Accounts receivable management in nonprofit organizations

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1 - ibited. - ibited. - ibited. - This copy is for personal us Zeszyty Teoretyczne Rachunkowości, tom 68 (124), SKwP, Warszawa 2012, s Accounts receivable management in nonprofit organizations Grzegorz Michalski Introduction This paper contributes to the discussion about nonprofit organizations (NPO) model of financial management in the accounts receivable area. In fact, when it is judged from a technical point of view, the opinion that nonprofit financial management do not differ from a for-profit business could be justified, and is known in nonprofit financial management discussion (Jegers, 2011; Hansmann, 1987). But that point of view is only partially right. Sloan et al. and Wedig et al. implemented with modifications a financial management portfolio theory to NPO financial management (Sloan et al., 1988; Wedig, 1994, Wedig et al., 1996; Jegers, Verschueren, 2006). In the paper, the model of financial liquidity management in NPOs is presented from the perspective that claims the basic financial aim of an NPO is the most financially effective realization of the mission, resulting in the donors support for the organization (Leone, Van Horn, 2005; Eldenburg et al., 2011). It is close in many points to the maximization of for-profit firms values, but in fact it has many differences, and non-profit entrepreneurship could attract entrepreneurs more than for-profit organizations (Michalski, 2012; Chapelle, 2010). The net working capital requirements and the elements shaping it, such as the level of cash tied up in accounts receivable, inventories, the early settlement of accounts payable, and operational cash balances, is one of the fields where a difference could be seen. Not many NPOs have to deal with all aspects of liquidity decisions or current assets management. Like for-profit organizations, some of them use only cash from current assets, redistributing it from donors to beneficiaries. Other NPOs collect free-of-charge goods for resale, using this income to realize their mission. Many NPOs are almost identical in operating processes with for-profit businesses, but are nonprofit because of their main mission. An NPO s management team s decision about the accounts receivables policy is a balance between gaining new customers by way of a more liberal organization s trade credit policy and limiting the risk of allowing for delayed payment from unreliable purchasers. That kind of decision shapes the level and quality of Dr. Grzegorz Michalski, assistant professor, Department of Corporate Finance and Value Management, Wrocław University of Economics, Grzegorz.Michalski@ue.wroc.pl Acknowledgment: the research is financed from the Polish science budget resources in the years as the research project NN

2 - ibited. - ibited. - ibited. - This copy is for personal us 84 Grzegorz Michalski accounts receivables (Michalski, 2012). Paraphrasing Keith Smith and James A. Gentry s observations, it is possible to observe that Robichek et al. (Gentry, 1988; Robichek et al., 1965; Smith, 1973) talk about the risk involved to accounts receivable decisions which must be accepted by financial institutions pledging of accounts receivable of the firm. Keith Smith (Smith, 1973; Gentry, 1988) predicted and Michalski (Michalski, 2008) showed how a portfolio theory may be used to decrease the accounts receivable risk. Current assets, and among them accounts receivables, could be viewed in the portfolio context as presented by Friedland (1966; Gentry, 1988). Pringle and Cohn (1974; Gentry, 1988) tried to adapt the CAPM theory to working capital elements. Bierman and Hausman (1970; Gentry, 1988) discuss the granting policy of an organization and shows that trade credit policy requires balancing the future sales gains against possible losses. Lewellen, Johnson and Edmister (Lewellen, Johnson, 1972; Lewellen, Edmister, 1973) explain how and why traditional devices used for monitoring accounts receivable should be changed by new and better ones. Freitas (Freitas, 1973) shows the relationship between liquidity and risk during accounts receivable management. The question discussed in that paper concerns the making of decisions by NPOs in the accounts receivables area. 1. Management of accounts receivable with efficiency maximization as its aim If holding accounts receivable at a level defined by the organization provides greater advantages than drawbacks, the NPO s efficiency will grow (Michalski, 2012; Shin, 1998; Ranjith Appuhami, 2008). Changes in the level of accounts receivable affects the efficiency of the NPO. To measure the effects that these changes produce, we use the following formula, which is based on the assumption that the NPO s efficiency is the sum of future free cash flows to the NPO (FCNPO), discounted by the rate of the cost of capital financing the realization of the NPO s mission: n FCNPO t p ( EREVt CEt NWR t CAPEX t ) FCNPO Vnpo, t t 1 1 CoC (1) where: EREV expected revenues of nonprofit organization, p probability of realization expected revenues, CE cash expenditures (fixed and variable costs), NWR net working capital requirements, NWR change in net working capital requirements, CAPEX capital expenditures resulted from long term operational investments, V npo nonprofit organization efficiency increase, FCNPO t future free cash flow growth in period t, and CoC discount rate equal to cost of capital rate.

