In the last post we discussed the concept of Working Capital and intoduced the cash collection cycle.

The cash collection cycle is an important driver of profitability for a company. When building a financial model of a company or performing a valuation it is important to understand the impact of a company's cash collection cycle. Companies can temporarily bolster cash reserves by manipulating their cash collection cycle around their end of financial year to appear more profitable and efficient, and can end up going insolvent from not managing their cash collection cycle effectively. Recapping the last post, the cash collection cycle is composed of the following: Receivables days + Inventory days - Creditor days. Each item is important, and there are different consequences for managing working capital to have a cash collection cycle of different lengths:

Receivables Days: If receivables days are long, this means that a company is taking a long time to collect money for its customers after providing them with a product. The advantage of running a long receivables days policy is that more customers are able to make a purchase immediately and this allows customers to manage their own cash flow better so they can pay their bill for the sale when they are ready and able to. The disadvantages of running a long receivables days policy is that this means that the company is taking credit risk against its customers, and therefore needs to allocate more resources/systems to manage the eventual collection of cash. Additionally this means that the company needs to find an alternate source of cash to fund the inventory or costs it has incurred in making the sale. If a company has a short cash collection cycle then this reduces credit risk for a company and means it generates cash from sales more quickly, but it can be counter-productive as it means that competitors may be able to lure customers away with more attractive sales terms. Inventory Days: If a company has a long inventory days period, this means that it keeps a substantial amount of stock compared to the amount it sells in a year. The advantage of this policy is that when a customer wants to make a purchase then it is highly likely the company will have the products available to sell to the customer. Additionally, as a general rule numerous businesses (in particular retail) achieve a higher rate of sales if customers come to the opinion that your point of stale (retail shop front, warehouse etc) is a good place to go in order to find the product they are looking for. Having a higher inventory level helps this effect. An additional benefit of running high inventory levels is that your suppliers are more likely to want to continue doing business with you and may also become more stable suppliers because they are able to depend on regular larger orders. Numerous companies try to run very low inventory days policies in order to optimise cash collection. An inventory management model called 'just in time' inventory management involves obtaining inventory from suppliers only at the point in time that it is needed for a sale or for part of a manufacturing process. This sort of model is more common when a company has substantial market influence or is the biggest player in its supply chain, and can therefore dictate terms. Disadvantages of running a low inventory days policy include the risk of not having inventory available when it is needed and stressing your suppliers' businesses.

Creditor Days: If a company runs a long creditor days policy this means that it takes a long time for the company to pay its suppliers. This helps in the cash collection process as it delays the payment of costs. Creditors can therefore be viewed as a form of interest free funding, and therefore from a pure capital allocation perspective it is generally viewed as positive to have a longer creditor days policy. Detriments of having a long creditor days policy include stressing suppliers or potentially being forced to come up with a substantial amount of cash if suppliers refuse to continue offering the same creditor terms. Suppliers may even just not want to deal with a company anymore if it won't pay its bills on time. A further detrimental effect of running a very long creditor days policy is that banks view a very stretched creditor day cycle as a sign that a company is stressed, which can lead to more restrictive banking covenants or even withdrawal of bank funding. The primary disadvantage of running a short creditor days period is that it has a detrimental effect on cash generation.

http://www.accountingtools.com/questions-and-answers/what-is-the-cash-collection-cycle.html

The cash collection cycle is the number of days it takes to collect accounts receivable. The calculation is to divide annual credit sales by 365, and divide the result into average accounts receivable. The formula is: Average accounts receivable Annual credit sales / 365 You should attempt to keep the cash collection cycle as short as possible for the following reasons:

Rapid collection means more cash on hand, which reduces a company's borrowing requirements An older invoice may not be acceptable as collateral for a loan An older invoice may not be acceptable for invoice discounting An invoice is generally more difficult to collect the longer it remains outstanding

Conversely, it may be acceptable to have a longer cash collection cycle if management uses a relaxed credit policy to extend credit to more marginal customers for which the probability of collection is lower than usual. You should always attempt to collect unpaid accounts receivable sooner, in order to accelerate cash flow. Several techniques for doing so are:

Invoice promptly. Always issue an invoice to the customer as soon as delivery of the merchandise or provision of the services have been completed. Otherwise, you are delaying collection by never giving the customer any document from which to pay. Contact customer before due date. It may be cost effective to contact those customers with larger outstanding receivable balances prior to the invoice due dates. The reason is that you may uncover a payment problem that you can start working on immediately, rather than several weeks later, when you would normally notice the problem. Dunning letters. Send an automated notice to the customer, reminding them that a payment is about to be due, or is now past due. There are a variety of ways to send a dunning letter to attract the attention of the recipient, such as by overnight delivery. Obtain payment of undisputed amounts. If a customer is complaining about a particular line item on an invoice, then insist that the customer pay for all of the other line items while you continue to investigate the one item that is in dispute. Personal visit. It is much more difficult for a customer to delay a payment when you are sitting in front of them. Clearly, this is only cost-effective for very large overdue balances. Salesperson collects. If your company uses a hands-on sales staff to make sales, these people have the best contacts at a customer, and so are in the best position to collect payment. Take back merchandise. If the customer simply cannot pay, and you sold it merchandise, then attempt to recover and re-sell the merchandise. Issue attorney letters. Also known as a "nastygram," this is a threat of legal action without actually taking legal action. It is a relatively inexpensive way to involve an attorney, and is usually issued on the attorney's letterhead. Turn over to collection agency. If no other method works, turn over the account to a collection agency, which may be more aggressive with its collection activities than you are willing to be.

