Is Your AR Generating All the Cash Flow It Should?
Five Reasons Accounts Receivables Under-Perform and How Automation Helps
Effectively managing accounts receivable (AR) is essential for a company's financial well-being. Poor receivables performance affects cash flow, and it is no secret that cash flow problems are the leading cause of business failures.
Traditional AR operatuons, involving manual data entry and processes, too often result in costly errors and inefficiencies. Automation tools reduce errors and increase efficiency, but to better understand why that is the case, we need to first delve into the primary causes of AR performance failures.
It also bears noting that even if you have to some extent automated your AR, the primary causes of AR performance failure remain the same. Therefore, no matter the sophistication of your AR processes, understanding these five causes of AR performance failure will allow you to better diagnose your own operations.
1. Processing Delays
There are several AR activities that often take longer than they should and therefore cause delays: processing credit applications, approving orders, generating invoices, and posting payments. Nothing is more frustrating to the sales team than an order from a new customer that sits waiting for approval. Credit evaluations, however, often take time. References require checking, a credit report must be ordered, all the information evaluated and a decision made. Once the customer is set up in your system, orders need to be approved, and very often there are additional delays when credit limits are set too low, automated order-release parameters set too tight, or the order approval process is manual. As a result of credit application and order approval delays, invoices are generated later rather than sooner
Billing itself can also be a problem. Best practices dictate that invoices be generated within 24 hours, or less, of when the order is fulfilled. Failure to do so results in delayed payments. Studies show that when it takes 2 to 4 days to generate an invoice, customer payments will tend to arrive a week or more later than when the invoice is transmitted within 24 hours.
Since the funds are in your firm’s possession, you might think posting payments does not cause any further delays. However, failure to update your AR within 24 hours for any payments received will affect your collection process as items that have been paid continue to show up as past due, and that can cause unnecessary collection activities, which beside being a waste of time will also degrade your customer’s satisfaction with your company. The greater the number of payments you receive daily, the greater this problem will be.
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2. Process Errors
The same areas of the AR process come into play when it comes to generating errors. Bad credit decisions lead to both risky sales when too much credit is granted as well as lost sales when credit is too restrictive. Neither situation helps your cash flow. This issue will be addressed further in the next section.
Issues with invoice accuracy can be a big problem. Invoice errors will cause your customer to pay late because the discrepancies require additional processing on their end. To make matters worse, invoice errors also tend to generate payment deductions (partial payments). This in turn creates more work for your AR team. Correcting invoices and reconciling payment deductions are essentially rework: work that is not necessary if you got it right the first time.
To make matters worse, most payment posting errors will involve deductions. When a customer only pays in part, it is sometimes difficult to know their intentions. When you start getting a lot of credits, debits and partial payments on a customers account, reconciling the account becomes more difficult and detracts from more focused collection efforts. If your receivables contain a lot of this sort of “junk,” you have processing and quality problems that need to be addressed.
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3. Poor Credit Management'
We’ve already talked about how poor credit decisions can impact sales and collections. In small companies, this may occur due to a lack of credit analysis skills. Training in financial analysis only helps, however, if you are getting financial statements from your customers. Depending on your industry situation and tolerance for risk, you should require customers to submit financial statement if you will be extending somewhere between $10,000 to $50,000 in credit to them.
For lower credit limit requirements you will need to rely on the account’s payment history, available from their references and on their credit bureau report, or possibly a credit score. You also should be checking for derogatory information — liens, judgements, prior bankruptcies, etc — found on their credit report or in public records. Ultimately, you need to have the information, skills and tools to make a good decision. Here’s more on credit evaluations.
Credit management, however, doesn’t stop with the initial customer analysis. You still need to be monitoring the performance of your customers, and this requires periodic reviews. Lacking that effort you open the door to increasing the risk in your AR portfolio without realizing it when some of your customers’ financial conditions deteriorate. By the same token, other customers may be growing stronger and without knowing that you may be missing the opportunity to sell them more.