3 - ibited. - ibited. - ibited. - This copy is for personal us Accounts receivable management in nonprofit organizations 85 Changes in the accounts receivable levels influence the NPO s efficiency, and to estimate such an effect, the acceptance of discount rate equal to the average weighted cost of capital (CoC) is needed. The results of the mentioned changes are long-term in their character and strategic in some meaning, although they refer to accounts receivable and traditionally short run area decisions (Michalski, 2012; Maness, 1998, pp ). Remembering that the fundamental financial aim of the NPO is not enterprise value creation but as close to the realization of the mission of that organization as possible (Zietlow, 2007, pp. 6 7), it is controversial to use analogous rules like for for-profit firms, but in fact such a solution is proposed in textbook literature (Brigham, 2004). A modified version of that classical approach is used in this paper. The approach presented here claims that a higher risk should be linked with a higher cost of capital rate used to evaluate the future results of current decisions (Michalski, 2012). That approach is also positively connected with the level of efficiency and effectiveness in the realization of the NPO s mission. Effectiveness is understood here to be successfully carrying out the wishes of the NPO s donors. They fund the organization believing that the money they donate will be spent on projects which are close to their social ideals. The cost of financing the accounts receivables policy is a result of the risk included in the organization s strategy of financing and/or investment in accounts receivables. The holding and increasing of accounts receivables ties up money used for financing accounts receivables. Based on that, it is possible to estimation the free cash flows, which are treated as the free amount of money after cash expenses which could be used for future NPO actions. With the accounts receivables level increasing, the NPO must utilize and tie up more money, and this decreases free cash flows. NPOs offer growth, which usually necessitates increased levels of the most liquid assets of the NPO, such as cash, inventories, and accounts receivables. Most of this growth will be covered with current liabilities that automatically increase with the growth of production and sales. The remaining money requirements (that are noted as net working capital requirements growth, ΔNWR) will require a different form of financing (Michalski, 2012). In figure 1, the influence of the accounts receivables policy changes when the NPO s efficiency is presented. These decisions change future free cash flows generated by the NPO s operations (FCNPO), the point in time in which the organization will generate its free cash flows (t) and the rate of the cost of capital financing of the NPO s operations (CoC). Changes to these three components influence the efficiency of the NPO (ΔV npo = nonprofit organization efficiency increase). Accounts receivables policy decisions changing the terms of trade credit create a new accounts receivable level. Consequently, the accounts receivable policy has an influence on a NPO s efficiency. This comes as a result of alternative costs of money tied up in accounts receivable and general costs associated with managing accounts receivable. Both the first and the second involve modification of future free cash flows and, as a consequence, the NPO s efficiency changes.

