ORIENT ACADEMIC FORUM

The Risk Control of Accounts Receivable for SMEs WANG Lixin, XIE Jiao School of Economics and Management, North China University of Technology, China, 100144 [email protected] Abstract: In recent years, as the rapid development of private economy, the small-and-medium-sized enterprises (SMEs) have made significant achievements and become an important force in economic and social development. Compared to the large enterprises, the SMEs have weaker market competition either in organizational structure, management level or in scale in the crisis environment. They are more sensitive for macroeconomic changes in the situation. So risk management is especially important for SMEs and management for accounts receivable in SMEs is one of the part. Started from the characteristics of production and management for SMEs, this paper analyzes the special requirements of accounts receivable; then learns the advanced methods and concepts of risk diversification for accounts receivable based on the study of problems which exist in the risk management of accounts receivable in SMEs; finally, proposes some recommendations that meet the risk management of accounts receivable for SMEs, and expects the risk management model of accounts receivable will be applied to the SMEs and enable SMEs to achieve better development. Keywords: SME, Accounts receivable, Risk control, Risk management

1 Introduction These years, SMEs have become an important part in economic and social development after the rapid development. As of the end of October 2006, the number of SMEs in China has reached more than 42 million, accounting for 99.8% of total enterprises; provided 76.6% of urban employment opportunities. The value of final goods and services, total exports and taxes paid respectively account for 58%, 68.3% and 50.2% of the country. But SMEs have weaker market competition either in organizational structure, management level or in scale and have Very limited financing channels. In this case, risk control of accounts receivable for SMEs becomes more important.

2 Analysis of Risk Management of Accounts Receivable for SMEs There are several problems existing in the current risk management of accounts receivable for SMEs in China, such as the lack of customer credit management, ineffective control on bad debt ratio of accounts receivable and turnover ratio and the problem of supervision and control of credit sales and so on. 2.1 The lack of customer credit management system In China, there are collection difficulties in accounts receivable of SMEs. The most fundamental reasons lie in not establishing the State Credit System in nationwide; not making the credit legalized and institutionalized; the lack of customer credit management concepts. "According to statistics, 67% of Chinese enterprises have no credit management, 31% does not have a detailed credit review, 56% have never used third-party information and only 6% conduct a comprehensive credit management." In the above areas, the SMEs in china are even worse. The basis of our whole society’s credit is still relatively weak; social credit system is not yet complete; the credit management system is still being explored and relevant policies and regulations have not yet introduced. Beside, majority of enterprises in China relatively have weak awareness of risk management of accounts receivable, have a single management. Most enterprises still do not establish a perfect credit management system. The imperfect customer credit management system leads to the limited capacity of SMEs for customer management, blind sells goods to customers of low levels, which affects the recovery of accounts receivable.

382

ORIENT ACADEMIC FORUM

The main causes of lack of customers credit management system is due to the low level ranks, many types of SMEs’ customers, who have no credit history and credit grading standards. So the established credit files and standards have nowhere to be investigated, and the client’s credit indicators and data cannot be obtained. This requires the country to develop national policies to support, establish and improve the SME customer credit management system. 2.2 Ineffective Control on Bad Debt Ratio of Accounts Receivable and Turnover Ratio Currently, because of the lack of proper and effective credit managemen, bad debt loss ratio of accounts receivable of SMEs in china is far beyond the extraction standards of provision for bad debts the current accounting system sets.This not only inflate the book profits, but also hide the tremendous risk of bankruptcy. According to a survey conducted by the professional organization, accounts receivable have been accounted for 40% -50% of liquid assets in SMEs of china, have lower turnover ratio(longer collection period) and many of them have been overdue more than a year. In order to fight for market and compete for customers, SMEs in china blindly give customers credit sales without investigation or further understanding of customer credit situation, which leads to a large proportion of accounts receivable and gradually increased bad debt ratio. All the above is due to weaker competition and anti-risk capability of SMEs. Table 1

