Managing your receivables in today's economy

The entire U.S. economy is under severe stress. According to recent figures from the American Bankruptcy Institute, business failures are rising throughout the country in every major industry sector. Confronted with this environment, receivables managers are increasingly pressured to ensure viability

within their respective organizations. While striving to maintain revenues, it's critical to exercise tight scrutiny in the granting of credit, so effective management of this asset-often the largest on the balance sheet-becomes a necessity in today's economic environment. Here's why the economy is stressed out and what you can do in the receivables management arena to strengthen your competitive position.

THEN AND NOW

The extended economic boom of the 1990s has come to a screeching halt as the American economy has slipped into a recession. Consumers who were tipsy in the last decade with a sense of newfound wealth resulting from a rapid run-up in stock market values are now reckoning with the reality of a major market correction. Many had borrowed against their lofty investment portfolios only to see them crumble, and since the sense of prosperity is gone, they're now spending accordingly and paying down debt.

Driven by this consumer demand in the '90s, American businesses loaded up on debt to meet capital expenditure requirements. Now that the economy has taken a turn south, much of corporate America has found itself overextended, and many industries are dealing with overcapacity issues.

Beyond the decline in consumer demand and overcapacity issues, there are several other problems with the economy:

* The sudden demise of the technology sector,

* The collapse of worldwide markets triggered by the events of September 11,

* An upswing in unemployment,

* An erosion of consumer confidence, and

* The uncertainty over the war on terrorism.

It all translates into a major burden on American companies who reckon with the prospects of meeting debt obligations and keeping wary investors happy.

In this economy, businesses in the entertainment and travel industry are most vulnerable. Despite a massive government bailout initiative, airlines in America are laying off thousands of employees, eliminating hundreds of daily scheduled flights, and issuing warnings of potential future business failure. On September 25, 2001, Renaissance Cruise Lines shut down and filed for bankruptcy. The hotel industry has seen significant declines in occupancy rates, and the gaming industry has been hit particularly hard, with occupancy rates in Las Vegas hovering at about 40% of maximum capacity.

Problems in the economy aren't just restricted to the entertainment and travel industry. Many well-known American businesses are struggling to keep their heads above water. Consider Polaroid. This company recently defaulted on nearly $1 billion in debt service with little alternative but to seek protection under bankruptcy. And it isn't alone: A recent article in The New York Times identifies Nordstrom, Ethan Allen Interiors, and Gateway as businesses in peril as a result of the current economic situation. The list will only grow. In addition, accounting irregularities and the overstating of profits have also taken their toll on a number of businesses including Enron, Global Crossings, and Adelphia Communications.

The current economic conditions, unfortunately, aren't likely to resolve themselves in the near future. The Federal Reserve has repeatedly reduced rates, and the federal government has infused massive amounts of capital into the economy through tax cuts and bailout funding. These stopgap measures that have served well to fire up the economy in the past haven't produced tangible results.

WHAT YOU CAN DO TODAY

Make no mistake about it, in these difficult times the primary job of the person responsible for the administration of credit and collections is to ensure that funds are collected as close to the terms of the obligation as possible. There should never be any doubt as to why this task is critical to the well-being of your organization. Your customers have an obligation to pay within the terms of the agreement, and it's the job of the manager of customer receivables to make sure that this obligation is met.

The receivables manager is confronted with doing a fine balancing act between managing receivables while satisfying counter philosophies of increasing revenues in a down economy and becoming more restrictive in credit granting as a hedge against the rise in business failures. Needless to say, restricting credit to marginal customers is going to negatively impact revenues, while relaxing credit terms to marginal customers will have a positive impact on revenues but will negatively impact receivables turn and lead to an increase in bad debts. This situation presents a major challenge to the corporate credit department because today's credit professionals are burdened with the responsibility of maximizing revenues for their business unit while containing or minimizing losses.

Receivables management requires the ability to control the flow of inventory, determine what constitutes a worthy credit risk, and administer systems that streamline the order-to-cash process. In order to do these well, you must address the following areas: procedures for review and extension of credit, methods to automate, performance measurement, and an efficient reporting system. Focusing on best practices will help maximize profits and minimize losses.

Implement Procedures

You need to establish procedures for review and extension of credit to attain corporate sales objectives while at the same time limiting potential bad debts to a level within the constraints prescribed by corporate fiscal policy. This means a credit policy must be in place. The credit policy is governed largely by the objectives of the business. How best to accomplish these goals depends on the application of good business sense and a combination of factors peculiar to the business and its respective industry. You should consider the following points when establishing credit policy and procedures:

* Nature and size of the business,

* Overall company objectives,

* Classes of customers,

* Competitive conditions, and

* Current business conditions.

There are four basic types of credit policies. For details on each, see "Choosing the Right Type of Credit Policy, p. 45?

Careful consideration of the advantages and disadvantages of each type of policy should help in choosing a good working credit policy for a particular business. Any policy must be somewhat flexible, but you should maintain a firm, businesslike attitude in the relationships with both the sales organization and customers. The terms of sale should be sound, practical, competitive, and clearly expressed, and the credit period should be clearly stated and adhered to as closely as possible.

Receivables managers who are most successful at maintaining equilibrium between ensuring receivables turn while maximizing revenue potential will likely maneuver their company into a very competitive position within its industry.

Automate

You'll want to adopt methods to vigilantly monitor each account within the receivables portfolio in order to identify those posing the greatest risk. Automation is the answer here. The rapid advance in risk-assessment software has resulted in sophisticated and affordable PC-- based software that screens entire customer portfolios in minutes and isolates those businesses that have the potential to fail. In the past, screening thousands of customers would have required a substantial number of analysts.

