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STAFDA Cash Flow Consultant Abe WalkingBear

Monitoring A/R's Vital Signs

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By asking a series of questions and analyzing results, business managers can identify what’s going right – and wrong.

On the surface, the role that business managers play is fairly straightforward: develop strategies and then monitor the execution of plans. In an ideal world, management teams establish clear goals for the different functions of their organization and then check the progress, or lack of progress, being made.

They attempt to hire the right people capable of
carrying out the work necessary to achieve goals. Most importantly, the management team makes sure the goals are clear for everyone involved, and then monitor for the desired performance. The basis for synergy and efficiency is common understandings by managers, the people doing the work and by those affected by the work.

But before you can monitor vitals for credit and accounts receivable management, you have to know what you are dealing with and what you can and should expect. Many business managers misunderstand and under utilize their company’s credit and A/R management function.

The Basics

1. 80 to 90 percent of all business-to-business sales involve payment at a later date; credit terms are extended.
2. A/R is short-term money due from the sale of products or services and is often one of the largest business assets. On average the A/R is 40 percent or more of the total assets.
3. Next to cash on hand, A/R is the most liquid asset, only one step removed from money in the bank.
4. In the course of approving credit sales and then managing the A/R (not collections), the credit and A/R function interfaces with customers, sales, marketing, accounting, operations, the warehouse, service, vendors/suppliers, attorneys, transportation and many others involved with the supply chain. It can provide invaluable information on where there exist “areas of opportunity for constant improvement.”

Credit Sales
Companies make an investment in getting business customers to the point where they want to buy. A vital sign of how well that’s being done is the number of new customer-information forms (not credit applications) being submitted by sales to credit. How many potential new customers were submitted in total this month versus last month and the same month last year? How many potential new customers were submitted by each salesperson?

If the number of submitted new-customer information forms is down during key times of the month (the 5th day, 10th, 20th, 25th, end of month) compared to the prior month and the same month the prior year, sales people can be motivated to turn the month around. This can be done by daily contests, which can also include the credit team. They can be challenged with the goal of processing new-customer information forms in a timely manner.

Another vital sign during key times of the month is the total amount of credit that has been applied for, and what percentage of the applied-for credit has been approved by the credit department.

A good credit manager can be worth three or four good sales people – if they view pending sales as their highest priority and focus on finding ways to approve profitable sales while remaining confident of payment.

Sales people should focus on the quality of potential new customers, and the credit people should focus on both making the deal happen and on granting a larger line of credit than requested. The percentage approved should be more than 100 percent of the applied-for amount. It’s called selling up.

When monitoring the vital signs, a question to be asked is “why?” If the percentage of applied-for credit approved drops during the key times of the month mentioned above, is it because the quality of the potential new customers is down, or because the sales force is calling on the wrong market? Is it due to a down economy, or because the credit area isn’t working hard enough to find ways to make profitable sales happen?

At times the management team sends confusing messages to the credit area. They’ll stress the need to get pending and profitable sales on the books, and then they turn around and measure the credit area’s performance based on DSO (days sales outstanding) and the percentage of bad debt. That, in turn, leads credit to focus on risk management rather than on sales and profit. Risk and profit are two very different things.

Sometimes the management team itself doesn’t understand or know the most profitable approach to credit approval. Therefore they can’t provide the credit team with the proper understanding and training on how to weigh the potential customers’ profile and past
performance with the company’s product value at time of sale. When done properly, this maximizes sales and minimize risks.

Management and Cash Flow
The correct profit management of A/R results in good cash flow, sustained repeat sales and controlled bad debt. The vital sign directly connected to all three conditions is the payment days index (PDI) at the end of the month and the daily payment percentage during the month.

Before addressing the mechanics and importance of PDI and daily payment percentage, management must clearly understand that accounts receivable – both current and past due – is not “collections.”

Collections is the enforcement of payment and rightly the function of collection agents and attorneys. A/R management, both current and past due, is about completing the sale – about keeping credit customers paying, even if not current. It’s about assuring that those customers are buying from your company and not from your competitors.

Another goal of A/R management, both current and past due, is the early identification and control of potential bad-debt accounts.  