In addition, you should be periodically undertaking a thorough portfolio analysis of your AR. Credit evaluations and account monitoring focus on individual customers. Portfolio analysis involves segmenting your AR to identify concentration risks that are difficult to observe when you are evaluating one account at a time. When unobserved risks build up in your AR, the impact will be slower payments and defaults leading to bad debts.
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4. Haphazard Collections
Late Payments are the reason you need a collection function. Even if your credit management is superior and invoices are accurate and timely sent, you are still going to have to deal with late payments. Nor should you be waiting to initiate collection efforts when a past due items “comes to your attention.” To be effective, collections need to be intentional, not hit-or-miss.
In order for collections to be effective, they need a strategic framework. While collection skills, such as the ability to negotiate, are valuable, collections are primarily a time-management challenge. Once a company has more than 100 customers (and often not even that many), there is never enough time to individually call every past due account when they go past due, and then complete all the subsequent follow-up activities. A strategic approach to collections is primarily a communication strategy to ensure comprehensive coverage of all past due receivables. Your collection strategy will determine when a past due customer should be called and when they should be emailed or other action taken.
Two key components of any collection strategy are prioritization and escalation. Contacts should be prioritized by risk and amount owed. The higher the risk and the bigger the balance the sooner they should be contacted. Age of the receivable is secondary because you want to collect as much as possible as soon as possible as well as minimize bad debts. As you move through each stage of your collection process you also want to be escalating your messaging, both in terms of the urgency and strength of your demand for payment, as well as who you are contacting (e.g., if you are not making progress with the accounts payable clerk, move on to an accounting supervisor, then the controller, CFO, owner/president). Finally, when you have exhausted your internal efforts, don’t hesitate to hand the matter over to your collection agency or attorney, which is the last stage in your strategy. For more on a strategic approach to collections, go here.
5. Computer System Weaknesses
Accounting software packages include AR capabilities, but they typically remain very much accounting focused: billing, remittance posting, and journal entries. In a perfect world that is all you need to maintain an accurate AR. Unfortunately, this is not a perfect world and credit and collections are actually treasury functions, not strictly accounting functions. Consequently, accounting software does not provide all the tools to support the entire order-to-cash (O2C) process, hence the need to resort to manual processes and tasks.
Besides a lack of workflow and contact management tools, accounting software does not provide sufficient process visibility to support credit and collections. Easy access to documentation, integration with credit information resources, and embedded communication tools are weaknesses inherent in accounting software. This makes reporting more difficult and time consuming, Furthermore, the lack of automated journal entries hinders record-keeping and facilitates posting errors on the general ledger, which further prolongs the tortuous month-end close.
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The Case for Automation and Digitization
By automating your AR operations, you can address common challenges such as slow processes, inaccurate invoicing, insufficient credit management, late payments, ineffective collection strategies, and the limitations of your accounting software. This is why digital solutions are highly cost effective. By saving you time, they also save you money and improve the quality of your AR operations.
Slow AR processes can cause payment delays and financial strain, but automation speeds up operations and cuts costs. Inaccurate invoicing, often due to human error, can lead to financial losses, damage your reputation and delay payments, but automation reduces errors. Insufficient credit management can result in bad debts and missed profit opportunities, but automation helps assess creditworthiness and portfolio risk. Ineffective collection strategies lead to unpaid invoices and cash flow problems, but automation aids in strategic planning and better workload management. Late payments can harm cash flow, but automation tools can send reminders to customers. Lack of automation and integration creates inefficiencies, errors, and data tracking issues, but automation improves visibility and minimizes errors.
In conclusion, automation improves AR by increasing cash flow, lowering costs, enhancing client relationships, reducing errors, speeding up payments, and strengthening security. These are all prima facie reasons why automation is a valuable tool for effective accounts receivable management, ensuring financial stability and cash flow.