Comparison of Key Indicators of Accounts Receivable between China and the U.S. Chinese enterprises

American enterprises

Bad debt loss ratio

5%-10%

0.25%-0.5%

Average days of accouts in arrears

90

7

50%

20%

2%-3%

14%

accounts receivable proportion of total working capital the proportion of sales revenue for management, finance, marketing costs

From the table 1, it is not difficult to find out that accounts receivable management in our country’s enterprises have some promblems. Bad debt loss rate of accounts receivable is 5%-10%, 10-20 times U.S. enterprises. Average days of accouts in arrears is 90 days, about 13 times the U.S. enterprises. In our country, accounts receivable proportion of total working capital is much higher than the U.S., while the three major costs are very low compared to the sales revenue. "According to the statistical analysis of relevant institutions, total overdue accouts receivables are not more than 10% of accouts receivables in the developed market, while in our country, this ratio is as high as 60%. " SMEs face the same serious situation which accounted for 99% of our total registered enterprises. If the the actual number of days for accouts collection is more than the company's requirements, it is indicated that the debtor owed more than a long time, have lower credit, thus increase the risk of bad debt losses, and at the same time it is also indicated the accouts collection of creditor is ineffective, which make the assets doubtful or bad debts, thus causing liquidity problems for current assets(bad for the enterprises' normal production and operation). On the other hand, if the enterprises' accounts receivable turnover days are too short, it indicates that the enterprises take a tight credit policy and payment terms are too tight, which would limit the expansion of sales, especially when the costs of such restrictions (opportunity costs) is greater than the credit costs. It will affect the enterprises' profitability. Higher bad debt ratio is mainly due to the lack of effective rules and regulations. It can not make accounts recevable effective constraint for salesperson; The handling personnel can not be specifically responsible for accounts collection; Enterprises do not require the relevant departments and personnel

383

ORIENT ACADEMIC FORUM

solely responsible for collection; Auditing the bad debts is not strict enough or no auditing to clarify their responsibilities. In addition, some SMEs do not establish a strict credit approval system. 2.3 Problem of Supervision and Control of Credit Sales Owners, policy makers, managers are one person in most SMES( without special management team). Especially family enterprises have complex networks, whose owners lack the risk awareness of self-protection and prevention in the competition. One word comeing from the so-called friends becomes a decision, and managers agree to credit sales without clear investigating the actual condition of customers. Financial management system of SMEs is not perfect, which make it difficult or not to look into the economic, civil or criminal responsibility of person in charging and problems in bad debt losses are rarely exposed after Bad debts. Some SMEs, where salary of workers are related to economic benefits, have only requests but practical regulations. So it can not make the incentive system carried out effectively. This allows sales staff to have some misunderstandings, only concern about sales tasks and personal interests, take credit means blindly and ultimate lead to a substantial increase in accounts receivable. The lack of monitoring and supervising credit sales are caused by the lack of auditing for credit sales, or not clear the auditing responsibility. And there is no strict credit approval system in some SMES. SMES are lack of effective rules and regulations, which can not form effective constract to sales staff. The collection can not be specifically responsible by the people who handing them or full responsible by the relevant departments and personnel When recycled.

3 Learn Advanced Ideas and Methods of Risk Management SMEs in our country need to learn advanced ideas and methods of risk management to improve its risk management of accounts recevable. 3.1 Learn from the Banking Bustomer Credit Management System To reform the customer credit management, SMES can learn from advanced credit management system and methods. The customers credit management system in Agricultural Bank of China(ABC) are more perfect and practical,and worth learning. The customers credit management in ABC includes the methods and indicators of the customer credit rating system. The customer credit rating system in ABC is in accordance with the unified financial and non-financial indicators and standards, taking solvency and willingness as core, having integrated evaluation on the bank customers and confirming the bank customers’ credit rating from the credit performance ability, solvency, profitability, management and development capacity and so on. The bank’s credit rating evaluation depends on a combining of quantitative analysis and qualitative analysis and follows the principle of unite standards, strict procedures, classification management, dynamic adjustment. Customer credit rating is the foundation of the bank credit management work. Evaluation result is an important basis of bank customer access, credit risk review, credit pricing, and authorization management. The credit rating of bank customers has five aspects: credit performance evaluation, solvency, profitability assessment, operation and development capacity and overall evaluation. Overall evaluations include four aspects: leadership qualities, management, development prospects and business cooperation with the bank, etc. The bank customer credit rating system evaluations execute Percentile. Various rating categories of objects shall be graded in accordance with the appropriate indicators and score points. There are eight levels: AAA+ AAA AA+ AA A+ A B C according to score level and the individual index.

