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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

15 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

17 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.

18 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 reexamine 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).

20 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).

21 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

22 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

23 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

27 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

28 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 (Torresdel 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

29 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

30 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.

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