Best Practices: B2B Small Business Accounts Receivable

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1 Best Practices: B2B Small Business Accounts Receivable

2 Best Practices: B2B Small Business Accounts Receivable By Dan Drechsel For most business to business companies, their largest asset is also the most liquid, and at times, most mercurial, asset: Accounts Receivable. In his famous Inc. Magazine column, Street Smarts: Secrets of a $110 Million Man, 1 Norm Brodsky enumerates the top ten lessons learned in 29 years as an entrepreneur, Not surprisingly, two of the lessons focused on Receivables: #2) A sale isn t a sale until it is collected. and #5) Cash is hard to get and easy to spend. Make it before you spend it. Put the two together and you get Collect it before you spend it. Norm s point is well taken. Your business engine consists of money coming in and money going out. If you consistently let more money go out before money comes in, in Norm s words, The ball game s over. If you can get paid up front, you should. Most businesses, however, expect to be able to pay on terms, which means you must carefully manage your receivables. To stay in the game: turn your receivables into cash as quickly as you can. Never in the course of human history have so many owed so many so much Forgive the appropriation of Churchill s eloquence on such an everyday subject, but never in the course of human history have so many owed so many so much. B2B trade credit in the US is extremely large. In fact, it is ten times the size of the giant credit card market with nearly $20 trillion moving through trade credit while a mere $2 trillion moves through credit cards. Your customers owe you more than you realize. If you have $1 million in receivables, you are lending $1 million to your buyers. Average time to payment in the US is 54 days, so on average you ve lent this $1 million out for 54 days. As you grow your business your receivables normally grow but at a different proportion. For every 10% of business growth, you ll need to find 1.5% more cash to put into Receivables. Or stated more painfully, for every $1 million in sales growth you need to find $150,000 to lend to your buyers. Do you think of yourself as providing free financing to your buyers -- that is -- free to them? The largest source of financing for the most small to medium sized businesses (SMBs) in the US is Accounts Payable. That makes Accounts Receivable the largest use of cash for SMBs; so, you re not only financing them for free, you re paying for the money you use to do it. Best Practices: B2B Small Business Accounts Receivable 2

3 A mostly polite tug of war Now that you realize how much it costs you, in cash, to lend money to your customers, you may be thinking that you are not managing your cash as smartly as you thought. If you can shorten the length of time that your sales are uncollected, you can manage cash more strategically than your competitors. Applying best practices or lessons learned from other businesses as they ve improved their ability to bill and collect for services, will enable you to reduce your Days Sales Outstanding (the number of days of annual sales sitting in AR) and Bad Debts and, therefore, increase cash on hand. Beyond automating or streamlining processes, take the time to carefully reevaluate the assumptions behind your AR to collections policies. You may never make collections calls before 60 days because you assume your customers will be offended if you follow up before then. Would your aging improve if you made calls at 15 days to verify receipt of the invoice? What other assumptions are keeping you from successfully converting receivables to cash effectively. A quick checklist of possible improvements: decrease accounts receivable overhead and processing costs; make credit decisions with rigorous credit evaluation based on up to date, high quality information; improve communication with customers; standardize price lists and proposals; always require written quotes; verify receipt of invoices; standardize collection strategies by type or value of customer; process alternative forms of payment; eliminate manual processes and paper; look for leading indicators that customers are paying later or are in trouble; look for ways to reduce sales cycle time and monitor key performance ratios that will help you gain better control over revenue. Most business owners stop here. They fail to benchmark against best practices and other businesses in their industry; don t rigorously measure and monitor performance and most importantly don t carefully look at how much it costs them to finance AR. Best Practices: B2B Small Business Accounts Receivable 3