、

、

、 、 、、、

3.2 Learn an Effective Collection System from the Banking Industry It is necessary for SMEs to have credit accounts receivable collections. This can significantly reduce the proportion of bad debts in accounts receivable. Banking field is good at credit collection, and the

384

ORIENT ACADEMIC FORUM

mainly accounts receivable is loans. Sound internal control system is an important prerequisite and basis for commercial bank assets safe, orderly operation and risk prevention. The improvement of internal system can against operational risks effectively, helping to achieve three goals of the bank, performance goals, reputation goals and compliance goals. Banking industry established internal authorized management system with unified corporate management and legal authority as the main feature. Authorized periodic checks are used to ensure that delegated authority and lines of credit will not be exceeded. The banking industry is confidence in recovering large loans. Thanks to the perfect collection system with dedicated staff on loans, collection loans; established line of credit or collateral to prevent the customer does not submit repayment schedule, etc.

4 Construction of Risk Management Model of Accounts Receivable for SMEs In view of production and management features, special requests, questions of SMEs and advanced concepts and methods learned, we hope accounts receivable risk management model can bring more useful hints to SMEs. 4.1 Construction of Risk Management Model of Accounts Receivable The risk management model of accounts receivable in SMEs primarily includes accounts receivable risk management procedures, management systems, management measures, management tools and so on. The key lies in the development and implementation of related systems. The main line of the contents is the sales process. It includes pre-control, things in control and control after things ,which are related to a series of risk management tasks. To deal with the risk of accounts receivable, SMEs should strengthen the management of the credit, including: establishing specialized credit institutions to manage credit businesses; establishing and improving mechanisms for dynamic assessment of customer credit; strengthening the credit evaluation of customers; establishing credit monitoring system; formulating reasonable credit policies; enhancing supervision for the daily dynamic status of accounts receivable; establishing regular customer reconciliation system; tracking accounts receivable; establishing management and collection system for accounts receivable; Taking different measures for different customers. The risk management model of accounts receivable in SMEs is shown in Figure 1.

385

ORIENT ACADEMIC FORUM

Manage ment program

Manage ment system

Manage ment measures

Pre-credit management procedures

Interim Credit managements

Establish credit investigation and evaluation system

Establish system of creditor protection The establish of management, monitoring, reporting

