Few business owners will dispute the fact that “cash is king”. A lack of operating cash was the primary “cause of death” for many U.S. “dot-coms” in the early 2000s. Poor cash flow management continues to result in the collapse of business enterprises, large and small, around the world.

Cash flow, simply put, is the movement of money in and out of a business. The goal of cash flow management is to decrease the amount of time it takes to collect cash, while increasing the time interval for disbursing it.

The first step in improving cash flow management is to determine why there's a cash flow problem. Where cash is tied up? Some potential cash traps include:

Cash sitting in non-interest bearing accounts
Unrecognized costs, unnecessary or underused inventory
Fixed assets: building, equipment, cars, etc.
Loans to officers, employees, affiliated companies
Uncollected sales/accounts receivable

The Accounts Receivable Cash Trap

One of the most common cash traps is uncollected sales, a.k.a. accounts receivable.

Selling on credit is pretty much a requirement in today’s economy. Most companies can’t compete unless they can offer some buyers, hopefully those that will end up paying, credit terms. But, too many credit buyers treat credit terms as if they were interest-free, perpetual loans. Their tactic is to drag out payment as long as possible. Unfortunately, as a result, many sellers end up with an inordinate investment in accounts receivable tying up their cash flow.

Determining just how much it costs to carry your receivables is relatively simple. You determine how much interest you would pay per day on your total annual receivables and multiply this by the average number of days it takes you to collect on credit sales (DSO).

You only need three numbers: your total annual receivables, your DSO and interest rate.

The interest rate could be the actual interest you pay for your line of credit, the prime rate, the marginal cost of capital, etc.

Example:

XYZ Company has $20,000,000 in annual credit sales and a DSO of 65 days. We’ll use the U.S. prime interest rate of 5.00% (as of 5/1/08).

Cost of carrying receivables:

((Total Receivables x Interest) / 365 (days)) x DSO
((20,000,000 x 5.00%) / 365) x 65 = $178,082.19

Thus, it costs XYZ Company about $178,082 in interest per year to provide its customers $20,000,000 in credit.

All well and good. But is this a reasonable investment? Here's one way to determine that. First, benchmark your DSO against an industry average. Then, complete the worksheet below to determine your excess investment in receivables. (See Some Sources of Credit and Collection Benchmark Information below.)

Example:

We’re going to assume that the average DSO in XYZ Company’s industry is 50 days.

Excess Receivables Investment

XYZ's DSO	65 days
Industry DSO	-50 days
Excess Investment in Receivables	15 days
1 Day's Sales (Annual Sales/365)	x $54,795
Cash Invested in Excess Receivables	$ 821,925
Cost of Borrowing	x 5.00%
Annual Interest	$ 41,096.25

In this example, XYZ Company has $821,925 cash invested in excess receivables, plus $41,096.25 in interest charges, for a total $863,021.25 in cash flow trapped in its receivables!

Improving Cash Flow by Reducing DSO

If XYZ Company can reduce its DSO by just 5 days, it can free up almost $288,000 in cash flow. Let’s see how:

Example: XYZ Company

Excess Receivables Investment with DSO = 65 days		Excess Receivables Investment with DSO = 60 days		Improvement
XYZ's DSO	65 days	XYZ's DSO	60 days	5 days
Industry DSO	-50 days	Industry DSO	-50 days
Excess DSO	15 days	Excess DSO	10 days
1 Day's Sales	x $54,795	1 Day's Sales	x $54,795
Cash Invested	$821,925	Cash Invested	$547,950	$273,975
Cost of Borrowing	x 5.00%	Cost of Borrowing	x 5.00%
Annual Interest	$41,096.25	Annual Interest	$27,397.50	$13,698.75

If you add the $273,975 improvement in Cash Invested in Receivables with the $13,699 reduced interests costs, XYZ Company was able to reduce their cash trapped in receivables by $287,674

Reducing DSO

As you can see, DSO has a tremendous impact on cash flow. Reducing DSO, even slightly, can go a long way toward improving the health of your company.

The next step, of course, is to find ways to reduce DSO. Answer these questions in each area of your A/R management process to find holes that need to be plugged.

Credit Approval

Are you performing credit evaluations on all new customers? Are your credit terms appropriate and adhered to by your sales department? Do you have a procedure in place for updating credit information on a regular basis? Do you belong to an industry credit group?

Invoicing

Are your invoices accurate and prompt? Are payment terms clearly stated? Do you provide incentives for early pays? Have you considered EIPP (electronic invoice presentment and payment)?

Receivables Management

Do you have a process in place? Do you adequately follow-up on customer disputes and late pays? Are you measuring performance against goals? Do you regularly review aging reports? Do you have an understanding as to why customers are paying late (i.e. invoice discrepancies, quality issues, etc.)? Have you trained your customers to pay within terms?

Collections

Do you have employees focused on collections? Are they well trained? Do they have enough time to follow up on all past due accounts? Have you considered outsourcing part of your receivables portfolio (small balances, specific divisions, etc.) for 1st party follow-up? Should you consider using a professional 3rd party collection firm?

Just a small improvement in DSO can go a long way toward improving the health of your company – and a healthy company is in a position to meet the needs of all its stakeholders, making everybody happy.

Some Sources of Credit and Collection Benchmark Information

If you belong to a credit group, you should have access to this information through your membership. If you don’t belong, consider joining one. Participation in the confidential exchange of credit data provides members with access to valuable information for evaluating credit risks and thereby minimizes collection problems and helps improve DSO.Your banker may be able to provide this information through the Risk Management Association’s “Annual Statement Studies” (formerly the “Robert Morris Associates Annual Statement Studies”).

The Credit Research Foundation conducts surveys by industry which detail relevant statistical information concerning domestic accounts receivable performance. The summary data of the most recent quarterly report is available on the Credit-to-Cash Advisor web site – “U.S. Trade Receivable Statistics”.

Strategic Advantage provides financial benchmarks online for a fee. You can purchase a 24-hour subscription for just $3.95.

Credit-to-Cash Advisor article “Using DSO to Measure Collection Efficiency” (2/23/05) provides some industry DSO benchmarks by SIC code, as of the date of the article.

Some Articles on Cash Flow Management

“Cash Flow – The Pulse of Your Business”, Accountant Site

“Improving Cash Flow”, Inc.com

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This information is provided by ABC-Amega Inc. -- providing 1st and 3rd party commercial collection services since 1929, and collecting in more than 200 countries worldwide. For further information, contact info@abc-amega.com.