Better management of your Accounts receivable (debtors) frees up cash from your working capital cycle and increases the value of your business. In other words, it’s worth doing. The problem with most growing businesses is that they start off desperate for sales, then desperate to produce what customers have ordered, and before they get around to the invoicing side they’re off selling again. Invoicing seems almost like a chore compared to the hunt for a new sale, so the invoice is sent a few days late…and then since we’re so busy selling or producing we don’t chase the payment. Over time and with the continued pressures of launching our business, a few days becomes a week, a week becomes a month and suddenly we have a healthy 5 year-old business except that our clients paying us on 60 days.
Let’s think about what that means: we’re waiting 60 days to get the money clients owe us for something they’re already benefiting from. Providing we’ve done our pricing right, the money clients pay us includes coverage for all costs of the production and distribution process, plus coverage for all overheads and our own financing costs, plus our profit margin. In other words, it’s far more important to manage the people who owe you money rather than the people you owe money to! (Trade creditors typically reflect only input costs, so they’re often only a fraction of the value of your debtors – this is obviously very industry dependent since in high-volume retail the difference between cost and sales price can be only a few %).
Another way to think about this is that Accounts Receivable is the business extending an interest free loan to its clients. Think about this for a while: why do your clients deserve a loan from you? Is your business a bank? What does it tell you about the ‘credit-worthiness’ of your clients if they can’t repay your loan?
The typical measure by which we measure the amount of cash locked up in debtors is ‘Debtors days’. The formula is really simple: Debtors days = Debtors/Sales*365
The level will vary for each industry and will depend on how much power you have over your customers, so benchmarking is really the only way you’ll know if you’re doing well or not. What one tends to find is that businesses that have high levels of Debtors compensate by charging high margins: the margin covers the cost of financing the clients paying on 60 days and also those who never pay. In theory, if you know your cost of capital you’ll be able to structure your debtors (and your creditor) terms in such a way that they give you a better return than your cost of capital.
Let’s have a look at the effects: To do this, I’ll use the demo business on ValuationUP.com and look at how flexing debtors changes Free Cash Flow in year 1, and thus valuation. We’ll call the starting point ‘Old Sloppy’ with Debtors days of 75 and annual sales of 30,000, and the ‘Tight Ship’ scenario shows how much Free Cash flow is generated by improving debtors, with a similar improvement to valuation:
|Debtors days||Free Cash Flow Y1||DCF valuation|
The next question is how to do manage your debtors more effectively? The first steps are that you need to measure your debtors days and report on them at least monthly. You should also be doing this for each client, so that you have a clear idea of which clients are paying you late (a debtors age analysis). Secondly have a good look at the terms you offer your customers – while competitive pressures will probably dictate them to some degree (again, benchmarking will help) you can do a lot to incentivise earlier payment through offering trade-credit on their next purchases through you. What you really are wanting to achieve is that your debtors pay you before they pay other suppliers, and the only way you’ll do that consistently is to make it worth their while (and to make sure they know its worth their while). Lastly, make sure that you have someone whose bonus depends on getting your debtors days right and make sure they are managed and measured to achieve this. It has to be someone’s specific responsibility, preferably someone used to sucking blood out of a stone!
It’s worthwhile to note that managing debtors (aka collecting money) can be challenging. There are a number of large companies who buy debtors books from other businesses at a discount, and then try to extract as much money from that book as possible. There techniques are specialist and advanced, but in broad terms they follow the legal process (along with legal threats), they use statistical techniques to score each debtor and understand what will work best to get money from them, the process is measured in detail and managed daily, and lastly that each person involved is incentivised to achieve. If they can do it, so you can you.