Managing your accounts receivable should be one of your top priorities. Business owners or senior managers should be highly involved on a day-to-day basis. In good times and bad you need to ensure your A/R is as current as possible.
Accounts receivable is the hard-earned yet uncollected money your customers owe you. Although not yet cash on a business’s balance sheet, it is the closest asset to cash for most businesses and should be managed just like cash deposits. Assuming your business earns a 5 percent net margin, for every dollar of A/R or cash lost, you must generate an additional $20 in new revenue to replace it. And keep in mind that there’s a higher chance of bad debt write-off during an economic slump. You can follow these strategies to keep payments coming:
- Know A/R days of turn: Accounts receivable turnover is a performance measurement of overall A/R collection. As the number of days it takes to collect increases, the “strength” of the overall A/R weakens. A decrease in the average turnover is a positive sign of A/R strength. You can calculate receivable turns and number of days outstanding using the following formula:
Credit Sales by Month / Average Outstanding A/R = Receivable Turns
Then take Receivable Turns / 365 = Number of Days Outstanding
- Communicate with your customers: Taking a highly proactive approach to A/R management is critical. Call regular customers when they pay on time and let them know you appreciate their business. This makes it much easier to call when payment is late. Using a persistent soft collection approach is often all it takes to keep your customers current.
- Grant credit to new customers cautiously: Especially in downtimes, beware of new customers who suddenly want to move all their business from a competitor to you. Often the prospective customer is making the quick switch because he or she has hit hard times and has been put on credit hold by his or her existing supplier. Require new customers to fill out a credit application, and check their references. Obtain a business credit report if the customer is substantial enough to impact your overall accounts receivable balance. Some businesses require 50 percent down with the first order. This helps qualify a new customer’s ability to pay.
- Watch for trends in total A/R: A good A/R manager can spot trends in overall collection of accounts receivable and with individual customers. If the overall A/R days of turn are increasing and the business’s collection and credit practices haven’t changed, this could be a sign of an overall weakening in business among all customers. When one of your customers starts stretching out payments, contact the customer and open lines of communication.
- Set credit limits and review regularly: Many businesses make the mistake of not setting customer credit limits in their computer selling systems. Credit limits for new customers are especially important. Set a credit limit so the system alerts you when the customer’s outstanding A/R balance is about one and a half times the last 12-month average. Credit limits can be overridden if the customer warrants a credit increase temporarily. When a customer has a large credit limit and isn’t using most of it, reduce it to avoid surprises.
Using these credit management techniques, you can improve overall collections and reduce accounts receivable days of turn. Few businesses can escape a year without a small amount of bad debt write-off, but the key to good A/R management is keeping all of your accounts receivable as current as possible.
Sam Thacker is a partner in Austin, Texas-based Finance Solutions.