10.27.2020 | Posted by Erik

How Much Are Your Accounts Receivables Costing You?

Expending time and energy overseeing your accounts receivable can be a frustrating task.  Every day that invoices are not paid by customers costs you money in the form of borrowing costs (interest) if you have a lender, poor cash flow that can force delayed vendor payments, affect payroll, and cause myriad other headaches.

Let’s explore the effects of slow-turning receivables on any company, large or small.

Borrowing Costs

Many companies borrow against their receivables and interest accrues every day an invoice remains unpaid.  Interest rates vary widely, from a bank’s or ABL’s low rates (below prime to Prime +2 or 5.5% annual and upwards), to a second or third tier lender’s high rates (1.5 to 2.5% per month, 18-30% annual). Low interest rates are often only available to larger companies that borrow significant dollars against their receivables. Smaller companies generally pay higher rates based on size and financial standing.

The number of days you can reduce your DSO translates into lower interest costs.  Collecting payments quicker from customers can save you tens of thousands of dollars annually depending on the amount you borrow.

Poor Cash Flow

The second, and maybe even more important issue, is the effect slow pay has on your business from a cash flow perspective. While there are a number of ways to measure AR turnover, most companies use DSO (days sales outstanding). For example, if you have 100 unpaid customer invoices billed on net 30 terms and they are all paid 20 days past their due dates, your DSO for those 100 invoices would be 50 days (net 30 + 20). More simply, DSO is the average number of days it takes to receive customer payments from the original date of the invoice.

A company borrowing against their receivables can expect an advance of 80% against outstanding accounts receivable (or range from 75-90%, but 80% is standard). This 20% holdback (reserve) held by the lender comes back to you, less any fees, when your customers’ payment is received. For example, if you have $250,000 in outstanding receivables against which you borrow $200,000 (80%), and on average your customers pay 20 days slow on net 30 terms, a total of $50,000 of your uncollected funds are hanging out there for the first 50 days. That is money you are unable to use until the customers pay their invoices. In this example, improvement in the collection of past due invoices by just 10 days puts $50,000 into your business that much sooner. The additional funds reduce the stress of tight cash flow while at the same time, it reduces borrowing costs.  You can see the significance of this problem if your average DSO is 60 days (net 30 + 30 days slow) or even higher.

No matter what terms you set for your customers – net 15, net 30, net 60, etc. – any company that can collect their receivables within 3-5 days of the due date is doing a very good job.  Certainly, it is unrealistic to expect all customers to pay within that time frame, but getting as many as possible to do so enhances cash flow.  As the number of days it takes to receive payment increases, more effort by experienced staff is needed to keep the funds coming in.  This effort translates into time and money.  The time they could be spending on other projects that could bring more revenue to your business.

Another way to reduce DSO is to shorten terms with your customers.  If you typically give net 60 or net 90 terms, your DSO is going to be high no matter how close to the due date you get paid.  While changing terms with an established customer is difficult, getting new customers to agree to shorter terms is possible. Always thoroughly review vendor agreements with new customers. The terms will be included there and negotiating terms at the beginning of the relationship will be easier than after shipments have begun.

Lastly, having an internal credit department can minimize bad debt by only approving terms on creditworthy customers. This will also help the collection department keep the DSO to a reasonable number. A company may decide to aggressively increase sales by extending terms to less creditworthy customers that pay slow but do not appear to be a bad debt risk.  Approving terms for these types of customers will increase sales and profits but will also increase DSO and the risk of credit losses due to defaults.  Therefore, you need to calculate whether this potential sales increase is profitable enough to offset these risks before adopting a more aggressive credit policy.  If you have a sufficient G/P margin, you may still benefit through increased sales. The downside will be reduced cash flow. If you have a low G/P and cash flow is most important, it will be costly for you to do business with slower paying customers. For those companies that want to take on more risk to achieve increased sales, finding and hiring experienced personnel to evaluate the credit risk of new and existing customers is paramount.

Balance Between Sales Growth and Low DSO

In the end, how much your receivables cost you depends on how well you’re able to juggle the balancing act between aggressive sales growth and a low DSO.  For growing companies, it is a truly difficult endeavor. As a general rule, having an experienced and focused collection department will be the most cost-effective way to save you money.  By staying on top of the collection process and making calls as invoices come due, good collectors will pay for themselves through reduced DSO and fewer credit losses.

Implementing the ideas in our blog 9 Surefire Ways to Get Paid Faster will improve your DSO immediately and start saving you money today.

Need help with your accounts receivable management? Contact us today to discuss your current AR objectives.