding up

collections and reducing bad debts, and setting terms of sale to assure ultimate

collection. As part of accounts receivable management, the company should

appraise order entry, billing, and accounts receivable activities to be sure that

proper procedures are being followed from the time an order is received until

ultimate collection.

There are several factors in determining credit policies. R. Roque, (2011)

gave the following factors such as: 1.) Credit standards, which are the criteria

that determine which customers, will be granted credit and how much. The credit

standard should not be too stringent or too tight which may eliminate the risk of

non-payment, but also eliminate potential sales to rejected customers; neither

should the standards to be loose or liberal, which may lead to higher sales but

also higher bad debts losses and collection cost. Such factors in establishing
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these standards are character, capacity, capital, conditions; 2.) Credit terms,

defines the credit period and any discount for early payment.

Foreign Study

Trade credit is considered as an essential marketing tool, acting as a

bridge for the movement of good through production and distribution stages of

customers.

A company grants trade credit to protect its sales from the competitors

and to attract the potential customers to buy its products at favorable and

competitive terms. When the company sells its products or services and does not

receive cash for it immediately, the company is said to have granted trade credit

to customer.

Trade credit means receivable or book debts which company is expected

to collect in the near future. The book debts or receivables arising out of credit

have three characteristics, first it involves an element of risk which should be

carefully analyzed. Cash sales are totally risk free, but not the credit sales as the

cash payments is yet to be received. Secondly it is based on economic value of

the goods or services which passes immediately at the time of sale, while the

seller expects an equivalent value to the received later on. Thirdly, it implies

futurity (J. Elangovan, April 2005).

Receivables management is a complex activity that is part art, part

science. Yet, the majority of A/R departments face significant human, process,

and technology barriers to becoming a best in class operation. The typical A/R
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department resource is mired at the transaction level, unable to move to more

strategic activities. This quagmire is caused first and foremost by the tremendous

percentage of paper-based invoices and payments which require significantly

more effort, time, and cost to send, manage, and clear. (Aberdeen Group, 2007)

Aberdeen (2007) research has shown that Electronic invoices cost

between 68% - 76% less to process. Another significant challenge facing a

majority of A/R organizations is the existence of numerous and disparate

financial systems to manage orders, billing, collections, and cash flow

management. The benefits of efficient A/R management includes: 1) Superior

cash flow management; 2) Better cash flow visibility; 3) Greater profitability; 4)

Lower credit risk and; 5) Improved customer relationships.

A study of M. Gofman, (2012) found out that average accounts receivable

constitute 16.5% of total revenues and 15.5% of total assets. The level of

accounts receivables is comparable to the level of total bank debt (15.7% of total

assets). Accounts payable for the firms constitute 10.9% of total assets.

Therefore, the levels of trade credit are significant comparing to other sources of

finance. The average firm has a large exposure to its customers and an average

60 days of credit. This is a suggestive evidence that trade credit is not just a loan

for a period required to deliver a good from a seller to a buyer.

In a model without bank loans, Bougheas et al.(2009) showed that, for a

given liquidity, an increase in production will require an increase in trade credit. A

higher production is associated with a higher production cost, which for a given

(insufficient) amount of liquidity, implies that firm will need to take more trade
 24

credit. So trade credit works as an alternative mean to finance production. Also

Cuat (2007) argues that fast growing firms may finance themselves with trade

credit when other types of finance are not sufficiently available.

In the study of Fernando et al. in (2012) concluded that the use of trade

credit of a firm is a twofold process in which a firm can receive trade credit from

its suppliers (accounts payable) and, in turn, can extend trade credit to its

customers (accounts receivable). That shows, it is not just the accounts payable

or just accounts receivable that matter, but the sum of the two, which work as a

credit channel of trade.

Firms taking credit from their suppliers can simultaneously offer trade

credit to their customers. In fact, there are firms have higher amounts of accounts

receivable than accounts payable. Firms use trade receivables as a tool form

implicit price discrimination across suppliers, in cases where it is not possible, for

instance on account of legal restrictions, to discriminate directly on the bases of

prices (Meltzer, 2003). In such cases, firms with a stronger market position my

choose to make greater recourse to accounts receivable, selling to customers on

credit with a view to enhancing their competitive position in the market.

Accounts receivable are proven to be a useful tool when there is a

considerable uncertainty about the quality of a firms product among potential

customers. The firm can increase its sales by allowing delayed payments, such

that the customer can witness the quality before paying. Also, firms provide more

trade credit to customers that are in temporary distress. This also enhances their

sales, since otherwise the distressed customer would not be able to buy the
 25

goods. Firms will however only offer additional trade credit when they believe

there is a future surplus of having a long-lasting relation with that customer

(Cuat, 2007).

Trade credit is the largest use of capital for a majority of business to

business (B2B) sellers in the United States and is a critical source of capital for a

majority of all businesses. For many borrowers in the developing world, trade

credit serves as a valuable source of alternative data for personal and small

business loans. The 1993 National Survey of Small Business Finance (NSSBF)

indicated that ethnic differences in the use of trade credit are present, especially

for Black-owned businesses, which research shows use less trade credit, are

less likely to take advantage of discounts for early payment, and are more likely

to have payments past due. There are many forms of trade credit in common

use. Various industries use various specialized forms. They all have, in common,

the collaboration of businesses to make efficient use of capital to accomplish

various business objectives. (Federal Reserve Bank of Chicago, Supplier

Relationships and Small Business Use of Trade Credit, December 2004).

