Are You a Lender of Last Resort?
Neglecting your accounts receivable will inevitably prove to be a very expensive management mistake. Following are the most common reasons why a company experiences a growing list of receivables:
Credit terms are too liberal
An invoicing system that is too slow
Ineffective collection strategy
Money that is tied up in aging receivables is not available to invest within the organization to produce more goods and/or services, resulting in fewer sales. Replacing this tied up money with borrowed working capital increases operating costs, resulting in lower profits.
Many of our clients ask how one can best determine when their receivables are too high or when an account has been on their books too long. The two simplest tests to enable you to keep watch on the credit side of your business are:
Aging your receivables
Calculating the average days sales outstanding (DSO) or average collection period
Aging Your Receivables
Aging your receivables is the classification of outstanding receivables according to date of sale.
Four categories are normally sufficient:
90 Day and Over
If you age your accounts as of October 31, any account that had activity during October will be current, any that are active in September are 30 day, activity in August indicates they are 60 day, and activity in July or prior would be 90 day and over. With your credit terms being established at net 30 days, requiring receipt of payment within 30 days it is easy to recognize who your problem customers are.
Research shows that if you let accounts fall 90 days in arrears you will collect less than 75% of them. As time marches on your probability of collection diminishes. Another way to view your written-off accounts is in terms of profit replacement. If your organization generates a 10% net profit it would take an increase in sales of $10,000.00 to replace a bad debt of $1000.00
Days Sales Outstanding (DSO)
The second test of the health of your receivables is by calculating the average days sales outstanding (DSO) or the average number of days your customers are taking to pay your invoices.
To calculate your DSO you need to know your accounts receivable total in dollars and the average daily amount of sales made on credit. The DSO is simply:
Total Dollars divided by Daily Average Credit Sales
Example; Assume you have total outstanding accounts receivable of $40,000.00 and you make average daily credit sales of $1000.00 ($40,000.00 divided by $1000.00 = 40 days). This establishes that your customers on average pay in 40 days. If your credit policy is net 30 days this identifies that you will need to take steps to receive more prompt payment.
Review Your Past Due Customers
Review your past due customers to determine the most effective collection action by determining if the account is:
1. a cannot pay, willing but unable
2. a will not pay, able but unwilling
The first type may have some temporary problems now but may pay in the future and return to be a valued customer. The second type is better off your books as soon as possible.
Handle these two situations differently:
1. patient (within reason) with the first
2. a pay or else position with the second Remember, if your business is not a lending institution, you are not a banker and cannot afford to be a lender of last resort for your customers.
Paid up customers buy more. The prompt receipt of payment reduces the costs associated with running your business and allows you to provide more competitive prices and better customer service.
From William Shakespeare (Hamlet 1:3)
“Neither a borrower nor a lender be
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry."
…Some food for thought.