When I was a young MBA student, one of my professors had a saying that has stuck with me ever since.
“You can live without sales, you cannot live without cash flow” he used to say.
This saying has been proven again and again to me in the course of my career as executive and as a commercial banker. Most of my commercial customers who sought lines of credit were doing so to cover cash flow issues they were having. Some were experiencing rapid growth and needed the short term borrowing to purchase inventory or finance work ahead of payment. From time to time however, I found myself in front of a customer that had severe cash flow issues that were not associated with rapid growth.
Finding the Cash Flow Problem
One particular case was intriguing for a number of reasons that highlight both the need for short term borrowing for cash flow issues, and how that very borrowing can delay the company in confronting the underlying cause of the cash flow issue at hand.
In this particular case, the company was experiencing very slow payment on its accounts receivable.
Normally in such a case, the bank calculates an average collection ratio. This is calculated on an annual basis by taking the accounts receivable divided by (total sales/365). The shorter the number of days, the more quickly the company is collecting payment on its A/R. And of course the quicker the collection the better the cash flow.
For this particular company, the average collection was over 90 days. Some accounts were in excess of 365 days. To compound the issue, the owner never wrote any debt off as bad debt in the belief it was all eventually collectible.
That meant that profits were calculated on an accrual basis for sales that had never resulted in any payment to the company. At the end of the year a healthy profit was shown, but little cash collected.
The company had a profit sharing plan and the owner had to borrow to fund the profit sharing on profits that – had the debt been deemed uncollectible – might have been smaller or non-existent.
I quickly realized that the cause of the cash flow crunch was due to faulty A/R collection. But why?
Investigating the Cash Flow Problem
I recommended an out of work CFO I knew well to the owner. She was engaged to investigate the matter on a part time basis.
It turned out that faulty billing of the company’s customers was largely to blame.
With the part time CFO’s help, the owner was able to correct the billing issue and regular, timely, payments began to come in. Unfortunately, the company had suffered in this situation for a few years before making these changes. But the changes in cash flow after the problem was corrected were dramatic.
It’s About Controls and Process
Often slow payment can be due to the customer being cash strapped themselves or a poor credit risk.
There are three major approaches to improving your cash flow.
1. Formalize and strengthen your credit review procedures
2. Offer a discount for paying early
3. Negotiate your payment terms up front
Larger companies have credit review procedures in place that dictate who receives credit and in what amount. Those companies monitor their collection ratio to ensure the best possible cash flow is achieved. Accounts going over their credit period are routinely called and asked for payment.
Many companies offer a discount for paying early. Those discounts add up for the customer and it is generally considered good business practice to take discounts whenever possible, even borrowing to do so. 2% Net 30 is a standard discount offered by many companies. To promote early payment by their customers. a 2% discount is given for customers paying within 10 days, and the total amount due without any discount is due in 30 days.
Some large customers dictate long payment terms as a matter of doing business with them. Often those terms may be as long as 120 days.
GE often demands lengthy payment terms. However, this does not mean that all customers are paid the same by the same customer. I have had one customer who does an extensive amount of work with GE whose average collection with them is 22 days. I also know many who sell to GE who get paid in 120.
How you set up your collection process can determine how quickly you get paid. The customer who got paid in 22 days billed electronically and was paid in the same manner.
You should also start discussing your payment terms right at the proposal stage of your sales process.
To summarize, be proactive in managing your cash flow. Doing so effectively will ensure sound sleep on the part of the owner.
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