In the study of the Federal Trade Commission in (2009), the credit

collection process commences when a company issuing credit to a consumer

(e.g., a credit card issuer of Telecommunications Company) determines that the

account is delinquent and that the consumer must be contacted about the deb. In

an effort to obtain payment, many credit issuers have their own collection

departments contact delinquent consumers via telephone calls, collection letters,

and other communication methods.

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Local Study

Accounts Receivable includes money due from customers. They are

substantiated by invoices and arise as a result of the operating cycles process of

selling products or services on terms that allow delivery prior to the collection of

cash. Normal transactions would be product is sold and shipped, an invoice is

sent to the customer, and later cash is collected. The seller allows delivery of

goods or services to a customer prior to receiving cash payment. The receivable

exists for the time period between the selling of the product of service and finally

the receipt of cash.

Purpose of receivables is directly connected with the objectives of making

credit sales. The overall objective of committing funds to accounts receivable is

to generate a large flow of operating revenue and hence profit than what would

be achieved in the absence of no such commitment. Control of receivable is a

key element in macroeconomic and budget but it must be complemented by an

adequate system for managing commitment (Alvarez, 2004).

In the study of Parnada et al. (2011) states that management of accounts

is a process of making decision relating to the investment of funds in this asset

which will result in maximizing overall return on the investment of the firm. Thus,

the objective of receivable management is to promote sales and profits until that

point is reached where the return on investment in further funding of receivables

is less than the cost of funds raised to finance the additional credit. As the prime

role of receivable management is to manage effectively and provide clear

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fundamental guidelines, thus, the company needs to ensure both efficient

implementation of their budgets and good management of their financial

resources.

In the Study of Torres-del Valle, 2012 stated that accounts receivable

management is not simply a collection function; it is an integral part of working

capital management that is linked to a companys entire business process,

including invoicing, collection, credit, operations, accounting, and treasury, and

supply-chain management. Most often, additional benefits in the context of

improved cash flow and cost savings may be attained from modifying the

accounts receivable process. For instance, a company could opt to redesign its

invoicing pattern and customer credit arrangement to shorten the accounts

receivable cycle. Alternatively, the company could work with its bank to structure

a more efficient collection solution and implement an integrated account

management system to facilitate more effective cash flow management. In

addition, outsourcing of non-core accounts receivable management activites,

such as reconciliation and information capturing would create additional value

through cost reduction and increased efficiency.

Managing the turnover of accounts receivable is an integral part of

working capital management. Accounts receivable is one of the core elements of

current assets and is directly linked to a companys cash flow, inventory, credit

risk, and liquidity positions. Given its importance, companies are constantly

seeking ways to enhance effectiveness in receivables management and, most

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often, attention is focused on expediting fund availability though shortening the

collection and clearing cycles (Torres-del Valle, 2008).

The collection process is an important component of receivable

management, but it can only represent a subset of its underlying value (Torres-

del Valle, 2008). Essentially, receivables management may impact on every part

of a companys business process and, if applied effectively, can offer vast

opportunities for a company to revamp its operational arrangements and

business strategy to gain a competitive advantage.

Proper management of accounts receivable coordinated with appropriate

implementation of company policies may improve cash flow and promote cost

efficiency of the company, which may eventually result to better financial position.

Accounts Receivables and Claims Management policies of the SOM

Division of XYZ marketing were in place and were found to be generally

adequate to ensure protection o companys resources by mitigating risks caused

by aging and uncollected accounts receivables. Though there were many strong

points on the existing ARCM policies, there is still a necessity to review the

current policies. Enhancement of the existing policies to better protect the

companys resources is indispensible, more importantly; the commitment of the

whole team in resolving the problem is essential (Torres-del Valle, 2008).

An Improper management of cash flow components such as, accounts

receivables, accounts payables, and inventory will result in difficulties in the firms

continued operations. Cash flow problems can cause operational problems,

which will ultimately results in real costs to business. These cost can be direct
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cash costs such as bad debt losses caused by failing to follow up on overdue

receivables, storage and carrying costs of excess inventory, operating and

insurance costs associated with excess fixed assets, and interest cost on

borrowings necessitated by the cash flow problems (Aguilar, 2012). But

sometimes it is not the company that causes the inefficiency of collection; it may

also due to the customers pay their amount dues (Li, 2011).

A key requirement for effective sales and accounts receivables

management is the ability to intelligently and efficiently manage the entire credit

and collection process. Greater insight into a customers financial strength, credit

history, and trends in payment patterns is paramount in reducing the exposure to

bad debt.

Synthesis of the Reviewed Literature and Studies

The literature and studies, cited in this chapter, provided relevant insights

and gave a clear direction to the conduct of the study. The researchers were

convinced that the related literatures and studies, both local and foreign which

were chosen and assessed are vital in the conduct of this research.

The researchers had come to identify the similarity of our study to a

graduate thesis entitled Cash and Receivable Management of Selected

Branches of Rizal Commercial Banking Corporation, by Parnada, et al (2011),

cited in the local study, where the author tackled the purpose of receivable

management, as well as its objective. It signifies that there is a relationship on

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the efficiency of the collection of receivables and with a proper receivable

management.

Related literatures written continue to emphasize the impacts of receivable

in a company, its positive and negative effects, and how the efficiency of

collections of these receivable can help the company maximize the return and

minimize the cost of handling these receivables which found by the researchers

relevant to the current study being conducted.

The review materials which include foreign and local books and theses

support the notion presented in this study. Information obtained from these

related literatures and readings stimulated the researchers to conduct and

pursue the study as they sought to confirm the efficiency of collection of the

receivables of the company.