September 5, 2019
Cash is King! And healthy accounts receivable (A/R) makes for a sustainable kingdom that promotes an environment of profitability and growth. The management of A/R is an extremely important area of accounting. A business that doesn't have control of its A/R will usually have poor cash flow and have trouble meeting its expenses in a timely fashion and is usually a sign that there are other financial issues that will hamper growth and sustainability.
When you sell your services, you generate top line income. If you collect the money, its cash in the bank. But what about when you don’t collect? Obviously, you create A/R, but with no money in the bank. As business people we understand that there is a difference cash and A/R but many of us have trouble managing cash flow as opposed to managing net income. Effective A/R management is the first step in effective cash flow management.
Many of us know how to manage a P/L. However, just because we show a profit doesn’t mean there is cash in the bank to pay the bills. We don’t pay bills from the bottom line. We pay them from cash in the bank! Take for example the PCO that provides services to his customers for $50,000 for a month. If his technician labor, materials, vehicle costs and other direct costs amount to 50% or $25,000 leaving a gross margin of 50% and his sales and other non-direct costs are another 35% or $17,500, he is left with a 15% or $7,500 net profit. Not bad! But what happens if he only collects 75% of his sales or $37,500? He is owed $12,500 and is short not only of his net profit of $7,500, but another $5,000 needed to pay his bills.
Most of us understand this concept as it is fundamental to managing a business. But why do many of us have trouble executing an effective cash management program? Are we to aggressive in trying to make that sale by giving overly generous terms to our customers? Or have we designed our business to service mostly commercial accounts that take a minimum of 30 days to pay? Under either scenario we may not be doing the wrong thing. But we better have a plan to either collect that money quickly or access other funds or credit lines to fund the current expenses of our businesses. In terms of formulating this plan, here are some factors that should be considered:
1. Don’t Become the Bank
Allowing your customers reasonable credit terms is not a bad idea. It’s when they take advantage and go beyond those terms that problems begin to surface. Banks make bad loans and you will have customers that don’t pay. In this situation, a bank won’t lend them any more money. When you run into this situation, you cannot grant them anymore credit without a firm commitment to pay. If they don’t pay for a service shame on them. If you then perform another service and they don’t pay, shame on you for servicing them without payment for the first service.
2. Attack the Problem
Accounts receivable management starts with laying out a formal procedure for collection. This procedure starts with an accounts receivable aging report. This report should categorize the firm's receivables by age. There should be a “Current”, “30”, “60”, and “Over 90 Day” column. At each point along the way a collection effort should be made (i.e. at 30 days perhaps a phone call to the customer, at 60 days perhaps a letter and at 90 days perhaps a stronger effort). In any event, the service firm should not allow a very large percentage of their receivables to go over the sixty-day column. History shows that the older a receivable is, the more difficult it is to collect. Carefully monitor your A/R aging report and call on those customers who have exceeded your credit terms both in amount and number of days past due.
Making collection calls is one of the worst jobs most people can think of. But, surprisingly, there are certain individuals who are good at it. Look at your team and see if there is someone who has a professional presence, adept at working with and handling difficult people, skilled at follow up and well-organized in order to document collection efforts. This is the person for the job. If not, there are outside agencies that you can outsource this task to.
3. Improve Company Cash Flow
Create a financial environment where days-to-collection with regards to A/R are less than days-to-payment with respect to accounts payable. This isn’t always easy but if you give your customers 30 days to pay, see if your material suppliers will give you 60 days to pay their bills and the like. This will ensure that you will have enough money in the pipeline coming in to meet the expense payments in the pipeline going out.
4. Ensure Access to available credit
If you are growing quickly, make sure that you have a credit line available to fund your outstanding receivables. On several occasions I have been asked to help with companies that are literally days away from going broke because they are growing so quickly, extending their customers payment terms but have no cash to make payroll or pay other expenses. If you are in this situation, you should speak to a CPA or other financial professional to do the projections necessary to secure a credit line that will allow for this growth.
Accounts receivable management is one piece of the financial and management function of growing a business. When managed properly, A/R management allows the successful service firm owner to operate from a position of strength and make sound business decisions about expansion, cost reduction and efficient operation of his firm.
As your firm grows there are several other aspects of financial management that should be explored and implemented. But the firm that successfully employs sound A/R management principles outlined above will accumulate much more in terms of wealth than the firm that manages their A/R poorly.