By Maurie Cashman
Accounts receivable management relates to business value. Collection of accounts receivable requires diligence on the part of management, and accountability by the right people in your organizations.
1) Accounts receivable are an asset on a company’s balance sheet. All assets must be funded, either by owners’ equity or by external funding. Lower levels of accounts receivable are better given the current level of sales. If we can lower accounts receivable by $1 or by $1 million, that is $1 or $1 million less that we have to borrow or to retain on the balance sheet. Keep this in mind every time you look at A/R.
2) Customers are the source of accounts receivable. The only way we get accounts receivable is by making a sale on credit to a customer. Accounts receivable are a good problem to have. But when we do business with customers without collecting cash payment, we essentially lend money to our customers. So it is a good idea to understand each customer’s ability to pay. You have the opportunity to examine customers’ financial statements in the process of proposing business and to make a judgment about ability to pay based on this review, other information provided and any independent investigation you conduct. Banks don’t lend money to their customers without first qualifying them. Neither should you.
3) Your accounts receivable to a customer is an account payable for them. Their account payable to you is an interest-free loan from you to them. While a dollar less of A/R is good for you, a dollar more of A/P is good for them. In normal times, companies pay A/P and collect A/R within normal trade terms. But when times get tight with customers, there can be a tendency for them to stretch their A/P days outstanding. If yours is one of their A/P (your A/R), then they will silently ask you to lend them your good money interest-free, perhaps for a long time.
4) Accounts receivable “turnover” is the rate your A/R “turn,” or are collected. Turnover can be measured in a couple of ways. One way is to measure the number of times your A/R turn in a year. A/R Turns = Total Credit Sales / Average Accounts Receivable. Days A/R Outstanding = (Average Accounts Receivable / Total Credit Sales) x 365. For A/R Turns, assume sales are $10.0 million for the last twelve months, and average accounts receivable are $1.0 million. So the A/R turns are $10/$1 = 10x. The other ratio, Days A/R Outstanding inverts the ratio and multiplies by the number of days in a year. Days A/R Outstanding is equal to ($1 / $10) x 365 = 36.5 days.
If your A/R turnover is 2.0x your days A/R outstanding are 182.5. Relative to a firm with 35 days outstanding, you are waiting an additional 150 days, on average, to collect A/R! Do the math. The first business above was doing $10 million in sales with $1 million in A/R. If you have $2.5 million in A/R, and $5 million in sales, at an A/R turnover of 10x, you should have about $500 thousand in A/R. So you’ve got $2 million in very slow paying or potential loss receivables. No rational purchaser of your business would want to take on the task of collecting those receivables. So the value of your business is being hampered by your accounts receivable management policies.
5) Accounts receivable get harder to collect as they get older. Businesses tend to look at A/R in terms of various “buckets” of aging like: 1) current (usually meaning 30 or less old), 2) 31-60 days old, 3) 60 to 90 days old, and 4) over 90 days. What I have learned is that the older that A/R become, the higher is the probability that they will be written off. When you work on someone’s behalf, or you deliver product or services to your customers you should have an expectation of being timely paid. We have a contract, or engagement letter, for every assignment. We promise to deliver, and we do. We expect our clients to honor their contracts and to pay us according to the schedule in the contract.
6) Watch credit quality like a hawk when sales are tough. There is a real temptation to take on business of marginal credit quality to keep sales flowing. This tendency may be good temporarily for commissions for salespersons, but it is disastrous for the business and the salespersons in the longer run. The credit folks in your business have to be vigilant. No one wants today’s sales to become tomorrow’s write-offs, because write-offs do not produce cash, they waste cash, and cash is the lifeblood of any business.
7) Have policies for the collection of accounts receivable. Years ago, I became General Manager for a manufacturing business that was selling a lot but collecting very slowly. I saw very quickly that the company had no real policies for A/R collection. When receivables became stale, or more than 90 days old, they were given to the controller to make calls for collection. The controller did not have an aggressive manner and customers were able to bully him. In the meantime, the sales force continued to make sales to, and collect commissions from, customers with high receivables balances. I took the late collection responsibility from the controller, gave it to the salespersons and told them that they would have the problem until they solved it. We enforced it by changing commission policy to stop payment of all commissions on any account that was overdue until it had been brought current. Within 90 days, we had cut the A/R by 40%, and within six months, we were turning at industry levels. We added $12 million to cash flow by collecting those aged A/R. That $12 million did not have to be borrowed and could be used to pay down debt or to purchase plant and equipment.
8) Position collection responsibility with the right people. We had to take collection responsibility away from the controller in the example above. Accounts receivable collection should be handled by those with accountability for the sale and the customer. We changed the accountability and made our sales force extremely uncomfortable. They were concerned that they would lose accounts if they got tough on collection. Sales are of no value if the money is not collected. By making our salespeople responsible, we were able to deepen their relationship with our best customers.
9) Your best customers want you to succeed. Your customers rely on you and don’t want other customers (perhaps their competitors) to put you in financial jeopardy. They will still do business with you and may even feel better about you. Problem accounts should be reviewed as to whether they should remain customers
10) Your accounts receivable may indicate another problem. I became the CFO for a production company a number of years ago. We were selling a perishable product on contract to large customers that had multiple relationships with our company. Our receivables had exploded to the point that our average collection was nearing 6 months, about $25 million. The survival of the business was at stake. It was a very complex issue involving crashing commodity markets, a severe product quality that was not being addressed, and accountability for A/R with someone who could not make decisions. I assumed the task of resolving the A/R issue. The first thing we attacked was the product quality problem. We had simply not been able to get our arms around this very difficult problem and our production team did not understand the problem it was creating for our customers. So we found a temporary source of product which we were able to sell to our customers until we could get our production back online. We also sat down face to face with our customers and aggressively worked out the A/R problem, crafting an individual solution for each customer. This required us to take significant write-downs in some cases and to make contract modifications in others. It was a brutal process, but with nine months we had eliminated our receivables issue and had put checks and balances into the system to prevent it from ever happening again. At the end of the year we had earned back the respect of our customer base.
11) Your Accounts Receivable policies can cost you real money. I had dinner with a private equity investor a few years ago and we talked about how they looked at potential acquisitions. I asked him about what he looked for in accounts receivable management. They had just acquired a business with $40 million in sales. The EBITDA margin was 9%, and the multiple paid was 5x, which included a discount related for uncollectable Accounts Receivable. The purchase price was $18 million. Due diligence of accounts receivable management had indicated no significant credit issues. The receivables were turning 8.1x, or about 60 days outstanding. Industry standard was about 45 days. Based on their experience, they believed they could improve collections to industry standard within 120 days. Within 120 days of purchase, they had lowered Accounts Receivable days outstanding from 60 days to 45 days. That meant that the private equity buyers lowered Accounts Receivable by $1.7 million, or nearly 10% of the purchase price. By the end of the first year, they had lowered the collection period to 40 days. In all, they pulled $1.8 million out of working capital that immediately was available to pay down their acquisition debt.
The owner of the business left $1.8 million on the table because of poor accounts receivable management, and the new investors paid down 14% of their acquisition price because of their aggressive accounts receivable management. If that money had already been taken out of the business before the acquisition, chances are the sale price would have been pretty much the same.
Every firm that does business on credit needs to have a set of excellent accounts receivable management policies that are implemented and monitored regularly. Managing accounts receivable is not rocket science. However, your policies need to be clear and followed.
Look at your accounts receivable today. Are there any ideas above that are helpful?
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