Receivables practices in American corporations.
This article is adapted from a paper about the results of a survey of the receivables practices in American corporations. The purpose of the survey was to obtain information on whether firms are maximizing the value of their shareholders' wealth in the area of receivables.
A basic tenet of corporate finance theory and practice is that firms will engage in behaviors and activities that maximize the value of shareholder wealth. Professors and authors Ned Hill and William Sartoris have translated this into an objective to maximize the net present value of operating cash inflows less operating cash outflows. They note that in trying to do this managers will:
* Speed cash inflows
* Reduce administrative costs connected with cash flows
* Maximize the value of information provided to management while recognizing the tradeoffs in these activities.
The question addressed by this survey is whether firms are in fact attempting to achieve and/or maximize this objective.
While none of the previous surveys have the scope of our survey, some of their results are relevant. (References are given at the end of this article.) Most of the respondents to a survey of the Fortune 1000 used more than one method for credit granting, thus increasing the administrative costs associated with this decision. They also used more than one method to monitor their customers' payment behaviors, which also tend to increase administrative costs. A study of credit limits showed that most firms used both judgment and ratio analysis to determine on whom to impose credit limits. Another study found that nearly 60 percent of the respondents to their survey establish credit limits for virtually all of their customers. Again, this will increase administrative costs.
Regarding speeding cash inflows, a 1984 survey reported that although many firms used the postmark date as the date of payment, this was changing. In that survey, more than 40 percent of the respondents accepted the date the check was received at the firm's lockbox as the payment date, while only 27.4 percent accepted the postmark date. Using the date the check is received as the payment date requires customers to mail their payments earlier than using the postmark date would. Consequently, one may conclude that firms are attempting to speed their collections, thus maximizing their cash inflows.
In terms of maximizing the value of information provided to management, a 1994 survey reported that the vast majority of firms used more than one method to report the status of their receivables to management, thus tending to increase the value of information provided to management, but again boosting administrative costs. In summary, the evidence regarding the maximization objective in the working capital arena is mixed.
In early 1997, I conducted a mail survey of 200 randomly selected credit managers of American firms listed in the 1996 Business Week Global 1000. The sample represents 50.5 percent of the American firms listed. The survey focused on three areas of receivables management: presale issues, postsale issues and ongoing issues.
Eighty-nine usable responses were received. The majority of the respondents were managers from seven industries, the largest of which were consumer goods and technology. In comparison with nonrespondents, the survey respondents had lower market value, sales, profits and assets, and higher return on equity.
Exhibit 1 provides additional information about how receivables are handled in the companies that responded. The exhibit shows that a majority of the companies (55 percent) did not have any of their receivables processes automated. It also indicates that 45.9 percent had up to 20 percent of their receivables overdue. It also shows that almost 90 percent of the firms do not outsource any of the receivables process, and virtually all of the firms responding neither factor nor pledge their receivables.
Exhibit 1. Descriptive Information % of Receivables Automated % Automated % of Respondents 0 55.1 1-20 6.7 21-40 0.0 41-60 1.1 61-80 2.2 81-100 34.8 % of Overdue Receivables 0 30.3 1-20 45.9 21-40 14.4 41-60 4.4 61-80 1.1 81-100 3.3 Other Information % of Respondents Who Do Not Outsource Outsource Any Receivables - 89.9 Factor Any Receivables - 98.9 Pledge Any Receivables - 97.8
Credit managers were asked about the methods they used in deciding how to grant credit. They were asked if they used any or all of such methods as the Five Cs of credit, credit scoring, financial statement analysis or if they used another method to decide to whom to grant credit. In fact, ratio analysis is the most popular method, as 78.9 percent of the respondents indicated that they used ratio analysis (at least) in granting credit. Other results are shown in Exhibit 2. The majority of the respondents (54.9 percent), used more than one method, mostly ratio analysis and credit scoring. Somewhat fewer (40.4 percent) of the respondents used only one method, mostly ratio analysis.
These results are similar to a 1989 study, in which the vast majority of the respondents (88.9 percent) ranked other methods as most important in their credit granting process. Given the current results, one could posit that these other methods include ratio analysis.
