Controlling Risk in Accounts Receivable Management

In granting trade credit, the credit manager must weigh the expected profit from a sale against the risk of customer default. A common procedure is to sell on credit only to those customers whose risk of default is below some critical level. This procedure does not effectively control a firm's ratio of bad debt to sales. In this paper, formulas are derived for the variance of this ratio under various assumptions regarding the number and size distribution of customers. Knowledge of this variance enables the credit manager to more accurately control his credit losses.