Attention Small Business Owners! Announcing a new business model guaranteed to make you rich quick, this is a revolutionary secret so please don’t share it!
Loan your customers money, and then let them pay you back 70% of it in 4 months.
Sounds pretty shaky don’t it? Where’s the get rich quick part? Yes, you can laugh at such a ludicrous concept, but before you laugh too hard, let’s take a look at your Accounts Receivable – you know, the loans you give out and book as a sale. Now, I am not saying extending credit to your customers is a bad thing, in fact, it’s difficult to do business these days without offering terms, if you don’t, chances are your customers will go to someone who does.
The problems start when you extend credit without having a strong Credit & Collection Policy in place. If you don’t have one, or if you don’t consistently execute the one you have, then I would wager your Accounts Receivables are well aged and your Cash Flow tight at best. In simpler terms – you can’t pay your bills on time, or at all, because your customers have not paid you. How aggravating is that!? You’re being hassled by your creditors, maybe even taking out a loan to cover shortfalls, and there your money sits, in someone else’s bank account!
At the foundation of any good Credit & Collection Policy must be the idea that:
A credit sale is not really a sale until the account has been collected.
Prior to collection; the only thing tangible that a credit sale produces is a financial burden that strains cash resources. Payment for products and services delivered have not been received, but expenses for salaries, supplies, equipment and overhead have been incurred and probably already paid.
Look at it this way – assign a dollar value for the product/service you provide (Hint: your sale price which covers the cost of sale plus overhead and desired profit), say it’s $100, now instead of delivering the product or service – just fork over the cash to your customers and tell them to pay you when they can!
Wait, it gets worse! Did you know that for every 30 days your customer doesn’t pay you back you are incurring additional costs that were not factored when you came up with your sales price? Here they are:
> Time Cost. Calculates how much money you would have to invest today, at a given interest rate, to generate a principal-plus-interest amount equal to what will be collected in the future.
> Administrative Cost. Expense of increased collection efforts like phone calls, letters, lawyers, etc.
> Opportunity Cost. Rate of return you would have received if that money was available to invest in other sales/projects.
> Predictability Costs. Expenses resulting from imprecise cash forecasting.
> Financing Cost. Cost of a Line of Credit or loan to cover slow collection periods.
> Bad Debt Costs. Statistics show the older an account becomes, the greater the risk of not collecting. For example, of accounts 30 days past due, only 99 cents of every dollar is collected. Beyond 30 days the chances of collecting become progressively poorer. At six months this hits 50% and continues to drop with time.
So let’s look at the value of that $100 you “lent” your customer as it ages over time (certain assumptions have been made to calculate costs, results will vary per business).
Customer—Current—–30Days——60Days—–90Days—-120Days
XYZ———–$100———–$98.18——-$89.71——-$80.26—–$69.29
Remember, the $100 should cover the cost of sale, overhead and profit. Let’s assume your $100 is broken down as follows: cost of sale (COS) 70%, overhead 25%, and net profit 5% – it would look like this:
———————Current—–30 Days——-60 Days—–90 Days—–120 Days
Sales ————-$100——$98.18——–$89.71——-$80.26———$69.29
COS —————$70———-$70————-$70———–$70————-$70
GrossProfits——$30——-$28.18——-$19.71——-$10.26——($0.71)
Overhead ———–$25———$25————-$25———-$25———-$25
Net Profit ———-$5——-$3.18——–($5.29)——($14.74)——($25.71)
At 30 days you have eaten into your profit by almost $2; in 60 days all your profit is gone and you have $5 less to pay toward overhead expenses; at 90 days your short $15; and at 120 days not only can’t you pay your overhead, you’re coming up short covering the cost of sale (i.e. what you paid your vendor for the widget and/or the labor you paid your employees to perform the service).
Now multiply that times all your credit sales; still wondering where all the money went? I am absolutely positive you would never lend your customer $100 and tell them to pay you back $69 in four months! You wouldn’t would you? Unfortunately, if cash is tight, it is very likely that’s exactly what you are doing. Imagine, paying customers for the privilege of selling to them!
Ready for that Credit & Collection Policy now? Your policy should consist of the following three elements or activities:
1. The decision on granting credit and the terms to be offered.
a. Credit Application filled out and signed pre-sale (get a Personal Guarantee signed while you’re at it!)
b. Credit References thoroughly checked (if credit amount is substantial pull a credit history report – it is well worth the cost! Resources: Credit.net, D&B, Experian, etc.)
c. Designated authority decides on credit limits and terms based on established criteria.
d. Notify applicant in writing of acceptance, limits, and terms (include credit hold and late fee/interest penalties)
e. Notify sales team and file in customer folder, update accounting systems accordingly.
f. Review and update annually, sooner if “red flags” appear.
2. The monitoring of Accounts Receivable
An Accounts Receivable aging report must be generated weekly and all accounts reviewed, this way problem accounts can be identified early enough that effective collection proceedings can be initiated.
3. The formulation and execution of an effective collection policy
a. You must have a correctly aged listing of the Accounts Receivable.
b. Designated person with the authority and credibility to collect, and still maintain the highest possible client relations.
c. A record of collection efforts for each account, include follow-up action to be taken and when. An Excel spreadsheet works well for this.
d. Work in this “tickler” file every day. Follow-up should happen exactly as indicated and when.
e. Establish Collection Procedure similar to following:
1) Current: Make a “customer service” call pre-due date to ensure product/service was delivered satisfactorily and invoice was received without discrepancies.
2) 30 days: Call customer with friendly reminder. This will be followed by a brief letter confirming the agreements reached.
3) 45 days: Call customer to determine why money still hasn’t arrived and secure a new commitment. Send second letter.
4) 60 days: Call customer and send letter notifying of suspended account and intent to enforce collection.
In summary, the foundation of a collection policy should be clear, effective, and consistent communication between you and your customers. This communication begins with the customer’s application for credit, and continues through all subsequent contact. The emphasis of this communication is the customer’s responsibility as a recipient of credit, and your responsibilities as creditor. Avoid writing off bad debt by having a clearly articulated credit policy, and by letting all customers know what the policy is, and that you are committed to executing it till they comply. Happy collecting!
Mark A. Sandate is the Managing Director of MASSolutions, LLC – a small business advisory firm, and an accredited Executive Associate of the Institute for Independent Business (IIB). For more information and to inquire about a free, IIB sponsored, 4 hour consultation please email mas@mas-solutions.biz.
