The size of accounts receivable is determined by a number of factors. Some of the important factors are as follows:
1. Level of Sales
This is the most important factor in determining the size of accounts receivable. Generally in the same industry, a firm having a large volume of sales will be having a larger level of receivables as compared to a firm with a small volume of sales.
Sales level can also be used for forecasting change in accounts receivable. For example, if a firm predicts that there will be an increase of 20% in its credit sales for the next period, it can be expected that there will also be a 20% increase in the level of receivables.
2. Credit Policies
The term credit policy refers to those decision variables that influence the amount of trade credit, i.e., the investment in receivables. These variables include the quantity of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to be given and any special terms to be offered depending upon particular circumstances of the firm and the customer. A firm’s credit policy, as a matter of fact, determines the amount of risk the firm is willing to undertake in its sales activities. If a firm has a lenient or a relatively liberal credit policy, it will experience a higher level of receivables as compared to a firm with a more rigid or stringent credit policy. This is because of the two reasons:
- A lenient credit policy encourages even the financially strong customers to make delays in payment resulting in increasing the size of the accounts receivables.
- Lenient credit policy will result in greater defaults in payments by financially weak customers thus resulting in increasing the size of receivables.
3. Terms of Trade
The size of the receivables is also affected by terms of trade (or credit terms) offered by the firm. The two important components of the credit terms are Credit period and Cash discount.
4. Credit Period
The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of “Net days”. For example, if a firm’s credit terms are “Net 15”, it means the customers are expected to pay within 15 days from the date of credit sale.
5. Cash Discount
Most firms offer cash discount to their customers for encouraging them to pay their dues before the expiry of the credit period. The terms of cash discount indicate the rate of discount as well as the period for which the discount has been offered. For example, if the terms of cash discount are changed from “Net 30” to “2/10 Net 30”, it means the credit period is of 30 days but in case customer pays in 10 days, he would get 2% discount on the amount due by him. Of course, allowing cash discount results in a loss to the firm because of recovery of less amount than what is due from the customer but it reduces the volume of receivables and puts extra funds at the disposal of the firm for alternative profitable investment. The amount of loss thus suffered is, therefore, compensated by the income otherwise earned by the firm.