It is interesting that the majority of the respondents (54.9 percent) used more than one method for granting credit. One explanation is that firms know that the risk of late payments or default on receivables is partly a function of the customer to whom credit is granted. Accordingly, they may be using more than one method to ensure that their decision to grant or not to grant credit is correct. However, statistical analysis showed that although firms are increasing their administrative costs by using more than one method to determine to whom to grant credit, this is not having an impact on whether they have past due receivables. In this area, therefore, the respondents do not appear to be maximizing the net present value of their cash flows because they are increasing cash outflows to pay the larger administrative costs.
Sources of Information
The survey asked credit managers whether they obtain the information used in their credit investigations from the applicant, Dun & Bradstreet, Compustat or an on-line service. As shown in Exhibit 2, the majority of the respondents obtained their information from more than one source, mostly the firm applying for credit and Dun & Bradstreet. In fact, 78.9 percent of the respondents get information from Dun & Bradstreet. The fact that the majority of the respondents obtain information from more than one source may be a function of the increasing availability of information or a wish to ensure that the data they analyze are complete, thus assuring that their credit granting decisions are correct. In this case, as in the previous one, statistical analysis showed that the respondents appear to be increasing their administrative costs (by obtaining information from more than one source) but are not decreasing their risk of late payments, and, consequently, are not maximizing the objective function.
Respondents were asked whether they manage their credit investigation costs by making the scope of the investigation dependent on the size of the potential sale, by doing the same credit investigation for all customers, or by using the sequential method, cost-benefit analysis or another method. The majority (see Exhibit 2) said the scope of the investigation was dependent on the size of the sale. This indicates that firms understand the cost of investigating potential customers and attempt to manage these costs. Such behavior decreases the administrative costs associated with receivables, and maximizes the net present value of the firm's cash flows.
Decreasing Risk of Nonpayment
I also investigated the use of techniques to decrease the risk of nonpayment. Credit managers were asked whether they establish a credit limit or cutoff point for each customer, obtain credit insurance, or use another technique. The survey results indicated that a majority of the respondents used credit limits solely or in combination with another method. Again referring to Exhibit 2, we can see that almost half of the respondents use only credit limits to decrease the risk of nonpayment. In fact, only 39 percent of the respondents set credit limits for all their customers. This is similar to the results of a 1985 study, where 43 percent of the respondents set credit limits for all their customers and that 80 percent set limits for a majority of their customers. It is also similar to a 1991 survey that reported 58 percent of its respondents set credit limits for 91 to 100 percent of their customers.
Because the majority of the respondents set credit limits for their customers, the question of the impact of such limits on the existence of past due accounts arises. Here statistical analysis showed that, although administrative costs are increased as a result of having to monitor the credit limits, this has a positive impact on the existence of overdue receivables.
Regarding maximizing shareholders' wealth in the presale portion of the receivables process, the results of survey are mixed. Firms do not appear to be maximizing the objective function when determining whom to grant credit and the sources of information used in the credit investigation, but they are when managing the costs of the investigations and setting credit limits. Accordingly, firms should be studying the credit granting process and the sources of information to ascertain whether they can create greater efficiencies.
This section addresses payment due dates, methods of speeding collections, and procedures used to deal with late payments.
Payment Due Date
The survey asked whether the respondents consider a payment on time based on its due date or postmark date. There has been a great deal of debate on the issue of when a payment is due. For instance, Keller, in his article on best practices, reported that Procter & Gamble is now requiring payments to be in the lockbox by the due date. Johnson, in his article, concluded, "The use of the postmark date in deciding when a bill is paid is another current trade practice of corporate management that seems to be an anomaly in the age of instant satellite communications." In this survey, a solid majority (78.7 percent) of the respondents considers a payment on time based on its due date. This is similar to the results of Hill et al., who found that fewer companies were using the postmark date. Using the due date means that firms are requiring their customers to mail payments earlier than they would if the firms used the postmark date. This in turn means that firms are receiving their payments more quickly, and thus are maximizing the net present value of their cash inflows. However, a few respondents said they use both dates, which is difficult to explain, so these results arc suspect. One possibility is that the respondents who said both meant either but did not have that option in the survey.
