Converting accounts receivable to cash is a critical process in developing healthy cash flow. While recording an account receivable is accomplished through a simple accounting transaction, the process of maintaining and collecting payments from your customers requires a firm commitment to a systematic accounts receivable management process. To most effectively convert accounts receivable to cash, it is essential that the credit and collection process be highly efficient so that you can shorten the accounts receivable cycle time.
The accounts receivable cycle begins with a sale (credit sales) which in turn creates an account receivable (money owed to your business) and then eventually converted to cash. The time it takes for your business to complete this cycle, from sale to accounts receivable to cash, is the collection period. The shorter the collection period, the less time cash (equity) is tied up in the business process, and therefore the better for your company’s cash flow.
Try to limit outstanding accounts receivable to no more than 10 to 15 days after your credit terms. If your credit terms are net 30 days, then the collection period should not extend beyond 45 days. Please note that average collection periods vary due to industry standards, company policies or customer financial conditions. Comparing your company’s actual pickup days to the average pickup days within your industry is good business practice. It’s also a good idea to compare your actual billing days to your projected billing days (no more than 10-15 days in credit terms).
Your company’s average billing period is calculated using an average billing period ratio. The relationship is called the Activity Relationship; measures how quickly your business converts non-cash assets into cash assets.
Average Collection Period (ACP): ACP = Accounts Receivable / (Credit Sales/365))
A high average collection period means that your business may be too liberal in granting credit to your customers and too lax in the collection process. A low number of days in your collection period could mean that your credit and collection policies are too restrictive. This restrictive position may be holding back your sales.
The Accounts Receivable Turnover Index (ART) is an accounting measure used to quantify the efficiency of your company in the granting of credit, as well as in the collection of its debts. This ART Ratio is considered a Liquidity Ratio; measures the availability of cash to pay off debt.
Accounts Receivable Turnover (ART): ART = Net Credit Sales / Average Accounts Receivable
A high receivables turnover rate implies that your business operates in cash or that your credit extension and receivables collection are efficient. A low ART ratio means your business needs to reevaluate its credit policies to ensure timely collection of monies due from the accounts receivable ledger.
A key requirement for effective sales and accounts receivable management is the ability to intelligently and efficiently manage the entire credit and collection process. A better understanding of a customer’s financial strength, credit history, and trends in payment patterns is paramount to reducing their exposure to bad debt. While a comprehensive collections process greatly improves your cash flow, your ability to penetrate new markets and develop a broader customer base depends on the ability to quickly and easily make well-informed credit decisions and establish credit lines. adequate credit. Your ability to quickly turn your receivables into cash is possible if you execute well-defined collection strategies.
Credit process:
The initial requirement of an effective credit management process is that each company you plan to do business with completes and signs a Credit Application form. Your credit application form should include “Terms and Conditions of Sale”, a space for the prospective customer to provide background information on the business, a list of primary owners with their ownership percentage, three to five references credit card and the name of your bank(s).
It is important to personally review your projected product purchases, both in dollars and units, with the prospect. This review helps to initially assess the amount of credit needed to purchase the projected products. This review also helps determine inventory requirements based on a projected sales forecast.
Collection process:
An efficient and effective collections management process includes well-defined policies and procedures that facilitate a more convenient sell-for-cash cycle. Collection procedures require “attention to detail” and must include:
- Billing: Preparation, registration and sending of invoices as soon as the product/service is delivered or installed.
- Account statements: Preparation, registration and delivery of follow-up statements that indicate the age of the outstanding balances.
- Accounts Receivable Aging Calendar – Preparation and distribution of an aging calendar that lists all customer accounts that have outstanding balances. These outstanding balances are classified into 4 time categories: 1 to 30 days, 30 to 60 days, 60 to 90 days and more than 90 days.
- Phone Calls: Making courteous and professional follow-up phone calls to customers with past due and outstanding balances in order to set up a payment date.
- Collection Letters: Preparation, recording and sending of collection letters with an urgent message demanding payment and providing details of the action to be taken if payment is not received by a certain date.
- Registration of payments: Publication of the amount of the payment in the account of the corresponding client. If possible, it is advisable that the person performing the collection functions not be involved in posting payments.
- Deposits of collected funds: The preparation of the deposit slip, along with the accompanying funds, must be deposited with the bank in a timely manner.
Factoring as an option:
Very simply, factoring is short-term financing obtained by selling or transferring your Accounts Receivable to a third party – at a discount – in exchange for immediate cash. In most cases, the third party, a factoring company, audits your accounts receivable to determine your ability to collect. If the factoring company believes that your accounts receivable are bona fide, they will offer to buy the current accounts at a discount. A factoring company may also, under the right circumstances, purchase your future receivables at a discount to the face value of the receivables. The discount percentage depends on the age of the accounts receivable, how complex the collection process will be, and how collectible they are.
Once the factoring company collects on a particular account receivable, it will pay you the remaining balance of the face value of that account receivable, less your fee. Rates vary widely from one factoring company to another. Therefore, it is recommended that you do your due diligence before engaging the services of any particular company. Factoring fees are not insignificant compared to the amount of interest you might pay to a commercial lender. For this reason alone, you should consider factoring only as a short-term solution rather than a regular outlet to collect your accounts receivable.
Many businesses, in need of an immediate infusion of cash to survive and/or close their cash flow gap, could benefit from the receivables factoring process. Since failing businesses often resort to factoring as a last resort, many people may view it as a negative. While factoring can be a great way to generate cash quickly, you should consider the perception that factoring can convey to your customers and others in your industry. Your good judgment here should dictate whether or not your business could benefit from the quick cash flow that factoring provides, or whether or not it would simply be an added financial burden on your business.
Shortening your accounts receivable cycle time generates the healthy cash flow required to sustain your company’s growth and prosperity.
Copyright © 2008 Terry H. Hill
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