Establish Performance Measures

You should also adopt a set of performance measures that monitor compliance with the policies. By design, these measures should examine all aspects of the order-to-cash process to ensure maximum efficiency and turn of receivables dollars. Meaningful measures must do the following:

* Fill the need of a specific objective,

* Be compared to a standard or it has no meaning,

* Be consistent,

* Be used to take action,

* Provide a benefit, and

* Be communicated in association with the standard.

We should remember that what gets measured gets done. If a measure doesn't accomplish a purpose, don't use it. The measure should be designed to support the organizational goals. Standards should be established in accordance with past organizational or industry values and trends in order to facilitate internal month-to-month or year-to-year comparison or comparison to industry standards. In a tight economy, working-capital turn is a key component. Investors and lenders want companies with a good credit rating and conservative, liquid balance sheets. To see how you compare, you'll want to benchmark your business within its respective industry to ensure a sound competitive position. Measuring your position is only relevant if you're able to compare that measure to a baseline that tells you whether you are average, above, or below average in relation to others within your industry.

Some measures to consider when evaluating receivables performance include:

* Days' Sales Outstanding (DSO),

* Best Possible DSO (BPDSO),

* Average Days Delinquent (ADD),

* Collection Effectiveness Index (CEI),

* % Current,

* % over XX Days,

* Gross Bad Debt to Sales, and

* Active Customers per Credit Employee.

Communicate

Communication is the catalyst to creating efficiencies and productivity within the organization. It's important that receivables management keep sales and customers alike informed of changes in terms and the credit status of individual clients. The credit department is generally the first to know of a breakdown in the system as the customer often withholds payment because of shipping issues or product quality, etc. As these issues become apparent, it's essential that the problem be brought to the attention of the appropriate parties within the organization.

Efficient reporting systems ensure adequate communication in the organizational structure. The key word here is efficient. Many organizations overburden themselves with reporting to the point where it hampers operational initiatives. Reporting should be employed in a strategic manner to allow others within the organization-those who have a need to know-to learn what you're doing and how successful you are at doing it.

Before assembling a report, ask several questions:

* What is the purpose of the report?

* What should be the distribution?

* What is the frequency of the report?

* What will be the format of the report?

BANKRUPTCY 101

The sudden economic downturn will only accelerate the occurrence of major bankruptcies, so it's also imperative to have a general understanding of the intricacies involved in the bankruptcy process. This will ensure maximum return in what might otherwise be a devastating financial blow to your organization. To protect your organization's position in Chapter 11 cases, a complete understanding of the automatic stay, reclamation process, defenses in preference proceedings, and claim-filing procedures is essential. There's also a need to understand appropriate protocol and fiduciary responsibility in the event the bankruptcy court appoints your organization to serve on a creditor's committee.

A FINAL NOTE

The pressures of today's uncertain economic situation coupled with the challenges of an ever-changing business environment dictate the need to embrace core business practices that ensure viability in managing the largest asset on the balance sheet of most American businesses today-- accounts receivable. The role of receivables management is critical in lending to the assurance of consistent revenue growth, maximization of cash flows, and increased profitability resulting from limited write-offs. Policies should complement the organizational mission. Measures should monitor compliance with the policies, and an effective reporting system should keep the organization informed of the role receivables management is playing and its impact on the business. An understanding of the laws that relate to bankruptcy and the extension of commercial credit also is essential. These strategies should keep your company growing strong in a weak economy.

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Credit Policy

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Among the alternative types of credit policy you can choose are strict analysis of risk and strict collections, strict analysis of risk with liberal col

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lections, liberal analysis of risk and vigorous collection effort, or liberal analysis of risk and liberal collections.

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Strict Analysis of Risk and Strict Collections

Under this policy, only high-credit-rated accounts are accepted, and very little variation from terms is allowed. The analysis of risk is thorough; collection efforts require a greater effort, and selling may be restricted. But the increased effort may pay sizable dividends in the form of improved accounts receivable turnover and minimal bad-- debt losses, leading to increased cash flow and profitability.

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Strict Analysis of Risk with Liberal Collections

This policy is somewhat more liberal in its collection procedures. It concentrates on the selection of good credit risks but doesn't aggressively press for payment. The assumption is that the good risks will, on average, pay their bills within terms; any additional time is less expensive to carry than the cost of following up accounts that are only a few days past due. If your cost of capital is high, this type of policy may not be wise, especially when

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customer orders involve sizable dollars, A more prudent course would be to follow collections closely.

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Liberal Analysis of Risk and Vigorous Collection Effort By emphasizing collections, this policy is the opposite of the one above. The credit analysis is liberal, so nearly all customers that apply will be accepted. But once the sale is made, close control is kept over collections. This type of policy would normally be followed in organizations selling high markup, low unit-price goods or services. The cost of credit analysis is relatively low in this type of credit policy, but collection costs are usually quite high.

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Liberal Analysis of Risk and Liberal Collections

Very few lines of business would find this policy profitable to operate. One advantage might be that it lends to lower credit costs. Yet the costs related to carrying receivables for long periods coupled with a resulting increase in bad-debt expense more than offsets the savings. The principal motivation for a company adopting this policy is to obtain maximum sales volume. For this policy to be effective, profit margins must be set high enough to counter the slow turn in receivables and resulting bad-debt losses.

AUTHOR_AFFILIATION

Lyle Wallis, CCE, is vice president of research for the Credit Research Foundation, the foremost nonprofit, member-- supported, education and research organization dedicated to the credit and financial management community. It provides training in portfolio reporting, failure prediction, credit and financial analysis, best practices in the cash-- conversion cycle, and commercial and bankruptcy law. CRF's website is www.crfonline.org. You can reach Lyle at lvlew@crfonline.org or (410) 740-5499.