Methods of Collection
The respondents were asked whether they use concentration banking, lockboxes, direct sends, electronic funds transfer (EFT) or another method to speed their collections. Most of the respondents (75 percent) use more than one method, generally lockboxes and EFT. The results suggest a desire to decrease the float, even in times of decreased costs due to lower interest rates. Of course, the desire to decrease the float may also depend on the risk associated with funds in transit. Regardless, most of the respondents do attempt to speed their collections, which supports the goal of maximizing shareholder wealth because it maximizes the present value of the firm's cash inflows.
When asked which method was effective in collecting receivables, letters, phone calls, collection agencies or other methods, most respondents indicated that they used more than one. Not surprisingly, letters and phone calls were the most commonly used methods.
Regarding maximizing shareholders' wealth in the postsale area, firms do appear to be maximizing the present value of their cash flows. firms are speeding their collections both in their determination of the payment due date and in their methods of accelerating collections.
This section addresses forecasting and monitoring receivables, and reporting the receivables position to management.
The survey asked the respondents what type(s) of forecasting techniques they used - the percent of sales method, the receivables balance fraction method, linear regression, an internally developed model, commercial software or another method - to forecast their receivables. A majority of the firms (nearly 60 percent) reported that they used the percent of sales method or an internally developed model to forecast their receivables. This is similar to a recent survey in which 59.4 percent of the respondents reported using receivables models. Other data are shown in Exhibit 3.
It is interesting that more than 70 percent of the respondents use only one method to forecast their receivables. One may posit that the receivables models used by the respondents are satisfactory because for the majority, no effort is made to use more than one model. This results in lower administrative costs, thus reducing cash outflows.
Respondents were asked whether they use aging schedules, bad debt percentages, exception reports, ratio analysis, trends analysis or another measure to monitor their receivables.
Nearly all (97 percent) of the respondents use at least an aging schedule to review their receivables. In fact, 23.6 percent of the respondents use an aging schedule alone (see Exhibit 3). Interestingly, only two of the respondents say they use Days Sales Outstanding (DSO) to evaluate their receivables. The most important outcome however, is not how firms monitor their receivables, but the fact that they do monitor them. This shows an understanding of the large investment most firms have in receivables and the risk associated with that investment.
Interestingly, only 30.3 percent of the respondents use just one method to monitor their receivables. Possible explanations for this outcome include the monitoring methods being unreliable or the respondents being aware of the importance of monitoring their firms' investments in receivables due the size and riskiness of the investments. The use of so many methods, though, will increase administrative costs. In this regard, statistical analysis showed that using one or more methods to monitor receivables has an impact on the existence of past due accounts. One explanation is that firms concerned with monitoring their receivables invest more resources to assure faster customer payment practices.
Reporting to Management
Managers were asked what information they used to report their receivables positions to management: DSO, aging schedules, bad debt percentages, exception reports, ratio analysis, trends analysis, or another measure. The majority (72.5 percent) of the respondents use between two and four methods, including DSO, aging schedules, bad debt percentages and exception reports. The results in the current survey are similar in one area and differ in another from those reported in Business Credit three years ago. At that time, 20.5 percent of the respondents used only one method to report the receivables position to management; the percentage in the current survey is 22.4 percent. However, the two primary criteria for reporting the receivables position to management were aging schedules and exception reports. Today they are aging schedules and DSO. The different outcome may be explained by the small sample size of the earlier survey.
Once again, statistical analysis shows that there is a statistically significant relationship between the number of methods used to report receivables to management (one or more) and the existence of past due accounts. One explanation is that managers who are concerned enough to require more than one reporting method tend to emphasize the importance of ensuring that customers pay on time.
Regarding forecasting and monitoring receivables, and reporting the receivables position to management, it appears that the respondents are maximizing the objective function because in forecasting. Administrative costs are lower due to the use of only one method, and in monitoring and reporting, there is a statistically significant relationship between the number of methods used (one or more) and the existence of past due accounts.