4 - ibited. - ibited. - ibited. - This copy is for personal us 86 Grzegorz Michalski Figure 1. The accounts receivable policy influence on nonprofit organization efficiency granting credit sale using PAR/EREV policy t = 0 CR = p EREV EV = p [(EREV CE) NWR CAPEX] V npo where: EREV expected revenues of the nonprofit organization, CR cash revenues, CE cash expenses (cash expenditures), CAPEX capital expenditures linked with investing in fixed operating assets; PAR projected accounts receivable level in the nonprofit organization, NWR changes in net working capital requirements, p probability of expected revenues realization, and t the time the decision is taken and their results on FCNPO and V npo. Source: own study based on Michalski (2008), Holmstrom (2001), Holmstrom (1996), Holmstrom (2000). Changes in accounts receivables (resulting from changes in the accounts receivables policy of the organization) affect the net working capital requirements level and also the level of accounts receivable management operating costs in the NPO; these operating costs are a result of accounts receivable level monitoring and recovery charges). Trade credit terms give evidence about a NPO s accounts receivables policy (or strategy). The parameters of the accounts receivable policy include the maximum delay possible in payment by purchasers (trade credit period); the time the purchaser has to pay with a cash discount; and the rate of the cash discount. The length of the cash discount period and the maximum delay in payment by purchasers give information about the character of the NPO s accounts receivable policy. These trade credit conditions are: CDR / CDP, net MPDP (2) where: CDR cash discount rate, CDP cash discount period, and MPDP maximum payment delay period. The terms of a trade credit sale are the result of a NPO s management team s decision made on the basis of information about factors such as market competition, the kind of goods or services offered, the seasonality and elasticity of demand, price, type of customer, and margin from sale. NPOs can use a smaller margin from sale policy than their for-profit equivalents. It is important to match the length of the trade credit of the NPO to its customer s capabilities. The organization giving the trade credit should take into account the purchasers (when it is appropriate) inventory conversion cycle as well as its accounts receivable conversion cycle. These two elements make up the operating t = 1

5 - ibited. - ibited. - ibited. - This copy is for personal us Accounts receivable management in nonprofit organizations 87 cycle of a purchaser. The shorter this cycle, the shorter the maximum payment delay period offered to a purchaser should be. The maximum payment delay period for purchaser is the maximum expected period of accounts receivable cycle for a seller. In order to choose what terms of sale should be proposed to the purchaser, the NPO management team can use the incremental analysis as a helpful criterion. The results should be compared with the influence of these proposals on the efficiency of the NPO. Incremental analysis is a tool for estimating the effects of changes in a trade credit policy on the organization. This analysis usually takes into account three basic elements: 1. Estimation of the results of changes on cash revenue as well as losses resulting from bad debts; 2. Estimation of the changes in the NPO s accounts receivable level. Cash investment in accounts receivable growth is calculated according to the formula: AAR ACP ACP 1 0 CR0 CR1 CR VC ACP , if CR 1 CR CR1 CR1 CR0 AAR ACP1 ACP0 VC ACP0, if CR1 CR where: ΔAAR forecasted accounts receivable increase, ACP 0 receivables collection period before change of accounts receivable policy, ACP 1 receivables collection period after change of accounts receivable policy, CR 0 forecasted cash revenues from sales without change of accounts receivable policy, CR 1 forecasted cash revenues from sales after change of accounts receivable policy, and VC forecasted variable costs (in percent from forecasted cash revenues incomes). Although VC do not influence the value of accounts receivables, they decide how much cash is tied up in them. 3. Estimation of the forecasted NPO efficiency change: ΔEBIT = (CR 1 CR 0 ) (1 VC) k AAR ΔAAR (l 1 CR 1 l 0 CR 0 ) (sp 1 CR 1 w 1 sp 0 CR 0 w 0 ) (4) where: ΔEBIT = ΔNOPAT forecasted increase of earnings before interests, k AAR forecasted operating costs of managing of accounts receivable in the NPO, l 0 forecasted bad debts loses without accounts receivable policy change, l 1 forecasted bad debts loses after accounts receivable policy change, sp 0 cash without accounts receivable policy change, 0 (3)

