Introduction to Corporate Finance

ONLINE CHAPTERS

a few accounts are significantly past due, then the company should analyse and pursue collection of

those specific past-due accounts. If the company has an abnormally high percentage of outstanding

accounts initiated in a given month, it may be attributable to a specific event during that time period,

such as hiring a new credit manager or selling a substandard product whose quality is being disputed by

customers withholding payment.

Table 18.5 provides an example of an ageing schedule. If the stated credit terms for the company

in this example were net 60 days, then the ageing schedule would tell us that 80% of the company’s

receivables are current and 20% are past due.

Payment-pattern Monitoring

The average collection period and the ageing of accounts receivable are excellent monitoring techniques

when sales are relatively constant. However, for cyclical or growing companies, both techniques provide

potentially misleading results. For example, the average collection period divides the accounts receivable

balance by the average daily sales. If the accounts receivable balance is measured during a cyclical

company’s high sales period, then the average collection period will be distorted by the cyclical sales

peak. Use of the company’s customer payment pattern avoids the problems of cyclical or growing sales

when monitoring accounts receivable.

The payment pattern is the normal timing in which a company’s customers pay their accounts; it is

expressed as the percentage of monthly sales collected in each month following the sale. Every company

has a pattern in which its credit sales are paid. If the payment pattern changes, the company should

review its credit policies.

TABLE 18.5 SAMPLE AGEING SCHEDULE FOR ACCOUNTS RECEIVABLE

Age of accounts Accounts receivable Percentage of accounts receivable

0–30 days $1,200,000 50%

31–60 days 720,000 30

61–90 days 336,000 14

91+ days 144,000 6

Total accounts receivable $2,400,000 100%

One approach to determining this pattern is to analyse a company’s sales and resulting collections on a

monthly basis. That is, for each month’s sales, the company computes the amount collected in the month

of sale and each of the following months. By tracking these patterns over a period of time, the company

can determine the average pattern of its collections using either a spreadsheet or regression analysis. For

most companies, these patterns tend to be fairly stable over time – even as sales volumes fluctuate.

example

Consider Eucla Manufacturing, which has determined

that it collects, on average, 10% of credit sales in

the month of sale, 60% in the month following the

sale and the remaining 30% in the second month

following the sale. Thus, if sales for the month of

January were $200,000, the company would expect

to collect $20,000 in January, $120,000 in February,

and the remaining $60,000 in March. Table 18.6

shows an example of this approach, which can be

extended to develop the cash receipts portion of the

cash budget.

payment pattern
The normal timing in which
a company’s customers pay
their accounts, expressed as
the percentage of monthly
sales collected in each month
following the sale