Understanding PDI
To calculate PDI, start with the total A\R balance as of the first of the month. This means all A/Rs regardless of age. Any new credit sales made during the current month will be picked up in the next month’s beginning total A/R balance.

Track payments and credits on those invoices that make up the beginning total A/R balance. During key times of the month (the 5th, 10th, 15th, 20th and the 25th), you want to compute the payment percentage as of that date by dividing the amount paid/credited as of that date by the beginning total A/R balance.

For example, let’s say that our total A/R balance as of the first of the month is $1,000.
If, by the 10th, we have been paid $200, our payment percentage as of the 10th is 20 percent.  

You should compare the current month’s payment percentage as of the 10th, or other key times of the month, against the prior month’s payment percentage at during the same time period. If the prior month’s 10th payment percentage was 40 percent, and the current month’s is 20, it doesn’t necessarily mean that a poorer job has been done this month than last. If there’s a variation, it’s not a matter of good or bad, but of why?

A lower payment percentage may be due to the credit or A/R person going on vacation and no one following up on current and past-due accounts. It may be that a product or service with a lower product value has been sold to a customer with a less-than-perfect past performance or payment history. Or it could be that the accounts were worked in alphabetical order rather than by largest dollar first.

By tracking the payment percentage during the month, you can determine if you need to exert greater efforts. If you are not happy with the collection percentage as of the 20th, you have 10 days in which to turn things around.

At the end of the month, compute the PDI by dividing the payment percentage into the terms of sale. 
For example: at the end of the month, you have been paid $500 of your beginning A/R total of $1,000, your payment percentage is 50 percent or .5. If you are selling on 30-day terms, your PDI would be 60 days.

Use this formula:

Terms of Sale (for each term of sale)
divided by
Payment Percentage (end of month) = PDI

If you have varying terms of sale, you must compute the PDI for each different term of sale and then average them out. If you have a good payment percentage, your cash flow will also be good and more of your established credit customers will buy from you.

A good payment percentage will also contribute to controlled bad debt. It’s a positive indicator that the accounts are being worked and that potential bad debt is being identified earlier in the process when the amount at risk is less. When that’s the case, you have a higher probability of customer cooperation and of being able to improve on your payment position.

Achieving Good PDI
All vital signs will differ, based on the variables involved. For example, if a company’s product value at time of sale is low because sales and related business activity is down, the unused capacity to do business (fixed expenses) goes up. When this is factored into the credit approval decision-making, riskier credit sales should be approved even if this results in slower payments, a lower-payment percentage, and even an increase in bad debt.

If done correctly, the utilization of the unused capacity (fixed expenses) will more than offset the slow payments and increased bad debt.

Another vital sign concerns why credit customers have not paid within terms. It’s important to focus on the past-due “types” and what percentage of contacted accounts fall into each type. Every past-due customer falls in one of three categories:

Slow-Pay Customers: Some stable companies in a stable industry have the cash, but have a history of paying slow. They are either disorganized (small businesses and government) or delay payment as a way of practicing cash management (larger companies).

Problem Accounts: The difficulty for these customers is due either a problem in  their system or your’s (something went wrong somewhere) or it’s financial in nature (inability to pay). Systems problems often make up the largest percentage of all past dues. Financial problems can be further broken down into clients that are short-term in nature and those that are long-term in nature. During tough times, the percentage of financial problems goes up.

Avoiders: These customers are uncooperative. They lie; make and break arrangements or agreements, and they skip out. Most often they account for the smallest percentage of past dues.

Because A/R management is not about collections, or the enforcement of payment, but rather the completion of the sale, the “avoider” problems should be sent to outside collection professionals for enforcement. CS

Editor’s note: Part two of this article will run in the February/March issue of Contractor Supply.

Abe WalkingBear is an International speaker/trainer/consultant on cash flow, sales enhancement and business knowledge organization. Co-founder of
 www.profitinnercircle.com, and president of www.abewalkingbear.com, he is the author of Profit
 Centered Credit and Collections, 1999, co-author of STAFDA’s Foundations of a Business, 2007,
and co-author of The Best Kept Profit Secret: The Executive’s Guide
 to Transforming a Cost Center, 2009. Reach him at 719-276-0595; abe@abewalkingbear.com; www.abewalkingbear.com.