Credit terms that are too liberal, an invoicing system that is too slow or ineffective collection will put you in a position where your receivables will grow. Money that is tied up in this way is no longer available to produce more goods or provide services with the result of fewer sales. Replacing this money with borrowed working capital means increasing operating costs, resulting in lower profits.
You can tell when your receivables are too high and when an account has been on your books too long. Two simple tests that enable you to keep watch on the credit side of your business are:
- aging your receivables
- calculating the average collection period
Accounts receivable aging is the classification of receivables according to the date of the sale.
Four categories are normally sufficient:
- Current
- 30 Day
- 60 Day
- 90 Day and over
If you age as of June 30th, any account that had activity during June will be current, any that are active in May are 30 day, activity in April indicates they are 60 day, and activity in March or beyond will indicate 90 day or over. Your 30 day credit policy requires payment within 30 days making it easy to recognize who are your problem accounts.
Research shows that if you let accounts fall 90 or more days in arrears you will collect less than half of them. Another way to view written-off accounts is if your business generates a 10% net profit it will take an increase in sales of $10,000 to replace a bad debt of $1000.
The second test of your receivables is calculating the average collection period or the average number of days your customers are taking to pay their bills.
To calculate the average collection you need to know your accounts receivable total, in dollars and the average daily amount of sales made on credit. The collection period is simply:
- Total Dollars divided by the Daily Average Credit Sales
Example: Assume you have accounts receivable of $20,000 and you make average daily credit sales of $500 ($20,000 divided by $500 = 40 days). This tells you your customers on average pay in 40 days. If your credit policy is 30 days you will need to take steps to receive more prompt payments.
If you must decide if collection action is required on an account, review the file before you proceed.
Decide whether the account is:
- a cannot pay, willing but unable
- or a won't pay, able but unwilling.
The first may have some problem now but may pay in the future and return to be a valued customer.
The second is better out of your books as soon as possible.
Choose to deal with these two situations differently:
- patient but firm with the first
- a pay or else attitude with the second
Remember you are not a banker and cannot afford to be a lender to your customers.
Paid up customers buy more. The prompt receipt of your accounts receivable reduces the costs associated with your business and allows you to provide lower prices and better service.
