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"Optimize Your Accounts Receivable"^©

By Michael F. Hornung

An investment in accounts receivable is a necessity for most companies to do business. However, too much receivables or too little can be unhealthy. An abnormally low level can be the result of over ambitious collection efforts or a credit policy that is too tight. These conditions can result in lost sales. An excessive receivables level can be the result of a credit policy that is too loose or inadequate collection efforts.  These situations can result in increased bad debt and higher costs. You want to be at your optimum receivables level.

The key measurements used to determine a company’s receivable position are the ‘Receivable Turnover Rate’ and ‘Days Receivable’. These ratios help you monitor your credit policies and collection performance. There are two ways of calculating these ratios. The method you will utilize will depend on what you are going to use it for.

 Receivables Turnover Rate:

External Receivables Turnover Rate = Total Sales / Accounts Receivable

For external comparisons you will divide your ‘Total Sales’ by your ‘Receivables’. Compare your value to industry standards for your business such as those contained in: the “Annual Statement Studies” by the Risk Management Association; “Industry Norms and Key Business Ratios” by Dun & Bradstreet; or those published by your trade association. You can determine where you stand relative to your industry and see if you need to take any actions.

Internal Receivables Turnover Rate = Credit Sales / Accounts Receivable

For internal evaluations, divide your ‘Credit Sales’ by your ‘Receivables’. This is your true turnover rate. Compare this to your historical past or to a budget. This internal ratio is also used in deriving other measurements to assess a company’s financial and operational performance.

Days Receivable (Collection Period):

Days Receivable (Collection Period) = 365 / AR Turnover Rate

The internal value is the average time it takes you to collect your money. Any collection period more than 1/3 over normal selling terms is considered slow.

Actions you can take to improve your position:

Compare your values watching for discrepancies or undesirable trends.

Increase your collection effort. If you offer terms of net 30, call your customers when their accounts reach 32 -35 days. Do not wait until the end of the month or 45 days.

Tighten or loosen your credit policy if needed.

Change the credit terms you offer your customers. If you offer terms of net 45, reduce it to net 30. You might offer a discount of 1% if paid within 10 days else net due in 30 days. This is equivalent to 18 % annual interest and most businesses will take those terms.

Shorten your invoice process.  Bill your customers as soon as possible. Do not wait until the end of the month. Invoice them at the time of shipment. This could reduce your day’s receivable by as much as 15 days. Email or fax your invoices saving another day or two. Most new accounting software systems contain this feature. Post the payments you receive and make deposits more frequently.

Place an emphasis on reducing billing errors.  Most customers delay payments when an invoice has errors and do not recognize the invoice until it is corrected. I have seen one case where the customer did not notify the vendor of the error until the vendor called for collection.

Finally, train your credit and collections personnel.

How to use these ratios to improve your performance:

You can determine how much Accounts Receivable you should have.

Recommended Receivables Level = Total Sales / External Published Turnover Rate

You can also determine the level of receivables required to support a specific sales volume.

Receivables Investment = (Desired Level of Sales * % credit sales)
                                       Internal Turnover Rate

You can use this formula to determine the additional amount of monies you will need to invest in receivables when contemplating an increase in sales. This information is very helpful when trying to establish next year’s budget and cash flow.

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