Do you often have a hard time collecting receivables from your customers? If you do, there is a good probability that a significant portion of your outstanding accounts receivable is bleeding out your cash flows. Difficult customers who always pay late are actually borrowing your money interest-free.
Every time your customers fail to pay on the due date, you incur costs that may not be obvious to you. These costs may be in the form of opportunities that you have missed. For example, you could have earned extra income by placing your collection proceeds in the money market. Or the cost may be actual interest expense for money you borrow from the bank to support your working capital requirements when you cannot collect your receivables.
An indicator for assessing your customer’s credit profile is to compute your average collection period. To do this, first compute your receivables turnover by dividing total credit sales with average receivable balance.
Assume, for example, that your total sales for the month was P3.5 million, and out of that amount, P2.5 million was sales on account. Your accounts receivable at the start of the month was, say, P5.5 million and it ended the month at P3.5 million.
To compute for the receivables turnover, you divide the total credit sales of P2.5 million (sales on account) with the average receivable balance of P4.5 million (P5.5 million plus P3.5 million, divided by 2). This gives you a ratio of 0.56. You use this ratio to divide the standard 30 days for a month, giving you an average collection period of 54 days.
If your normal credit term with your customer is 30 days and your actual average collection period is 54 days, then your collection is overdue by 24 days. When you multiply this by your average daily sales of P83,333 (P2.5 million divided by 30 days), you will get the figure of P2 million as your total uncollected accounts receivable.
The cost of the overdue accounts can then be computed by multiplying that figure by your normal rate of return from your business. If your business is earning, say, 2 percent per month on your investment, then your slow-paying customers are actually costing you as much as P40,000 a month!
You can manage your cash flow better by shortening your average collection period. You can do this either by implementing a stricter credit policy so that your credit sales will decrease in favor of more cash sales, or by intensifying your collection efforts to lower your accounts receivable balance. To have a stronger focus on collection, you can age your receivables by breaking down your accounts receivable balance into current, 30 days overdue, 60 days overdue, and 90 days overdue or over. Through this, you can identify the customers with whom your business has the biggest exposure. You can then prioritize your collection efforts accordingly.
Normally, you should be focusing on the small accounts receivables because they have a higher probability of being collected. You may treat larger accounts receivables that have long been overdue as uncollectible and therefore need to be written off from the balance. Of course, depending on the outcome of your collection efforts with them, you can always take legal action against customers with bad debt accounts.