6 - ibited. - ibited. - ibited. - This copy is for personal us 88 Grzegorz Michalski sp 1 cash discount after accounts receivable policy change, w 0 forecasted part of purchasers using cash discount without accounts receivable policy change, and w 1 forecasted part of purchasers using cash discount after accounts receivable policy change. To check how changes in the accounts receivable level and EBIT influence the NPO s efficiency, it is possible to use changes in forecasting future free cash flows. First we have changes in FCNPO in time 0: ΔFCNPO 0 = ( ΔNWR)= ( ΔAAR) (5) Next the free cash flows to the NPOs in periods (from 1 to n), as: ΔFCNPO 1 n = ΔNOPAT= ΔEBIT (6) In fact, that model should be extended. Case 1. The NPO which helps the unemployed by selling clothes collected from donors forecasts that its cash revenues without changing its current policy will be at the level CR 0 = 2,000,000. According to the same forecast VC = 40% CR. Forecasted operating costs of accounts receivable management in the organization, k AAR = 30%. The cost of capital, CoC = 18%. Without a change of the accounts receivable policy, 20% of the organization s customers use a 1% cash discount paying on the 14th day. The remaining customers pay on the 30th day. Forecasted bad debts losses are 3% of CR. The changes of accounts receivables policy (from 1/14, net 30 to 3/10, net 40) considered by the organization will result in 40% of the organization s customers using a 3% cash discount paying on the 10th day. The remaining customers will pay on the 40th day. Forecasted bad debts losses are 4% of CR. Forecasted cash revenues after the accounts receivable policy change CR 1 = = 3,000,000. The effects of changes in the accounts receivable policy would be felt for ten years. The horizon could be, according to the organization s forecast, finite or infinite and depends on information collected by the management team. Without a change of the accounts receivables policy, 80% of cash revenues are collected on the 30 th day, the rest, 20%, will be regulated up to the 14 th day, then the ACP 0 is: ACP days. The ACP 1 after the change is: 0 ACP days. That is why the expected increase of the average level of accounts receivable will be: AAR ,

7 - ibited. - ibited. - ibited. - This copy is for personal us Accounts receivable management in nonprofit organizations 89 Therefore, as a result of the trade credit policy change, the average state of accounts receivable will grow to 37,778. Then is possible to forecast ΔNOPAT=ΔEBIT: NOPAT EBIT % (4% % ) (3% % 1% %) 496,667 Next, the management team of the NPO can estimate change in the organization s efficiency: 496, ,778 V npo 37, ,201, Case 2. The same as for NPO s problem, but considered for for-profit business. Tax rate is 19%. In that case, the for-profit business value growth is forecasted: V fpo 496,667 (0.81) 1, , ,777,412. Taxation consumes 2,201,504 1,777,412 = 424,092 of efficiency, when we compare nonprofit and for-profit organizations. Case 3. Previously, a simplified version of the model was demonstrated. In fact it does not show the real influences of boundary conditions both from financial (cost of capital changes) and operating (γ, δ, ε, ζ, ι, μ) constraints. Trying to show a set of influences that moderate the NPO accounts receivable efficiency, there is a need to include more factors than previously. In table 1, column 0 refers to the basic situation from case 1, and column A to the conditions after the change. Table 1. Nonprofit accounts receivable efficiency model (expanded version) - 0 A {γ} {δ} {ε} {ζ} {ι} {μ} Expected Cash Revenues (EREV) Fixed Assets (FA) Bad debts loss 3% 4% Scount sale share 20% 40% Scount sale days Trade credit share 80% 60%

8 - ibited. - ibited. - ibited. - This copy is for personal us 90 Grzegorz Michalski Trade credit days Variable costs share (VC) 40% 40% Scount rate 1% 3% Accounts Receivable level (PAR) Inventory period (days) Inventories level Accounts Payable period (days) Accounts Payable level Operating Cash level ACP (days) PAR / EREV 7.44% 7.78% k AAR 30% 30% Cash Expenses (CE) Non Cash Expenses (NCE) NOPAT Non Cash Expenses (NCE) NWR (t-1) CAPEX (t-1) FCF (t-1) FCF (t) β e 1 1 Risk Sensitivity SZ {ϣ} β Le Risk Free Rate k rf 5.97% 5.97% Equity Risk Rate (ERP) 11.60% 11.60% Cost of Equity Rate (k e ) 24.02% 24.17% β Ld Cost of Debt Rate (k d ) 14.79% 14.86% Debt to Equity (D/E) CoC 18.00% 18.11% NPO efficiency growth V Incremmental efficiency change where: {γ} maximal outlets possibilities, {δ} market absorption, {ε} availability of stocks, {ζ} derived demand, {ι} availability of infrastructure, {μ} production possibilities, β e unleveraged and uncorrected equity risk indicator, β Le leveraged and corrected equity risk indicator, β Ld leveraged and corrected debt risk indicator, FCF free cash flow, SZ {ϣ} risk sensitivity, D/E debt to equity relation. Source: hypothetical data. In the expanded version of the model, it is shown that NPO efficiency growth is a function, not only simple indicators used to calculate the simplified version. The expected revenues level is not only the result of the accounts receivable policy, but it also depends on operating constraints, and is a function of factors from the first

