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


dr Grzegorz Michalski, Assistant Professor, Wroclaw University of Economics, Department of Corporate
Finance and Value Management, Wroclaw, Poland, ul. Komandorska 118/120, Z-2, KFPiZW; PL53-345
Wrocław, Poland, ph. +48503452860, fax +48717183313, Grzegorz.Michalski@ue.wroc.pl;
http://michalskig.com/
ACKNOWLEDGMENT: the research is financed from the Polish science budget resources in the years 2010–
2013 as the research project NN113021139

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kind of decision shapes the level and quality of 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
FCNPOt
p  ( EREVt  CEt  NWRt  CAPEX t )  FCNPO  Vnpo   ,
t 1 1  CoC 
t
(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; ∆Vnpo - nonprofit organization

2
efficiency increase; ∆FCNPOt - future free cash flow growth in period t; and CoC - discount
rate equal to cost of capital rate.
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, see: (Michalski, 2012; Maness, 1998, pp. 62-63). 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, p. 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

3
to these three components influence the efficiency of the NPO (ΔVnpo = 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.

Figure 1. The accounts receivable policy influence on nonprofit organization efficiency

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 ∆Vnpo.
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

4
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 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:

CR0 CR  CR0 (3)

AAR   ACP1  ACP0    VC  ACP1  1 , if CR1  CR0
360 360
CR CR  CR0
AAR   ACP1  ACP0   1  VC  ACP0  1 , if CR1  CR0
360 360
where: ΔAAR - forecasted accounts receivable increase; ACP0 - receivables collection period
before change of accounts receivable policy; ACP1 - receivables collection period after
change of accounts receivable policy; CR0 - forecasted cash revenues from sales without
change of accounts receivable policy; CR1 - 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:
EBIT  (CR1  CR0 )  (1  VC )  k AAR  AAR  l1  CR1  l0  CR0   sp1  CR1  w1  sp0  CR0  w0  (4)

where ΔEBIT = ΔNOPAT - forecasted increase of earnings before interests; kAAR - forecasted
operating costs of managing of accounts receivable in the NPO; l0 = forecasted bad debts

5
loses without accounts receivable policy change; l1 - forecasted bad debts loses after accounts
receivable policy change; sp0 - cash without accounts receivable policy change; sp1 - cash
discount after accounts receivable policy change; w0 - forecasted part of purchasers using cash
discount without accounts receivable policy change; and w1 - 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:
ΔFCNPO0= (–ΔNWR)= (–ΔAAR) (5)
Next the free cash flows to the NPOs in periods (from 1 to n), as:
ΔFCNPO1…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 CR0 =
€2,000,000. According to the same forecast VC = 40% × CR. Forecasted operating costs of
accounts receivable management in the organization, kAAR = 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 CR1 = €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 30th day, the rest, 20%, will be regulated up to the 14th day, then the ACP0 is:
ACP0  0.8  30  0.2  14  26.8 days.
The ACP1 after the change is:
ACP1  0.6  40  0.4  10  28 days.
That is why the expected increase of the average level of accounts receivable will be:

6
 2000 000 1000 000
AAR  28  26.8   0.4  28   €37,778.
360 360
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  1000 000  0.6  30%  37 778  (4%  3000 000  3%  2000 000) 
 (3%  3000 000  40%  1%  2000 000  20%)  €496, 667

Next, the management team of the NPO can estimate change in the organization’s
efficiency:
496,667  1  37,778
Vnpo  37,778   1  10 
 10
 €2,201,504 .
0.18  1.18  1.18

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:
496,667  (0.81)  1  37,778
V fpo  37,778   1  10 
 10
 €1,777,412 .
0.18  1.18  1.18
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} 4000 4000
{δ} 3500 3500
{ε} 3600 3600
{ζ} 2000 3000
{ι} 4000 4000
{μ} 5000 5000
Expected Cash Revenues (EREV) 2000 3000
Fixed Assets (FA) 2900 2900
Bad debts loss 3% 4%
Scount sale share 20% 40%
Scount sale days 14 10

7
 Trade credit share 80% 60%
Trade credit days 16 30
Variable costs share (VC) 40% 40%
Scount rate 1% 3%
Accounts Receivable level (PAR) 148.89 233.33
Inventory period (days) 20.00 20.00
Inventories level 44.44 66.67
Accounts Payable period (days) 30.00 30.00
Accounts Payable level 66.67 100.00
Operating Cash level 15.31 23.16
ACP (days) 26.80 28.00
PAR / EREV 7.44% 7.78%
kAAR 30% 30%
Cash Expenses (CE) 1090 1490
Non Cash Expenses (NCE) 290 290
NOPAT 620 1220
Non Cash Expenses (NCE) 290 290
∆NWR (t-1) 141.98 223.16
CAPEX (t-1) 2900 2900
FCF (t-1) -3041.98 -3123.16
FCF (t) 620 1220
βe 1 1
Risk Sensitivity SZ {ϣ} 0.2 0.21
βLe 1.556238 1.569207
Risk Free Rate krf 5.97% 5.97%
Equity Risk Rate (ERP) 11.60% 11.60%
Cost of Equity Rate (ke) 24.02% 24.17%
βLd 0.7602 0.766535
Cost of Debt Rate (kd) 14.79% 14.86%
Debt to Equity (D/E) 1.00 1.00
CoC 18.00% 18.11%
NPO efficiency growth ∆V 402.38 3615.15
Incremmental efficiency change 3212.77
Where: {γ} – maximal outlets possibilities; {δ} – market absorption; {ε} – availability of
stocks; {ζ} – derived demand; {ι} – availability of infrastructure; {μ} – production
possibilities; βe - unleveraged and uncorrected equity risk indicator; βLe - leveraged and
corrected equity risk indicator; βLd - 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 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

8
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 fig 2. there is data collected for Polish NPOs, for the
years 2009 and 2010. 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).
Figure 2. Short-term receivables in Polish NPOs in 2009-2010. Logarithmic scale

9
Source: own calculations based on (BOPP).

Table 2. Short-term receivables and other short-term levels in Polish NPOs in 2009-2010
- Inventories Short-term Long-term Cash Equity Long-term Short-term
receivables receivables debt (DL) debt (DS)
Size of 337 337 337 337 337 337 337
population
Arithmetic 160667 237882 1078526 1009797 4985934 54311 390571
mean
Standard 541755 886863 4075482 4050570 33992157 243401 902069
deviation
Median 35121 58202 132361 128318 345681 - 98900
Winsorized 52154 75577 260279 229818 763033 - 148915
mean
Truncated 220169 258843 1225386 1138878 3679884 95 559707
mean
Skewness 11 10 10 10 12 7 4
Source: own calculations based on (BOPP).

Figure 3. Receivables conversion period in Polish NPOs in 2009-2010. Logarithmic scale.

Source: own calculations based on (BOPP).

10
Table 3. Receivables conversion period and other short-term characteristics in Polish NPOs
in 2009-2010.

- Receivables Payables Inventory Operating Cash

conversion conversion conversion cycle conversion
period period period cycle
Size of 337 337 337 337 337
population
Arithmetic 1257 220 3037 4294 4074
mean
Standard 22240 2694 54783 77023 77078
deviation
Median 14.16 20.38 8.25 28.64 4.3
Winsorized 19.51 25.77 15.2 40.54 10.69
mean
Truncated 62.27 88.72 65.62 145.6 69.51
mean
Skewness 18.36 17.93 18.36 18.36 18.33
Source: own calculations based on (BOPP).

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 14.16 or 19.51 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.

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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

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 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.

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