Over the years, I’ve learned a thing or two about accounts receivable, which may not sound like a typical topic for this blog. A blog cannot include everything a certified internal auditor can tell you. But here are a few important things. Many business owners take their accounts receivable, and the collection of the A/R, for granted. We shouldn’t do so. Let me share a few thoughts about this seemingly mundane topic, and how the management of accounts receivable relates to business value. In the final analysis, collection of accounts receivable requires a diligent attitude and focus on the part of senior management, and implementation at the lowest level possible levels in our organizations.
- Accounts receivable are an asset on a company’s balance sheet. This may seem obvious, but the point is that all assets must be funded, either by owners’ equity or by external funding. One obvious inference from this is that lower levels of accounts receivable are better given the current level of sales. If we can lower accounts receivable by $1 or by $1 million, that is $1 or $1 million less that we have to borrow or to retain on the balance sheet. This is a good thought to keep in mind every time you look at or even think about A/R.
- Customers are the source of accounts receivable. When we do business with customers, whether delivering products or services, we essentially lend money to our customers. So it is a good idea to have a good idea about each customer’s ability to pay. We are in the business appraisal business and most often have the opportunity to examine customers’ financial statements in the process of proposing business. We have an opportunity to make a judgment about ability to pay based on this review, other information provided to us, and any independent investigation we conduct. Banks don’t lend money to their customers without first qualifying them. And neither should we (that’s you and me).
- Your accounts receivable to a customer is an account payable for them. Their account payable to you is an interest-free loan from you to them. While a dollar less of A/R is good for you, a dollar more of A/P is good for them. In normal times, companies pay A/P and collect A/R within normal trade terms. But when times get a bit tight with customers, there can be a tendency for them to stretch their A/P days outstanding. If yours is one of their A/P (your A/R), then they will silently ask you to lend them your good money interest-free, perhaps for a long time.
- Accounts receivable “turnover” is the rate your A/R “turn,” or are collected. Turnover can be measured in a couple of ways. One way is to measure the number of times your A/R turn in a year.A/R Turns = Total Credit Sales / Average Accounts Receivable. Days A/R Outstanding = (Average Accounts Receivable / Total Credit Sales) x 365. For A/R Turns, assume sales are $10.0 million for the last twelve months, and average accounts receivable are $1.0 million. So the A/R turns are $10/$1 = 10x. The other ratio, Days A/R Outstanding inverts the ratio and multiplies by the number of days in a year. Days A/R Outstanding is equal to ($1 / $10) x 365 = 36.5 days. Years ago, I had a conversation with an accountant who worked in business valuation and litigation support, and who should know something about A/R. He said his business was doing about $5 million per year, which I thought was pretty good at the time. He then told me he had A/R of $2.5 million. My response was immediate: “You are running a non-profit bank for the benefit of your clients!” That suggested that his A/R turnover was 2.0x, which is painfully slow, and his days A/R outstanding were 182.5. Relative to the firm with 35 days outstanding, he was waiting an additional 150 days, on average, to collect his A/R, or some five months!Do the math. The first business above was doing $10 million in sales with $1 million in A/R. My friend had $2.5 million in A/R, and five million in sales. At an A/R turnover of 10x, he should have about $500 thousand in A/R. So he’s got $2 million in very slow paying or potential loss receivables. No rational purchaser of his practice would want to take on the task of collecting those receivables. So the value of his practice is being hampered by his accounts receivable management policies, which brings us to the next point.
- Accounts receivable are said to “age” as they get older and stale, and they get harder to collect. Businesses tend to look at A/R in terms of various “buckets” of aging like: 1) current (usually meaning 30 or less old), 2) 31-60 days old, 3) 60 to 90 days old, and 4) over 90 days. As I’m writing this, the A/R at Mercer Capital are aged as follows: 1) Current (47.8%), 30-60 days (39.2%), 60-90 days (7.8%) and over 90 days (5.2%). What I can say is that the collection of A/R gets substantial and regular attention at Mercer Capital. What I have learned through personal experience, observation, and common sense, is that the older that A/R become, the higher is the probability that they will be lost, or “charged off.” I don’t know about you, but I hate charging off receivables. When we work on someone’s behalf, or you deliver product or services that your customers purchased, we (and you) should have an expectation of being paid, and timely. We have a contract, or engagement letter, for every assignment. We promise to deliver, and we do. We expect our clients to honor their contracts and to pay us according to the schedule in the contract. It is really simple.