Several conclusions can be drawn from the results of the survey. First, in the presale area, firms may want to examine their credit granting processes and the sources used in those processes to determine whether they can create greater efficiencies. Second, firms appear to maximizing the value of their shareholders' wealth in the postsale and ongoing areas. Thus, in general, the respondents appear to be maximizing the net present value of their cash flows in most of the receivables process. Specifically, the objective appears to be maximized in the areas of managing credit investigation costs, setting credit limits, choosing payment due dates, speeding collections, forecasting and monitoring receivables, and reporting the receivables position to management.
Exhibit 2. Presale Issues
In determining whether to grant credit, we use:
Five Cs - 2.2% Credit Scoring - 4.5 Ratio Analysis - 22.5 Other - 11.2 More than one method - 54.9 No answer - 4.5
We get the information used in our credit investigations from:
Firm applying for credit - 2.2% Dun and Bradstreet - 18.0 Compustat - 0.0 On-line service - 2.2 Other - 2.2 More than one source - 69.5 No answer - 5.6
We manage our investigation costs by:
Making the scope of the investigation dependent on the size of the potential sale - 57.3%
Doing the same credit investigation for all customers - 13.5
Using the Sequential Method - 1.1
Using Cost-Benefit Analysis - 5.6
Other - 3.4
Two methods - 10.1
No answer - 9.0
We decrease our risk of nonpayment by:
Establishing a credit limit for each customer - 48.3% Establishing a cutoff point for each customer - 5.6 Obtaining credit insurance - 0.0 Other - 11.2 More than one method - 29.0 No answer - 5.6
Percent of customers for whom the firm sets credit limits:
0 - 30.3% 1-40 - 10.0 41-80 - 11.1 81-100 - 48.2
Exhibit 3. Ongoing Issues
We forecast our receivables by using:
Percent of Sales - 34.8 Receivables Balance Fraction - 3.4 Linear Regression - 1.1 Internally Developed Model - 23.6 Commercial Software - 1.1 Other - 6.7 More than one method - 12.2 No Answer - 16.9
We monitor our receivables with:
Aging Schedule - 23.6 Bad Debt Percent - 1.1 Exception Reports - 4.5 Ratio Analysis - 0.0 Trends Analysis - 0.0 Other - 1.1 More than one method - 69.2 No Answer - 1.1
In reporting our receivables position to management, we use:
Days Sales Outstanding - 10.1 Aging Schedule - 11.2 Bad Debt Percent - 1.1 Exception Reports - 1.1 Ratio Analysis - 0.0 Trends Analysis - 0.0 Other - 1.1 More than one method - 72.5 No Answer - 2.2
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2. Besley, Scott, and Jerome Osteryoung, 1985, "Survey of Current Practices in Establishing Trade-Credit Limits," The Financial Review 20:1 (February), 70-82.
3. Gitman, Lawrence, and Charles Maxwell, 1985, "Financial Activities of Major U.S. Firms: Survey and Analysis of the Fortune's 1000," Financial Management 14:4 (Winter), 57-65.
4. Sanchez, Abenicio, 1992, "Past Due Receivables Management: Completing the Sale," Corporate Controller 5:2 (November/December), 38-39.
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6. Smith, Keith, and Brian Belt, 1989, "Working Capital Management in Practice: An Update," Purdue University Krannert Graduate School of Management Working Paper No. 951 (March).
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8. Hill, Ned, William Sartoris and Daniel Ferguson, 1984, "Corporate Credit and Payable Policies: Two Surveys," Journal of Cash Management 4:4 (July/August), 56-62.
9. Byl, Calvin, 1994, "Reporting Receivables to Management," Business Credit 96:9 (October), 43-44.
10. Keller, Jeff, 1995, "Best Practices in Receivables," TMA Journal 15(1) (January/February), 34-37.
11. Johnson, Theodore, 1982, "Credit Terms Policy and Corporate Payment Practices," Journal of Cash Management 2:5 (September/October), 14-20.
12. Gilbert, Erika, and Alan Reichert, 1995, "The Practice of Financial Management among Large United States Corporations," Financial Practice and Education 5:1 (Spring/Summer), 16-25.
Cecilia Wagner Ricci, Ph.D., is associate professor of finance at Seton Hall University, South Orange, NJ. She may be reached by contacting 973/761-9535; faxing 973/761-9217; or via e-mail to email@example.com