4 Table of Accounts Receivable Practices at Various Maturity Levels Accounts Receivable Process Maturity Businesses <$250MM Credit Administration & Credit Management Level I Level II Level III Level IV Initial AR Process Credit Awareness/ 'Typical' Small Business / Standard Practice Implementing/ Maturing Best Practices Leader Sales/Owner discussion of customer's 'Informal' Credit Analysis/ thought Important customers have credit limit AR Portfolio and Prospective client business and makes credit judgement done/ given on key orders base is segmented with differing approaches per segment Credit and cost of timeframe of payment is part of terms discussion Sales must be to clients with credit or a segment anticipated to be without credit lines - automated enforcement Credit is checked as part of order processing Use of third party credit sources such as D&B, Experian, Equifax periodic review of customer credit limits Use of credit insurance on certain credits Credit is ascertained for foreign and domestic orders Collections Owner or sales asks for payment after past due by 15 days or longer if current cash flow is sufficient Collections is an assigned task, but insufficiantly staffed Collections calls and letter escalation process on past due accounts Some allowed variance between written terms and agreement No variance between written terms and agreement Initial customer contact on collections is a Customer Service function, escalation is to Collections, only then followed by Owner or Sales Statements are generated periodically Defined collection timeline with proactive validation of invoice receipt, issue resolution and defined escalation process beginning prior to due date Invoice accuracy is a significant focus, error rate on invoices is recorded, root cause anaylzed and repaired; invoice accuracy is verified prior to collection efforts Potential risky orders are reserved for potential bad debt until cash receipt Statements are sent to problem Bad debts are accrued Automation of case management customers from time to time process with notes for collections prompt payment discounts Formal commercial terms on all sales Formal dispute policy with workflow Bad debts recognized well after they appear Outsourcing of printing or delivery of collection notices, statements Interest and unearned discounts rebilled on late payments Recovery process Payment Processing Checks received at office Online manual allocation of payments to invoices Deposits made in person at local Remote deposit capture branch Automated cash application of payments to invoices Lockbox processing of deposits Imaging of remittance details of customer payments Measurement AR Balance DSO is reported Customer exposure reporting Billing Quality Index (BQI) AR Aging and Past due Bad debt expense reporting Overall risk of AR portfolio Accounts Receivable Turnover Credit lines granted/ renewed Working Capital Finance None/ AR Pledged against general loan agreement w/owner guarantee Factoring in certain industries Bank working capital lines support working AR requirements at 70% advance rates Competitive bidding of working capital finance needs Bank working captial lines at 80-90% average advance rates Securitization of large volume working capital requirements Best Practices: B2B Small Business Accounts Receivable 4

5 and, like any war, it is really expensive The costs involved in and impacted by your AR operations are wide in the business. The very largest firms can run very effective and professional AR operations for 1% or less in revenue. As size diminishes, the relative cost to run AR operations costs increases dramatically and effectiveness diminishes likewise as smaller firms due to lack of scale. AR operations tend to be less mature and employ less of the best practices in effective AR management. Costs of AR Operations How can I improve cash flow by outsourcing accounts receivable? The most obvious, or directly traceable, AR expenses are bad debt and the various costs of personnel, systems and outsourced services involved from collectors to cash reconciliation. When assessing your all-in AR costs remember to include payments to outsiders for credit services, printing and telecom. You may not be thinking of your AR department as your most important customer service team. Yet, they are always dealing with your customers money and people are sensitive about money, even in a business situation. Developing the skills within your organization to take the emotion out of the AR process improves customer service. Every aspect of the sales cycle from order to collection is influenced by customer service. Recurring sales are often influenced by customer relationships; your AR department can cost you if it is not professionally monitoring and managing collections and customer relations. As we mentioned earlier, outsourcing accounts receivable is similar to a consumer retailer accepting a credit card for payment. By accepting a credit card for payment, the seller does not have to worry about the credit of the buyer, nor does the seller have to incur the costs associated with administering the account or bad debt all of this work is done, for a small fee, by the credit card issuer. As a result, over 95% of all consumer retailers have outsourced their accounts receivable and credit administration function by accepting the credit card. Best Practices: B2B Small Business Accounts Receivable 5

6 Over the next decade, as lenders and businesses become familiar with the simplicity of accounts receivable financing (also called trade credit financing), it will be the model by which virtually all B2B transactions will be conducted. Old and infirm Almost everyone has lost money due to customer non-payment at one time or another. We have all had to make collection calls to clients. Sometimes they were simply using our money; other times, they were in crisis and the discussion was difficult and emotional. This makes for an environment that strains our willingness to get this critical function executing well for business and follow Norm s Rule #2: A sale isn t a sale until it is collected. Age means uncollectible % of Accounts in a portfolio that are past due more than a few days involve a dispute.2 Price discrepancies are the leading cause of disputes at 30-70% of all disputes. Most businesses find that this number is closely followed by delivery, quality or service issues. If you make a happy customer and bill them accurately and in a way that fits into their accounts payable system you ll get paid fastest. Working Capital Finance and AR As your maturity of AR Management increases your financing options multiply. At low levels of AR operations maturity and processes, you simply have to provide the funding for AR yourself. As your maturity increases, you open up additional sources of finance. Initially, this is probably factoring, which is expensive and has a reputation of customer service and relationship issues. As you demonstrate higher maturity and the resultant understanding, transparency, and control, the options open further and costs of the funds can decline rapidly. Significantly, once a business proves that it provides good collateral to a bank for working capital lending, this source of finance can become quite inexpensive and impressively flexible, with best practices. By making it stronger you can improve your business There are proven ways to make the critical task of Accounts Receivable management a key capability of your company and execute at a world class level. By doing this you can make it less expensive, less unpleasant, safer and faster while you free up valuable cash to fund your business. 1 Street Smarts: Secrets of a $110 Million Man, Inc. Magazine, Oct Accounts Receivable Management Best Practices, John G. Salek, Wiley, 2005 Best Practices: B2B Small Business Accounts Receivable 5

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