Accounts receivable (AR) represent the amounts owed your business by your customers for the purchase of goods or services delivered on credit. Because AR constitutes one of largest assets on your books, proactively managing accounts receivable is crucial for the financial health of your business. Especially in these times of high interest rates and economic uncertainty.
There are two primary external factors that affect the performance of your AR — your ability to convert AR into cash as quickly as possible. One factor you have little to no control over, and that is economic conditions. The other factor is the credit worthiness of your customers, which you can impact, but cannot guarantee.
The Tyranny of Economic Conditions
You can adjust your policies to mitigate the impact of an anticipated deterioration of economic conditions, but the market can be very fickle as we have learned in recent years. Economic downturns can impact a customer's ability to pay, leading to delayed or defaulted payments. A recession or industry-specific downturn can significantly impact the value of accounts receivable, making it essential for businesses to diversify their customer base as much as possible.
Nobody anticipated Covid. Overnight, healthy customers found their enterprises on life support. Whole industries were disrupted. Consider what happened to restaurants. After suffering the impact of having to close during the initial shut-down of the economy, those that were able to pivot to a take-out model or provide outdoor seating gave themselves a chance at survival. Many restaurants didn’t. In addition, there was the impact on the entire food industry supply chain.
There is essentially nothing a business can do of a direct nature to prevent the impact of economic disruptions. In this case, it was set off by a pandemic, but the catalyst can just as easily be a natural disaster, war or sudden market collapse as in 1929 and 1989. All you can do is put a disaster plan in place, and that probably won’t cover all the contingencies.
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The Fluidity of Credit Worthiness
The other external factor that affects AR performance is the credit worthiness of your customers. Simply put, if customers have weak financials or a history of late payments or defaults, there is an elevated risk of bad debt. The new customers you take on should exhibit an acceptable level of risk, but this can change over time.
By performing due diligence before extending credit to customers and by monitoring their performance, you can mitigate the level of credit risk in your AR portfolio. That does not mean you will be able to avoid all bad debt losses due to business failures, but rather be able to minimize them.
There are a lot of reasons business fail. Ultimately, it is because they cannot pay their creditors, but there are numerous drivers to get to that point. Mismanagement on the part of your customers is often a major contributor, but lawsuits, natural disasters, cyber attacks, competition, deteriorating economic or industry conditions can all be catalysts. Effective credit management can mitigate the impact of deteriorating customer creditworthiness, but where there is credit there will always be risk.
Read on to learn:
Three things to avoid that will otherwise hurt AR performance
The cost of invoice errors
Are Internal Factors Depressing Your AR Performance?
Besides economic exigencies and the malleability of customer creditworthiness, there are three primary internal factors that impact AR performance. A lack of consistent credit policies and insufficient receivables management can lead to an accumulation of risky accounts receivable. Additionally, errors in invoicing and disputes over delivered goods will disrupt timely payments, impacting cash flow and causing profit dilution. Implementing effective credit policies, prioritizing proactive receivables management activities, and ensuring accurate invoicing are essential for achieving optimal AR performance.
1. Inadequate Credit Policies and Procedures
Informal credit policies, often characterized by the ad hoc extension of payment terms or inadequate credit checking guidelines, can significantly impact your AR. When businesses offer extended payment terms without a thorough assessment of the customer's creditworthiness and the context of the situation, they expose themselves to the risk of delayed or non-payment. Moreover, a lack of credit checking guidelines leads to inconsistent credit decisioning, further increasing the risk of non-payment.
The lack of formal credit policies and procedures typically results in an accumulation of accounts receivable with an increased probability of bad debts, affecting the company's cash flow and overall financial health. It may also lead to a strain on the resources and efforts required for debt collection, potentially affecting the business's ability to operate smoothly and meet its financial obligations.
To mitigate these risks, businesses should formalize their company’s credit policies and procedures. By strictly enforcing credit policy, businesses create a framework for assessing credit risk for both new and existing customers, thereby reducing the likelihood of non-payment and minimizing the accumulation of risky accounts receivable. Additionally, clear credit policies can help businesses maintain a healthy balance between sales growth and risk management, ensuring sustainable financial stability in the long term.