Establish records management system and collect customer information

Establish credit department and transfer credit risk

establish credit rating levels and divide credit Rating

Manage ment tools

Customers

Internal investigation External investigation

Talks

Develop credit management policies

Financial Evaluation Credit rating

Factoring Insurance and Collateral

Signed

Shipping

Late credit management procedures

Establish accounts management and collection system

Establish accounts Management system and monitor collection

Establish collection system

Recognition, monitoring and reminders

Maturity

Figure 1 Risk Management Model of Accounts Receivable in SMEs

386

Self-collect and ion commission

Receivable collection

ORIENT ACADEMIC FORUM

4.2 Contents and Use of Accounts Receivable Rsk Management Models To reform Risk Management model of SMEs not only needs to update the concepts of credit management, improve overall qualities of the related staff, set the special credit management agency ,also should use the customer credit tracking management model in practical work andSelf-develop or outsource the customer credit management system which is based on accounts receivable. It permeates all aspects of product sales: client development, contracts signing, goods issuing, due receivables, feedback, withdrawal (for) services and so on. It can provide timely and effective information to help manager to make the right decisions. SMEs in different industries choose to use these models according to their characteristics. 4.2.1 Establish a Scientific and Practical Customer Management System for SMEs Credit evaluation is the base of credit sales. SMEs should determine the accounts receivable risk scientifically according to the assessment of customer credit rating, and make it as the basis of credit decision-making. First of all, credit investigation. SMEs should collect and collate information that reflects customer credit to get direct contact with customers by using direct or indirect methods. SMEs can get necessary information through inquiry, observation, records, etc; can also collect information by the client's financial statements, credit rating agencies and information form banks and suppliers of enterprises, the relevant information from SMEs’ higher authorities, industry and commerce departments, tax authorities, consumer associations. Secondly, according to the respective circumstances of SMEs, those capable enterprises can collect customer information and analyze it then make evaluation, while those who have no ability don’t need to performance the requirements but need to have their own effective methods to manage customer credit. Thirdly, setting reasonable credit policy. Credit development standards are decided according to different customers. To give customers what kind of credit is expressed as the rate of bad debts losses. Credit policy, also known as accounts receivable policy, is an important component of enterprises’ financial policy, including credit terms and cash discount policy. Credit period means the limited time provided to customers from buying goods to actually payment. Credit period is an important part of the company credit policy. To extend the credit period will increase capital spending by the amount of accounts receivable and lead to the increased cost of accounts receivable. Conversely, reducing the credit period will cause a decline in sales to a certain extent. If credit period is too short, there will be less attractive to customers, thus leading to the corresponding decline in sales; if credit period is too long, sales will be increased, and the cost will also increase accordingly, which is a shift in relationship. Thus, SMEs must be weighed to determine the appropriate credit period. Generally speaking, if the increase in marginal revenue which is caused by extending the credit period is greater than increase in the marginal cost, extending the deadline can be used. Cash discount policy means price reduction for customers in the commodity, which will attract customers to enjoy the benefits and take advance payments and shorten the company's average collection period; in the same time, it may also attract some customers who regard the discount as decreasing price to come to purchase. Therefore, the cash discount policy might impose an income, but also increase the cost, that is, loss of price discounts. When the SMEs develop the policy, they should consider the benefits of discount and costs. 4.2.2 Establish the Effective Supervision and Control Related to Accounts Receivable of SMEs First, strengthen contract management and standardize business conduct. each Sales should sign a sales contract. The elements of the sales contract should be complete and in accordance with national laws, and especially payment method, duration and payment obligations of extension should be clearly and accurately for the future of the collection work well documented. Second, establish and improve the credit approval system. SMEs should develop credit approval systems according to their own actual condition, and clear credit approval authority, responsibility, and strictly control the occurrence of accounts receivable. In the sales process, sales departments should strictly enforce the credit approval system, to avoid subjective judgments, thus cause losses to the

