Converting accounts receivable to cash is a critical process in developing healthy cash flow. While the recording of an accounts receivable is accomplished through a simple accounting transaction, the process of maintaining and collecting payments from your customers requires a firm commitment to a systematic accounts receivable management process. To more effectively convert accounts receivable to cash, it is essential that the credit and collection process be highly efficient so that you can shorten the cycle time of accounts receivable.

The accounts receivable cycle begins with a sale (credit sales) which in turn creates an account receivable (money owed to your business) and then eventually turns into cash. The time it takes for your business to complete this cycle, from sale to accounts receivable to cash, is the collection period. The shorter the collection period, the less time cash (capital) is tied up in the business process and therefore the better for your company’s cash flow.

Try to limit outstanding accounts receivable to no more than 10-15 days after the terms of your credit. If your credit terms are net 30 days, then the collection period should not extend beyond 45 days. Please note that average billing periods vary due to industry standards, company policies, or customer financial conditions. Comparing your company’s actual pickup days to the average pickup days within your industry is good business practice. It’s also a good idea to compare your actual billing days to your projected billing days (no more than 10-15 days in credit terms).

Your company’s average collection period is calculated using an average collection period relationship. The relationship is called the Activity Relationship; measures how quickly your business converts non-cash assets into cash assets.

Average Collection Period (ACP): ACP = Accounts Receivable / (Credit Sales/365))

A high average collection period means that your business may be too liberal in extending credit to your customers and too lax in the collection process. A low number of days in your collection period could mean that your credit and collection policies are too restrictive. This restrictive position may be holding back your sales.

The Accounts Receivable Turnover Ratio (ART) is an accounting measure used to quantify the effectiveness of your company in granting credit, as well as in collecting your debts. This ART Ratio is considered a Liquidity Ratio; measures the availability of cash to pay the debt.

Accounts Receivable Turnover (ART): ART = Net Credit Sales / Average Accounts Receivable

A high accounts receivable turnover rate implies that your business operates on cash or that your extension of credit and collection of accounts receivable is efficient. A low ART ratio means that your business needs to reassess its credit policies to ensure timely collection of monies due from the accounts receivable ledger.

A key requirement for effective sales and accounts receivable management is the ability to intelligently and efficiently manage the entire credit and collection process. A better understanding of a customer’s financial strength, credit history and trends in payment patterns is paramount to reducing your exposure to bad debts. While a comprehensive collection process greatly improves your cash flow, your ability to penetrate new markets and develop a broader customer base depends on the ability to quickly and easily make informed credit decisions and establish credit lines. adequate credit. Your ability to quickly convert your receivables to cash is possible by executing well-defined collection strategies.

credit process:

The initial requirement of an effective credit management process is that each company you plan to do business with completes and signs a Credit Application form. Your credit application form should include “terms and conditions of sale,” a space for the prospective customer to provide background information on the business, a list of principal owners with their ownership percentage, three to five references credit card and the name of your bank(s).

It is important to personally review with the prospect their projected product purchases, both in dollars and units. This review helps to initially assess the amount of credit needed to purchase the projected products. This review also helps determine inventory requirements based on a projected sales forecast.

Collection process:

An efficient and effective collection management process includes well-defined policies and procedures that facilitate a more convenient cash sales cycle. Collection procedures require “attention to detail” and must include:

• Billing: Preparation, registration and sending of invoices as soon as the product/service is delivered or installed.
• Account statements: Preparation, registration and delivery of follow-up statements that indicate the age of outstanding balances.
• Accounts Receivable Aging Schedule – Preparation and distribution of an aging schedule that lists all customer accounts that have outstanding balances. These outstanding balances are classified into 4 time categories: 1 to 30 days, 30 to 60 days, 60 to 90 days, and more than 90 days.
• Phone Calls: Making courteous and professional follow-up phone calls to customers with past due and outstanding balances in order to establish a payment date.
• Collection Letters: Preparing, recording, and sending collection letters with an urgent message demanding payment and providing details of the action to be taken if payment is not received by a certain date.
• Payment record: Publication of the amount of the payment in the account of the corresponding client. If possible, it is advisable that the person performing the collecting functions is not involved in the accounting of payments.
• Deposits of Funds Collected: The preparation of the deposit slip, along with the accompanying funds, must be deposited with the bank in a timely manner.

Factoring as an option:

Very simply, factoring is short-term financing obtained by selling or transferring your Accounts Receivable to a third party – at a discount – in exchange for immediate cash. In most cases, the third party, a factoring company, audits your accounts receivable to determine its collectability. If the factoring company deems your accounts receivable to be bona fide, they will offer to purchase your current accounts at a discount. A factoring company may also, in appropriate circumstances, purchase your future receivables at a discount to the face value of the receivables. The discount percentage depends on the age of the accounts receivable, how complex the collection process will be, and how collectible they are.

Once the factoring company collects a particular account receivable, it will pay you the remaining balance of the face value of that account receivable, less your fee. Rates vary greatly from one factoring company to another. Therefore, it is recommended that you do your due diligence before engaging the services of any particular company. Factoring fees are not insignificant compared to the amount of interest you might pay to a commercial lender. For this reason alone, you should consider factoring only as a short-term solution rather than a regular outlet for collecting your receivables.

Many businesses, needing an immediate infusion of cash to survive and/or close their cash flow gap, could benefit from the accounts receivable factoring process. Since bankrupt companies often turn to factoring as a last resort, many people may view it as a negative. While factoring can be a great way to generate cash quickly, you should consider the perception that factoring can convey to your customers and others in your industry. Your good judgment here should dictate whether your business could benefit from the rapid cash flow that factoring provides, or whether or not it would simply be an additional financial burden on your business.

Shortening the accounts receivable cycle time creates the healthy cash flow required to sustain the growth and prosperity of your business.

Copyright © 2008 Terry H. Hill

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