- Watch credit quality like a hawk when sales are tough. There is a real temptation to take on business of marginal credit quality to keep sales flowing. This tendency may be good temporarily for commissions for salesmen, but it is disastrous for the business and the salesmen in the longer run. The credit folks in your business have to be vigilant. No one wants today’s sales to become tomorrow’s write-offs, because write-offs do not produce cash, which is the lifeblood of any business.
- Have policies for the collection of accounts receivable. Years ago, I was part-time CFO for a distribution business that was selling a lot but collecting very slowly. I saw very quickly that the company had no real policies for A/R collection. When receivables became stale, or more than 90 days old, they were given to the owner to make calls for collection. As you might imagine, he just didn’t get around to it, and the cash crunch intensified. I learned very quickly what to do by observing what happened with some of our suppliers, who were collecting from us. The good ones had their A/R clerks calling regularly to our A/P clerk. She was a nice lady, and she paid our A/P in order – i.e., in order of the companies who called her and were nice to her. I took the late collection responsibility from the owner and gave it to the controller and told him that he would have that problem until he solved it. And he got right on it. Within 90 days, we had cut the A/R by 40%, and within six months, we were turning at industry levels. Frankly, without that intervention, the business would have failed.
- If you are a service company, take collection responsibility from the partners. We had to take collection responsibility away from the owner in the example above. Professional service firms partners are notorious for wanting to maintain control fo the collection of “their” receivables. Accounts receivable collection should be handled at the lowest level in the organization as possible. A couple of years ago, I received a call from a partner in a law firm we had been doing business with for several years. He complained that our office manager had been “unprofessional” by writing him and calling him regarding payment of a long-outstanding invoice. I listened to what he said and then said that our office manager was, indeed, being very professional and was carrying out our firm’s collection policies. I told him that we had done the work that he requested and that the only thing unprofessional was his client’s slowness in paying our invoice. I don’t think he liked my sermon, but the bill was paid immediately, and we are still doing business, with timely payment, with clients of his firm. I was able to intervene as a “partner,” but only at the moment it could accomplish something. Service firm partners want to maintain control over their A/R, but are generally not very good at doing so.
- Your A/R policies can cost you real money. I had dinner with a private equity investor a few years ago and we talked about how they looked at potential acquisitions. I asked him about what he looked for in accounts receivable management. He told me of a recent acquisition. I’ll make up the numbers here, but they are similar to what he told me. They had just acquired a business, let’s call in $30 million in sales. The EBITDA margin was 8%, and the multiple paid was 5x. The purchase price was $12 million, and there was no debt. Due diligence of accounts receivable management had indicated a bit of laziness, but no significant credit issues. The inventory was turning 8.1x, or about 60 days outstanding. Industry standard was about 45 days. Based on their experience, they believed they could improve collections to industry standard within 90-120 days, and perhaps exceed that level. So they bought the company. Within 120 days, they had lowered A/R days outstanding from 60 days to 45 days. That may not sound important, but it meant that the private equity buyers lowered A/R by $1.2 million, or 10% of the purchase price. By the end of the first year, they had lowered the collection period to 40 days. In all, they pulled $1.6 million out of working capital that immediately was available to pay down their acquisition debt. The owner of the business left $1.6 million on the table because of lazy accounts receivable management, and the new investors paid down 14% of their acquisition price because of their aggressive accounts receivable management.
Every firm that does business on credit needs to have a set of excellent accounts receivable management policies that are implemented and monitored regularly. Managing accounts receivable is not rocket science. However, your policies need to be clear and followed.
In the last example, we saw a real business where, because of lazy accounts receivable management, the owners lost well over $1 million. Why do I say that? Because the next owners took $1.6 million straight out of working capital into debt reduction. If that money had already been taken out of the business before the acquisition, chances are the sale price would have been pretty much the same.
Accounts receivable don’t sound fun or sexy. But accounts receivable management is essential in well-run companies. Take a look at your accounts receivable today. Are there any ideas above that are helpful? I hope so. Healthy harvesting.
As always, please do not hesitate to give me a call to talk about any business or valuation-related matters in confidence (901-685-2120).
In the meantime be well,