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Your profit margin is not simply determined by how much markup you apply to your goods and services, but also by how long it takes for your customers to pay you.
Perhaps you require that residential customers pay upon completion of the job, but you allow builders to pay net 30 or 60 days. That may be an unavoidable fact of doing business, and it may even increase the number of jobs you do. But, to whatever extent you carry an accounts receivable balance, you are in some way diminishing your profits.
Think of extending credit to your customers as an investment. Credit control is one of the most fundamental aspects of improving your business's return on investment. It ties up your working capital and creates the possibility of losses from bad debts. How much and what types of credit you should extend depends on many factors, including your ability to manage credit and collections, as well as the alternative uses you might have for that capital. Remember, as your investment in accounts receivable goes up, your return on investment goes down.
When you sell goods or services on credit, you are effectively loaning working capital to that business or individual. Naturally, there is a cost associated with that — a cost that increases as interest rates increase and customers take longer to pay. Here's an example of how the effects of extending credit can vary:
Let's call our company Langdon Hardwood Floors. In 1998, Langdon borrowed to finance accounts receivables and allowed customers 30 days to pay. The company had sales of $1 million and average accounts receivable of $96,000. The cost of borrowing was 10 percent, making the interest cost $9,600. In 1999, sales and interest rates remained constant, but average accounts receivable increased to $137,000. The result is that extending credit in 1999 cost Langdon $13,700 — and that means $4,100 less profit in 1999 on the same dollar volume of business the company did in 1998.
Calculate the cost
To analyze how extending credit can affect your bottom line, start by calculating "collection days." That's an easy way to track the health of your credit sales by monitoring the average number of days customers take to pay their accounts. To do that, you need some simple formulas.
Calculate your annual Average Daily Rate(ADR) of charge:
ADR = Charge sales for the year /365 days
Calculate annual collection days:
Collection days = Average accounts receivable/ ADR
Calculate your monthly Average Daily Rate(ADR) of charge:
ADR = Charge sales in the month /Days in the month
Calculate monthly collection days:
Collection days = Month-end accounts receivable/ ADR
In Table 1 (see below), we can see how these formulas would be applied in the example of Langdon Hardwood Floors.
Applying the formula for calculating annual collection days, we can see that while Langdon Hardwood Floors had the same dollar sales in 1999 as it did in 1998, customers took 50 days, on average, to pay their bills in 1999, compared with 35 days in 1998.
We can also look at how the company did in two different months. In April, the company had charge sales of $100,000 and a month-end accounts receivable balance of $133,000, meaning that customers, on average, took 40 days to pay their bills. In May, Langdon did $150,000 worth of charge sales business, and had a month-end accounts receivable of $193,500. Again, the formula indicates that customers took about 40 days to pay their bills.
Calculating annual collection days is generally a good way to measure your credit-management performance from one year to the next. Comparing monthly collection days can be useful also, and lenders frequently use that measure when judging a business's performance. However, monthly collection days can be a misleading measure when applied during times of increasing or decreasing sales. During a period of increasing sales, for example, collection days can decrease or remain stable, even when a company is doing a worse job of collecting accounts receivable.
Our current example shows that. Although collection days remained at 40 in May, the past due accounts receivable balance actually grew from $33,000 to $43,500.
A better measure of your collection success is to compare one month's collections to the previous month's charge sales. The formula is simple: Divide the current month's collections by the previous month's charge sales.
Percentage collection =Current month collections /Previous month charge sales
Using the same data we used in the monthly collection days formula, we find that Langdon Hardwood Floors did a worse job of collecting accounts receivable in May, collecting 89.5 percent of April's accounts receivable, compared with April collections of 110 percent of March receivables.
A collection rate of 100 percent or more in any month means that your investment in past due accounts is decreasing or, at worst, remaining steady. A decreasing investment in past due accounts receivable not only increases your cash flow, it also decreases the potential for bad debt and improves your return on investment.
Your total accounts receivable may grow as a result of increased sales, of course. That may be an unavoidable aspect of increasing sales. However, your accounts receivable balance should never grow simply because you aren't doing an effective job of collecting the money owed you.
Manage the risk and reward
Credit is here to stay for most of us in business today. Open-account credit is an effective means of building sales and — with proper management — profit as well. However, when you let credit get out of control — when you let too much working capital get tied up in accounts receivable — you are really loaning money to your customers, interest-free. You owe it to yourself to have good credit policies and procedures in place.