Accounting: The Language of Business - Vol. 2 (Intermediate: Part 151)

Pay what you owe to others (James 5:4-6) ...

Short-Term Operating Assets: Cash and Receivables (Part P)

by

Charles Lamson

Interview

Dalton Smart

 Senior VP: Finance/Controller,

Merck & Co.

Dalton Smart

Dalton Smart is Senior VP: Finance/Controller for Merck & Co ., a leading U.S. pharmaceutical company.

Merck is a major international pharmaceutical company that sells its products through pharmaceutical distributors to different channels, including government, public and private health care institutions, and well-established retail pharmacy chains. So we must look beyond the distributor to the type of end user to evaluate the conversion of receivables to cash. Although they may pay slowly, governments eventually pay their bills; this reliability reduces our credit risk dramatically. Also, pharmaceuticals are a cash-flow-rich industry in contrast to industries such as manufacturing. A manufacturer selling to hundreds or thousands of small customers faces different credit risk worries than Merck, whose customers are large and more centralized. Merck is less concerned about the ability to pay than the timing of receivables.

We start with the type of customer and the quality of information we receive and then assess the potential customer's credit profile, credit rating, and financial statements. We look differently at government-related payers who pay in due course, such as nationalized healthcare systems, than we do emerging market customers. It is challenging to get good quality data from emerging market customers to access credit risk. We rely on various sources to determine the speed at which inventory is being consumed so that we record revenue at a speed consistent with the sales of products to end customers. We also watch such factors as days sales outstanding (DSO) and inventory levels where rising trends may indicate a larger period to receive cash. Finally, we consider market size, growth rates, and our market growth relative to that of our peers.

Consistent with GAAP, Merck applies the allowance method [(an estimate of the amount the company expects will be uncollectible made by debiting bad debt expense and crediting allowance for uncollectible accounts (Study.com)] to account for bad debts. Using the allowance method allows us to record revenues and expenses in the same period incurred. There is an inherent risk that customers could default on a payment, so accounts receivable are recorded at their net realizable value [the value for which an asset can be sold, minus the estimated costs of selling or discarding the asset (Corporatefinanceinstitute.com)] in each monthly accounting period, we calculate the receivable balance and estimate the allowance for bad-debt expense. We closely evaluate both a customer's ability to pay, based on financial metrics, and intent to pay, demonstrated through payment history and maintenance of performance ratios. We look for any significant changes in customer circumstances and monitor multiple metrics such as receivable aging and turnover ratios and financial condition changes such as bankruptcy proceedings, litigation, and credit-rating downgrades. Once we see gaps in a customer's payment history, we quickly analyze its ability to pay. Then, on a monthly basis, we examine bad debt expense and the number of write-offs as it relates to the overall reasonableness of the allowance for bad debts, and adjusting as required.

In addition to analyzing ability and intent to pay, we focus on whether we have exhausted all collection efforts, if there are any disputed balances, and if other public information exists about the customer. Another important factor that comes into play is the type of customer, Merck sells mostly to wholesalers, who then sell to the healthcare industries and customers---all with different speeds of receivables collection. We take the payment time frame into account, evaluating customers by type.

In certain markets, selling receivables works to Merck's advantage. We know that governmental institutions will eventually pay us, but we may want to collect now rather than wait. Our analysis of whether to sell receivables is a financial decision based on the rate we can receive for those receivables and our cost of capital. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., P. 474*

end