9 - ibited. - ibited. - ibited. - This copy is for personal us Accounts receivable management in nonprofit organizations 91 rows of table 1: f (γ, δ, ε, ζ, ι, μ). Risk sensitivity SZ {ϣ} depends on the organization s position and its resistance to the market situation (Soltes, 2012). Risk sensitivity sz {ϣ}is discussed in (Michalski, Mercik, 2012). 2. Management of accounts receivable in nonprofit organizations Many ways of managing accounts receivable exist. Each solution has different projected accounts receivable (PAR) to expected revenues relation (EREV). The policy with as small levels as possible of accounts receivables in relation to expected revenues: (PAR/EREV) min, is called traditionally the restrictive policy. The policy with as great levels as possible of accounts receivables in relation to expected revenues: (PAR/EREV) max, is called in the same spirit the flexible policy. A flexible policy with as liberal a policy in accounts receivables as needed to activate the cash revenues collection is linked with smallest level of operational risk and the smallest level of cash flow under risk (under probability of problems with its collection). Between the flexible and restrictive policies is the moderate accounts receivables policy in the middle. More restrictive solutions are cheaper from an operational (current costs) perspective thanks to smaller operational costs of managing accounts receivables but they are also linked with a higher level of operational risk, and that could cause a smaller probability of realizing expected revenues (p). This results in a higher cost of capital from financing and smaller efficiency from free cash flows generated by NPO operations. On the other hand, more flexible solutions are linked with a lower level of operational risk. This results in a lower cost of capital from financing and higher efficiency from free cash flows generated by NPO operations (Soltes, 2004). Nonprofit organizations should choose safer and more flexible accounts receivable policies to realize their missions. In figure 2 there is data collected for Polish NPOs, for the years 2009 and We can observe levels of accounts receivables for organizations which maintain inventories (a minimum 5000 PLN of inventories) and manage the account receivables (maintain a minimum of 5000 PLN of accounts receivables level).

10 - ibited. - ibited. - ibited. - This copy is for personal us 92 Grzegorz Michalski Figure 2. Short-term receivables in Polish NPOs in (logarithmic scale) Source: own calculations based on (BOPP). Table 2. Short-term receivables and other short-term levels in Polish NPOs in Inventories Short- -term receivables Long- -term receivables Cash Equity Long- -term debt (D L ) Short- -term debt (D S ) Size of population Arithmetic mean Standard deviation Median Winsorized mean Truncated mean Skewness Source: own calculations based on (BOPP).

11 - ibited. - ibited. - ibited. - This copy is for personal us Accounts receivable management in nonprofit organizations 93 Figure 3. Receivables conversion period in Polish NPOs in (logarithmic scale) Source: own calculations based on (BOPP). Table 3. Receivables conversion period and other short-term characteristics in Polish NPOs in Receivables conversion period Payables conversion period Inventory conversion period Operating cycle Cash conversion cycle Size of population Arithmetic mean Standard deviation Median Winsorized mean Truncated mean Skewness Source: own calculations based on (BOPP).

