Monitoring your accounts receivable may seem like one more chore in an already busy workday. But this simple activity is important. Here’s an illustration. Say you’re operating with a gross profit margin of 20% and your uncollectible receivables are $10,000. Your business must generate an additional $50,000 in new sales to make up for the $10,000 of uncollectible receivables.
How can you determine whether you need to tighten credit and/or intensify your collection efforts? Different formulas applied to your receivables collections can help you make the determination. For example, the “accounts receivable collection period” ratio gives you the average length of time customers take to pay.
To calculate the collection period ratio, divide your average outstanding receivables by annual credit sales. Then multiply the resulting decimal by 365 (the number of days in a year). This gives you the average number of days customers take to pay their accounts.
Once you’ve done the calculation, put your new knowledge to use. Compare the collection period ratio from year to year. If you find customers are taking longer to pay, you may want to strengthen your policies for extending credit and pursue collections more vigorously. Even when sales are growing, the average number of days customers take to pay should not increase.
Here are more suggestions to improve collections on receivables:
- Check the credit status of new customers.
- Invoice promptly. Your customers may not pay for products or services until you send a bill.
- Consider offering discounts for early payment of invoices.
- Prepare an accounts receivable aging schedule every month and monitor past-due accounts.
- Invoice for partially filled orders and bill for ongoing services as performed.
- Put customers who habitually pay late on cash-on-delivery terms.
- Hire a collection agency to pursue delinquent accounts.
A well-defined and regularly followed system can help keep your receivables collections on track and maintain your business’s all-important cash flow.