387

ORIENT ACADEMIC FORUM

enterprise. Again, SMEs should develop risk prevention system of accounts receivable according to the actual condition. First, develop effective sales processes. Sales business processes, includes sales contracts, credit approval, delivery, loan recovery, etc have something to do with business size, product category, sales network. Enterprises must choose delivery methods and settlement according to sales personnel, and establish a complete set of credit risk management business processes with risk prevention. The process can not affect the sales tasks seriously and take the overall balance between sales and the collection. Effective sales process is an effective way to prevent various departments or individuals acting ultra vires and to minimize the risk of accounts receivable within the enterprises. Second, enterprises developing a credit approval system according to their characteristics and management requirements, develop credit approval system and clear the approval limits. Authorization system restricts staff and functions to perform their functions within the mandate, to prevent the ultra vires act. Credit approval system is that mandated departments, business personnel may approve a credit limit, which will help to control within reasonable limits. At the same time, it should be based on the principle "Who approves, who responses ". Third, standardize the accounting for accounts receivable. To reflect the overall size of accounts receivable, Enterprise’s financial sector should establish a subsidiary ledger of accounts receivable according to regional credit customers, make a scale accounting for the credit business timely and count amount, accounts ages and changing situation of accounts receivable of all customers, and feed back to the executives and sales leaders timely. These can provide a reliable basis for the assessment, adjustment of credit customers, also be helpful to understand the overall situation of credit. Forth, check the account at regular intervals. It can get the legal basis for checking account, send the bill of the account to the customers who buy on credit regularly, get the bill which is positively identified and autographed and stamped by both the dealer and the accounting managers and make it as the original basis for both sides. This work needs financial department and marketing department to cooperate.Fifth, establish the responsibility system of accounts receivable collection. To the maturitied accounts receivable, enterprise should timely remind customers according to the contract; to overdue accounts, they should taken a variety of collection ways. The important overdue accounts receivable can be resolved through litigation. At the same time, SMEs of ability should establish the supervisory authority to clear debt collection, is responsible for credit growth targets, verify the collection performance of related responsibility department and its head. Defining responsibilities for the failure to timely recovery of accounts receivable. Accounts receivable credit and collection parts are the two most important parts, so it is vital to attach more management and supervision on them. The credit flow chart of accounts receivable refers to credit management system, business management system, management functions, management and technical specifications and other aspects of the SMEs. It aims to profit, takes the process management mode, uses the technique of credit management to reform the enterprise’s sales system, thus achieves the full control of the credit risk and improve marketing profit-making objectives. The specific is shown in Figure 2.

388

ORIENT ACADEMIC FORUM

Client Control

Order

Contra ct

Debt collectio

Collectio n

Deliver y

6collection 1credit investigatio n

Measure

Management system

3credit policy

Customer Credit Management System (Before the event)

5 Aged

7assess

cont

Credit management (Middle Management)

Receivable collection management system (Post-administration)

Figure 2 Flowchart of Credit Sales Management of Accounts Receivable

Because of the dynamic tracking to customers, SMEs can easily make the real evaluation of the customers’ credit. This has a certain part of the role for the collection of accounts receivable of SMEs. Specific results and countermeasures of accounts receivable credit in SMEs are shown in Figure 3.

Collection receivablee

Yes

Normal

No

Late

1Enhance credit rating 2expansion of credit 3relax policy

1 lower credit rating 2 increase inspection efforts 3 step receivable policy

Bad debts

1 resort to legal means 2 give up bad customers 3 Investigate bad debts

Figure 3 Flowchart of Collection of Accounts Receivable

389

ORIENT ACADEMIC FORUM

4.2.3 Diversify Risk through Factoring and Mortgage Business of Accounts Receivable The purpose of factoring accounts receivable in China's SMEs is to spread the risks. According to whether there is a right of recourse, it can be divided into recourse factoring and non-recourse factoring. If the factor approved to provide bad debt security to the undisputed accounts receivable, it is called non-recourse factorig. But factor are required to determine the credit amount for each buyer to distinguish between approved and not approved receivables. Non-recourse factoring buyers (financial institutions) will bear the risk of accounts receivable (bad debt losses of accounts receivable), while the sellers assume the sales discount, sales allowances, or the loss of returns. "Chinese SMEs have the precedent of handling these businesses. Such as Chase board of directors passed a resolution in Fuzhou in 2003. In order to further enhance the liquidity, the company decided to sign accounts receivable factoring agreements with the relevant financial institutions. Fuzhou Chase took 60 million from 1 billion for accounts receivable factoring. For recourse factoring, factor is not responsible for audit credit, uncertain credit limit, and does not provide bad debt security. Factor only provides trade financing, account management and debt collection services. If there is bad debt, regardless of causes, factor have the right to recourse to the supplier advances. Mortgage are divided into total mortgage and certain mortgage in accordance with different ways of mortgage loan. Under total mortgage, the debtors of accounts receivable are more in general, and will be responsible for recovery costs of accounts receivable and bad debt losses obligations. Under the specific mortgage loan, the two sides can agree on whether the loan outstanding customer will be notified. If the notice is given to the customer, Customer will pay the money directly to financial institutions. If do not inform customers, the borrower receive payments from customer, and then tranferred to the financial institutions.Mortgage for accounts receivable is practically significant in view of settling risk management of accounts receivable in SMEs. It can expand sales , while fully guarantee the availability of funds, help the enterprises fully exert functions of accounts receivable. Therefore, the state departments concerned should give active support to ensure the healthy development of SMEs. 4.3 Concerns about the Use of Risk Management Model of Accounts Receivable Risk management model of accounts receivable in SMEs emphasizes the establishment and perfection of credit risk management department. With the sales department, finance department and other business departments, it aims to improve the risk management levels of accounts receivable, accelerate the cash flow, increase business cash flow, change the situation of ineffective sales and make credit sales into effective means for enterprises to bring real profits. Simply making the credit risk management departments independent can not effectively play its an active role in accounts receivable risk management process. The position of credit risk management departments remains to be further considered.