12 - ibited. - ibited. - ibited. - This copy is for personal us 94 Grzegorz Michalski Conclusions Accounts receivable management decisions are very complex. On the one hand, too much money is tied up in accounts receivables, because of an extreme liberal policy of giving trade credit. This burdens the organization with higher costs of accounts receivable service with additional high alternative costs. Additional costs are further generated by bad debts from risky customers. On the other hand, the more liberal accounts receivable policy could help increase inflows from cash revenues. Data used for our calculations comes from 337 Polish NPOs. The considered raw population of NPO statements was larger, but few of the NPOs use accounts receivables management in connection to a real operational cycle with inventories. As we see in table 2 and table 3, there are only 337 statements included after taking into account that information. For paper discussion purposes, the median and Winsorized mean are helpful, showing that the accounts receivable period is in Polish NPOs near to or days. It is shorter than the adequate average period for Polish for-profit organizations. This shows that they generally can use a rather aggressive, rather than flexible idea of accounts receivable management. It s a riskier solution, but from a current operational perspective it is cheaper. References Bierman H., Hausman W.H. (1970), The credit granting decision, Management Science, vol. 16, no. 8 (April), pp. B Brigham E.F., Daves P. (2004), Intermediate Financial Management, Thomson, Mason. Chapelle K. (2010), Non-profit and for-profit entrepreneurship: a trade-off under liquidity constraint, International Entrepreneurship and Management Journal, vol. 6, no. 1, p Eldenburg L.G., Gunny K.A., Hee K.W., Soderstrom N. (2011), Earnings management using real activities: evidence from nonprofit hospitals, Accounting Review, vol. 86, no. 5, pp Friedland S. (1966), The Economics of Corporate Finance, Prentice Hall, Englewood Cliffs, New Jersey. Gentry J.A. (1988), State of the art of short-run financial management, Financial Management, vol. 17, no. 2, pp Hansmann H.B. (1987), Economics theories of nonprofit organization, [in:] W.W. Powell (ed.), The Nonprofit Sector: A Research Handbook, Yale University Press, New Haven, pp Holmstrom B., Tirole J. (2001), LAPM: a liquidity-based asset pricing model, Journal of Finance, vol. 56, no. 5. (October), pp Holmstrom B., Tirole J. (2000), Liquidity and risk management, Journal of Money, Credit and Banking, vol. 32, no. 3, part 1, pp Holmstrom B., Tirole J. (1996), Modeling aggregate liquidity, American Economic Review, vol. 86, no. 2, Papers and Proceedings of the Hundredth and Eighth Annual Meeting of the American Economic Association San Francisco, CA, January 5 7, 1996, pp Jegers M. (2011), Financing constraints in nonprofit organisations: a Tirolean approach, Journal of Corporate Finance, vol. 17, pp Jegers M., Verschueren I. (2006), On the capital structure of non-profit organisations: an empirical study for Californian organisations, Financial Accountability and Management, vol. 22, no. 4 (November), pp

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14 - ibited. - ibited. - ibited. - This copy is for personal us 96 Grzegorz Michalski Internet sources BOPP (2011), Database of Polish NPO s (online), cit. December 2011, Brigham E.F. (2006), Financial Management 11e, theory11e/web_chapters/bri59689_ch30_web.pdf (access: ). Summary Accounts receivable management should contribute to the realization of basic financial purpose of a nonprofit organization, which is the most financially effective realization of its mission. The nonprofit organization s mission realization is more effective when it is realized in the most efficient way. It is also executed with a focus on risk and uncertainty. This article presents the consequences that can result from operating risk to determine the level of accounts receivable in the nonprofit organization. Any change in the level of accounts receivables in a nonprofit organization increases the net working capital level and influences costs of holding and managing accounts receivables. Data collected from the 2009 and 2010 financial statements of 337 Polish nonprofit organizations are used to illustrate the material. Keywords: efficiency of nonprofit decisions, accounts receivable management, incremental analysis, nonprofit organizations. Streszczenie Zarządzanie należnościami w organizacjach nonprofit Zarządzanie należnościami w organizacji nonprofit powinno współgrać z podstawowym finansowym celem działania organizacji nonprofit, jakim jest najefektywniejsze finansowo realizowanie misji. Organizacje nonprofit bardziej efektywnie realizują swoją misję, gdy czynią to również najbardziej efektywnie pod kątem efektywności finansowej. W porównaniu z organizacjami nastawionymi na zysk, organizacje nonprofit, jako bardziej efektywne powinny stosować mniej ryzykowne rozwiązania w zakresie zarządzania należnościami. Rozważania artykułu są potwierdzone i uzupełnione wnioskami z danych empirycznych pochodzących z lat 2009 i 2010 z finansowych sprawozdań 337 działających w Polsce organizacji. Słowa kluczowe: efektywność decyzji nonprofit, zarządzanie należnościami, organizacje nonprofit.