What Is Aging?
Aging is a method used by accountants and investors to evaluate and identify any irregularities within a company's accounts receivables (ARs). Accounts are sorted and inspected according to the length of time an invoice has been outstanding, enabling individuals to get a better view of a company's bad debt and financial health.
- Aging is a method used by accountants and investors to evaluate and identify any irregularities within a company's accounts receivables (ARs).
- Outstanding customer invoices and credit memos are categorized by date ranges, typically of 30 days, to determine how long a bill has gone unpaid.
- Companies apply aging to understand the effectiveness of its credit and collections functions and to estimate potential bad debts.
- Investors can use this same information to identify potential cash flow issues and insolvency risks.
AR is the balance due to a company for goods or services delivered or used but not yet paid for by customers. Listed on the balance sheet as a current asset, it tells us any amount of money owed by customers for purchases made on credit.
Aging involves categorizing a company's unpaid customer invoices and credit memos by date ranges. Schedules can be customized over various time frames, although typically these reports list invoices in 30-day groups, such as 30 days, 31–60 days, and 61–90 days past the due date. The aging report is sorted by customer name and itemizes each invoice by number or date.
Generally, the longer a sales invoice goes unpaid, the greater the chance that the company will fail to collect what it's owed.
Companies rely on this accounting process to figure out the effectiveness of its credit and collections functions and to estimate potential bad debts. Management revises the allowance for doubtful accounts and determines the historical percentage of invoice dollar amounts per time period that often become bad debt, then applies the percentage to the most recent aging report.
Example of an Aging Report
Company A typically has 1% bad debts on items in the 30-day period, 5% bad debts in the 31 to 60-day period, and 15% bad debts in the 61+ day period. The most recent aging report has $500,000 in the 30-day period, $200,000 in the 31 to 60-day period, and $50,000 in the 61+ day period.
Based on the calculation ($500,000 x 1%) + ($200,000 x 5%) + ($50,000 x 15%), the company has an allowance for doubtful accounts of $22,500.
Benefits of Aging
Aging makes it easier for companies to recognize probable cases of bad debt, stay on top of outstanding invoices, and keep unpaid bills to a minimum. Management teams that keep tabs on receivables and categorize them appropriately should be better placed to identify which customers need sending to collections, which require targeting with follow-up invoices and whether the company is collecting receivables too leisurely and taking on too much credit risk.
Often, aging is a useful tool to determine credit and selling practices. If a company experiences difficulty collecting what it's owed, for example, it may elect to extend business on a cash-only basis to serial late payers.
Aging can also be used externally by investors and analysts. Signs of a slowdown in a company's receivables collection might suggest sloppy practices. If action isn't taken swiftly to rectify these issues, cash may dry up and creditors might be put off lending the company money. Cash flow problems are a major red flag. Without liquid currency to invest and pay the bills, the company risks insolvency, regardless of how much revenues and profits it registers.
Limitations of Aging
Though useful, aging is by no means without flaws. Since many companies bill at month-end and run the aging report days later, outstanding accounts from a month prior will show up. Even though payments for some invoices are on the way, receivables falsely appear in a bad state. Running the report prior to month-end billing includes fewer AR and shows little cash coming in, when, in reality, much cash is owed.
In addition, management may extend particularly long or unusually short credit terms to specific companies, meaning that some invoices might appear extremely overdue or on time on the aging report when they are, in fact, not. As a result, it's important that the company's credit terms match the time periods on the report for an accurate representation of the company's financial health.
Unapplied credits on the report also require special attention. They can be cleaned up by finding which invoices they are applied against and reducing the amount of overdue receivables on the aging report.