Accounts Receivable Collection Period

Description: Some people find that the accounts receivable turnover figure is easier to understand if it is expressed in terms of the average number of days that accounts receivable are outstanding. This format is particularly useful when it is compared to the standard number of days of credit granted to customers. For example, if the average collection period is sixty days and the standard days of credit is thirty, then customers are taking much too long to pay their invoices. A sign of good performance is when the average receivable collection period is only a few days longer than the standard days of credit. Formula: Divide annual credit sales by 365 days, and divide the result into average accounts receivable. The formula is as follows:

Average Accounts Receivable Annual Sales/365 days

Example: The controller of ABC Company wants to determine the company's accounts receivable collection period. In the June accounting period, the beginning accounts receivable balance was $318,000, and the ending balance was $383,000. Sales for May and June totaled $625,000. Based on this information, the controller calculates the average receivable collection period as: Average accounts receivable Annual sales / 365 days = ($318,000 Beginning receivables + $383,000 Ending receivables) / 2 ($625,000 x 6) / 365 days = $350,500 Average accounts receivable $10,273 Sales per day = 34.1 days accounts receivable collection period Cautions: The main issue is what figure to use for annual sales. If the total sales for the year are used, this may result in a skewed measurement, since the sales associated with the current outstanding accounts receivable may be significantly higher or lower than the average level of sales represented by the annual sales figure. This problem is especially common when sales are highly seasonal. A better approach is to annualize the sales figure for the period covered by the bulk of the existing accounts receivable.

Accounts Receivable Turnover Ratio

Description: Accounts receivable turnover measures the ability of a company to efficiently issue credit to its customers and collect it back in a timely manner. A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, while a low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital.

Formula: Add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows: Net Annual Credit Sales (Beginning Accounts Receivable + Ending Accounts Receivable) / 2

Example: The controller of ABC Company wants to determine the company's accounts receivable turnover for the past year. In the beginning of this period, the beginning accounts receivable balance was $316,000, and the ending balance was $384,000. Net credit sales for the last 12 months were $3,500,000. Based on this information, the controller calculates the accounts receivable turnover as: $3,500,000 Net credit sales ($316,000 Beginning receivables + $384,000 Ending receivables) / 2 = $3,500,000 Net credit sales $350,000 Average accounts receivable = 10.0 Accounts receivable turnover Thus, ABC's accounts receivable turned over 10 times during the past year, which means that the average account receivable was collected in 36.5 days. Cautions: Some companies may use total sales in the numerator, rather than net credit sales. This can result in a misleading measurement if the proportion of cash sales is high, since the amount of turnover will appear to be higher than is really the case. A very high accounts receivable turnover number can indicate an excessively restrictive credit policy, where the credit manager is only allowing credit sales to the most credit-worthy customers, and letting competitors with looser credit policies take away other sales. A final issue is that the beginning and ending accounts receivable balances are for just two specific points in time during the measurement year, and the balances on those two dates may vary considerably from the average amount during the entire year. Therefore, it is acceptable to use a different method to arrive at the average accounts receivable balance, such as the average ending balance for all 12 months of the year. Similar Terms Accounts receivable turnover is also known as the debtor's turnover ratio.

The Bad Debt Forecast

Creating an accurate bad debt forecast can be similar to reading tea leaves or consulting a crystal ball it is very difficult to make actual results come anywhere near the forecast. The usual approaches are to either create a forecast based on specific expected losses or to assign a loss probability based on the age of various receivables. Neither approach works especially well. An alternative with a greater level of accuracy involves assigning a risk class to each customer, and then assigning a loss probability to open receivables based on the risk class. Risk classifications can be calculated with elaborate in-house risk scoring systems, but there are many commercially-available alternatives available, such as FICO scores for individuals or the Dun & Bradstreet Paydex and Financial Stress scores for businesses.

Here are the steps needed to create a bad debt forecast based on risk scoring: 1. Periodically obtain new risk scores for all current customers, excluding those with minimal sales. 2. Load the scores for each customer into an open field in the customer master file. 3. Print a custom report that sorts current customers in declining order by risk score. 4. Divide the sorted list into fourths (low risk through high risk), and determine the bad debt percentage for the previous year for each category. 5. Use the format in the following example to derive the bad debt percentage: Risk Category Low risk Medium low Medium high High risk Totals Current Receivable Balance $9,500,000 7,250,000 3,875,000 750,000 $21,375,000 Historical Bad Debt Percentage 0.8% 1.6% 3.9% 7.1% 1.9% Estimated Bad Debt by Risk Category $76,000 116,000 151,125 53,250 $396,375

Podcast A discussion of credit best practices is available on Episode 86 of the Accounting Best Practices podcast. Listen Now.

Collection Dispute Cycle Time

Since time is money, it makes sense to track the time required to resolve collection disputes. The simplest approach is to use the same case tracking system used by the customer support function, and record within it the beginning and end dates for each dispute, as well as the amount in dispute, the cause of the problem, and who is handling its disposition. When summarized over a large number of disputes, this gives management a good idea of the average time required to settle a dispute, as well as which customers are repeatedly involved with the longest-running disputes, what root problems cause them, and which collections staff have the best (and worst) ability to quickly resolve disputes.

When used properly, an ongoing examination of collection dispute cycle time can result in decisions to eliminate more difficult customers, provide training to those employees who have problems resolving disputes in a timely manner, and to correct the underlying causes of disputed payments. The measurement can be deliberately skewed by altering the recorded beginning and end dates of dispute cases. To keep this from happening, do not tie reductions in dispute duration to a bonus plan; this ensures more honest record keeping. Podcast A discussion of credit best practices is available on Episode 86 of the Accounting Best Practices podcast. Listen Now.