2. Ineffective Receivables Management
Poor AR management, including delayed follow-ups on overdue payments or insufficient collection efforts, causes cash flow issues and increases the risk of bad debts. Implementing robust AR management practices, including effective onboarding procedures, ongoing customer credit monitoring, regular follow-up activities, timely collection efforts as well as timely and accurate cash posting is essential to mitigate this risk.
The importance of an effective AR function was brought home to me when working with a mid-market client in the construction supply arena. They had established policies and procedures that followed industry best practices. The problem was that they were not executing on the plan. More often than not it is the other way around: robust, but ineffective, receivables management due to a lack of policy and procedures. Here the problem was minimal monitoring of existing customer credit risk, too little collection activity, and irregular follow-up resulting in a ballooning AR, constricted cash flow, and the need to periodically increase the bad debt reserve, which was a blow to profitability.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
3. Inaccurate Invoicing and Disputes
Invoicing errors and disputes can have a significant impact on the performance of accounts receivable, potentially leading to delayed payments, strained customer relationships, and increased administrative costs among other things. Here are five (5) ways invoice discrepancies affect the AR:
Delayed Payments: Customers might withhold payment until invoice discrepancies are resolved. This can disrupt the cash flow of the business, leading to potential financial challenges, especially for small businesses with limited operating capital.
Strained Customer Relationships: Disputes over invoicing can strain relationships with customers, leading to dissatisfaction and potentially damaging the long-term business relationship. Maintaining strong customer relationships is crucial for repeat business and positive word-of-mouth referrals.
Increased Administrative Costs: Resolving invoicing errors and disputes often requires additional time and resources. Businesses may need to allocate manpower and resources to investigate and rectify any discrepancies, leading to increased administrative costs and a strain on operational efficiency.
Impact on Cash Flow Forecasting: Invoicing errors and disputes can make it challenging for businesses to accurately forecast their cash flow. Unresolved disputes create uncertainty regarding the timing of expected payments, making it difficult to plan for future financial obligations and investments.
Potential Bad Debt: In some cases, disputes left unresolved for extended periods can escalate into non-payment or bad debt write-offs. Failure to address invoicing errors and disputes in a timely manner increases the risk of non-recovery, negatively impacting the overall financial health of the business.
To mitigate the impact of invoicing errors and disputes on accounts receivable performance, businesses should prioritize accuracy in their invoicing processes, promptly address any disputes or discrepancies, maintain transparent communication with customers, and implement efficient dispute resolution mechanisms. By proactively managing these challenges, businesses can enhance their accounts receivable performance and maintain healthier customer relationships.
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The Final Analysis . . .
According to a report from Ardent Partners, the average cost to process an invoice is $13.11. If you do just 250 invoices each month, your processing cost alone is $38,730 per year. Further, suppose your annual sales are $3 million, which means your average invoice size is $1,000. If just 10 percent of your invoices contain errors, then $300K of your AR involves disputes over the course of a year. For most companies, disputed invoices are settled in favor of the customer 80 to 95 percent of the time. To be conservative, let’s assume only 25 percent of the $300K is actually disputed; in other words $75K. If ninety percent of that is credited back to the customer ($67,500), then invoices are costing you $106,230 per year, or 3.5 percent of sales — and that does not factor in the impact of the delay in payments from the disputed items on your cost of borrowing or the impact on customer relationships.
The point is that even a relatively small amount of invoice errors can have an ordinate impact on AR performance and profits. The impact of having inadequate credit policies and procedures or ineffective receivables management efforts can be even higher. Too often credit and collections are an afterthought, and when that happens you are setting yourself up for trouble.
Small and medium-sized businesses need to adopt proactive measures to manage their AR and eliminate internal factors that depress performance. This includes conducting thorough credit checks, maintaining accurate records, implementing stringent credit policies, monitoring economic trends, and employing effective accounts receivable management strategies.