Accounts receivable management decisions are complex. On the one hand, too liberal of a credit policy might cause too much money to be tied up in accounts receivables and increase the costs of accounts receivable processing.
This scenario burdens the business with higher costs of accounts receivable service with additional high alternative costs. Bad debts from risky customers further generate additional costs. Conversely more liberal accounts receivable policy may ultimately increase inflows from cash revenues.
The problem could be linked to the operational risk of customers interested in receiving trade credit who may be classified by too high a risk level. However, if they are considered one of several groups of enterprise customers, and if their payment habits are correlated with the payment habits of the remaining groups, what was before unlikely could become more manageable and ultimately turn profitable.
Portfolio theory is a mathematical framework that could be applied to managing accounts receivable. Applying portfolio theory to accounts receivable helps a company manage its risk and optimize its return on investment.
One way to apply portfolio theory to accounts receivable is through diversification. Like in a financial portfolio, diversifying accounts receivable reduces the risk of loss from any single customer. By spreading the risk across a wide range of customers, a company could reduce its exposure to any one customer defaulting on payment.
Portfolio theory is a mathematical framework that could be applied to the management of accounts receivable to manage risk and optimize returns.
Another application of portfolio theory to accounts receivable is through portfolio optimization. This scenario involves analyzing the expected return and risk of different accounts receivable and determining the optimal mix of accounts to maximize the return while minimizing the risk. This is accomplished by analyzing factors such as the creditworthiness of customers, the payment history, and the size of the outstanding balance.
Portfolio theory could also be used to analyze the impact of different credit policies on the accounts receivable portfolio. For example, a company uses portfolio theory to evaluate the trade-off between extending credit to a broader range of customers, which may increase sales and revenue, versus tightening credit standards, which may reduce the risk of bad debt.
In addition, portfolio theory could be used to evaluate the effectiveness of different collection strategies. For example, a company uses portfolio theory to analyze the trade-off between using a more aggressive collection strategy, which may result in a higher recovery rate, versus a more conciliatory approach, which may lead to a higher customer retention rate.
Organizations could reduce risk and optimize returns through account diversification and optimization, credit policy analysis, and collection strategy evaluation.
In summary, portfolio theory is a mathematical framework that may be applied to managing accounts receivable to reduce risk and optimize return. This is achieved through diversifying accounts, optimizing a mix of customers, analyzing credit policies, and evaluating collection strategies.