5 Conclusion With the rapid development of commodity economy and the increasingly fierce market competition, great business opportunities are brought to enterprises and in the same time a brutal challenge appears. It is in this way that the credit sales means have developed. However, credit sales are a double-edged sword:on one hand, it makes sales grow; and on the other hand, it also increases the financial burden of enterprises----occupying a large number of accounts receivable makes their sales cost and management costs both surge, bad debt loss increases, a serious shortage of cash flow, etc. All these hinder the true growth in profits.Sales can not be transformed into real profits, because they not only have lost the advantage of credit sales, but also make it more difficult for the enterprise business, even lead to bankruptcy. Coupled with difficulties in SMEs financing, the risk management of accounts receivable is invaluable. At the same time, the nature of SMEs decides that its management is less formal than large enterprises. Enterprises’ "rule of man"- business leaders often "hoodwink", which can not be avoided when designing risk management model of accounts receivable. Thus,only full accounting of its own 390

ORIENT ACADEMIC FORUM

characteristics, SMEs can make the risk management departments to maximize the role of risk management, expanding profits, improving the risk management of accounts receivable and enhancing the effective sales, so that credit truly become sales tools for the enterprises to create profits. This article is based on the Current situations. In connection with the problems exposed in risk management of accounts receivable, combined with the characteristics of SMEs production and management and special requirements, we proposed accounts receivable risk management model for SMEs should be developed. This article emphasizes that we should establish a scientific evaluation system and effective monitoring and control related to risk management of accounts recevable for SMEs, and proper use of factoring accounts receivable and mortgage loan business. Acknowledgements: Support from Beijing Municipal Commission of Education for Excellent Teaching Team and Major with Characteristics is acknowledged.

References [1]. Du Dianchu, Wang Mei. Accounts Receivable Risk Management. Contemporary Economic, 2007 (3): 44(in Chinese) [2]. Lou Fang. Research on internal control of SMEs. Economic Forum, 2008 (17): 79 81(in Chinese) [3]. Li Jiaojiao. Analysis of accounts receivable risk. Friends of Accounting, 2008 (3): 39 40(in Chinese) [4]. Pan Xingwang. Research on accounts receivable management. Operating and Management,2009 (1): 89 90(in Chinese) [5]. Tang Xiaochong. Analysis and Countermeasure on Accounts Receivable Management Status of SMEs. Financial Management, 2008(4): 83 84(in Chinese) [6]. Chen Yingxin. Analysis and preventive measures on Accounts receivable risk. Finance and Accounting Communication,2007 (6): 48 49(in Chinese) [7]. Li Enzhu. Enterprise Risk Prevention on accounts receivable. Accounting Research, 2007(2): 29 31(in Chinese) [8]. Xie Fang. Research on accounts receivable risk management of SMEs Management Vision, 2007(8): 514 515(in Chinese) [9]. Li Xiaofang, Zhen Jiahao. Accounts receivable management for SMEs. Enterprise Research ,2008 (7): 27 29(in Chinese)

～ ～

～

～

～ ～

～

391

～