Without cash flow your business can’t survive.
Matthew Gardiner looks at ways to manage debtors, one of the biggest factors in keeping cash flowing.
The core of any successful business is its ability to generate enough income to pay off any debts—cash flow.
Many business people fail to monitor cash flow, and so although profitable on paper, the business may not have enough cash to pay its debts.
Inability to turn sales into cash on a timely basis creates a range of problems and is one of the principle causes of business failure. Simply having a good product or service is often not enough; the ability to manage cash flow through business growth is critical to success.
To maintain a healthy cash flow, three main areas should be considered: debt, inventory and borrowings.
Regularly collecting money owed is the first area businesses should look at to increase cash flow levels. The best way to do this is to have a disciplined credit control system and debtor follow-up.
To help manage debtors:
• encourage automatic payments to a bank account;
• check credit ratings for new customers, in particular those placing significant orders from the outset;
• review credit ratings and reports regularly to check any changes in buying habits and increasing levels of debt—long-term customers are often the greatest credit risk because no-one thinks to check on them;
• set terms of trade at the outset and ensure the business sticks with them, automatically sending reminder letters;
• rank debtors by value and risk and monitor their accounts accordingly; and
• deal directly with decision-makers, monitoring collections and following up if payment schedules are not met.
Failure to collect from debtors on time means the business is funding its customers’ trading activities. Businesspeople can be too concerned about offending customers if they follow up debts. But slow-paying customers are unprofitable customers, and often become non-paying, and therefore loss-making. A disciplined and well-managed follow-up routine rarely offends.
Checking and reviewing customer credit ratings regularly will also help to identify and manage slow or non-paying customers. For example, one trap that many small businesses fall into is offering trade credit to new customers in order to attract their business, with little thought given to the associated risks. Obtaining credit information about new trading partners is a simple but important step to help a business protect its own cash flow.
Information on the credit risk of businesses is readily available from various agencies and business owners should take advantage of these. The cost of obtaining this information is often significantly less than the cost of bad debts. Including the assessment as part of the usual credit control process can save the business large amounts of money by weeding out bad credit risks at the outset.
Always remember that goods or services sold on credit are not actually revenue until the cash is in the bank, so assessing credit risk should form part of the overall customer application process.
It is important to ensure trading terms are followed by all customers. Allowing credit to slip beyond agreed terms sets a trend, and can create future cash flow problems in the form of bad debts or slow payment.
Strong internal control of debtors is the most simple and least costly of all credit control methods. Maintaining discipline helps the business avoid other, more costly, means, as cash is generated by the business itself rather than relying on working capital provided by other sources.
External debt collection can be effective for delinquent debtors. If internal efforts to collect outstanding amounts have failed, the threat of external collection will often work. Debt collection agencies are specialists in the area and have various tools at their disposal.
The downside of external debt collection agencies is the damage they can do to the customer relationship. Although agencies may claim their actions will not impact on the customer relationship, this is often not the case and so the value of an ongoing relationship versus prompt collection of outstanding debts is a trade-off that needs to be considered. However, a customer that doesn’t pay should be regarded as an undesirable one.
The cost of external collection, which can run to as much as 12.5 percent of the debt collected, is also a consideration.
Inventory must be regarded as capital. It has to be funded and excess inventory ties up business funds that could perhaps be more useful elsewhere in the business. This doesn’t mean keeping inventories at levels so low that orders are lost because items are out-of-stock. However, excess stock, particularly stock that may become superseded or redundant, should be avoided.
Investing in inventories with a long shelf-life, but which require suppliers to pay promptly, may lead to cash demands that can’t be met from normal cash flows. Inventories that are obsolete and will never convert to cash means businesses are carrying book losses by overvaluing inventories.
Reviewing Cash Flow
Reviewing borrowings regularly is a good discipline, as it requires business managers to review all aspects of cash flow, including debtor and creditor management. If the business is considering taking on more debt, it is important that the purpose of borrowing is considered in order to identify the best financing option. Some will be more suitable than others.
A bank overdraft, for example, should generally be used to fund the month-to-month operations of the business. It should not be used to fund long-term acquisitions. Alternatives such as lines of credit, business loans, leasing and corporate hire purchase are usually more appropriate to fund such acquisitions.
Debtor factoring is a worthwhile consideration for many businesses, especially while interest rates are still relatively low. It involves selling business debts at a discount to a financier who then has responsibility for collection. It can help cash flow considerably, reduce risks and overcome slow payment by customers.
Debtor financing is a useful tool for businesses with a large amount of debtors or for those experiencing growth which can often lead to disparity between creditor payment deadlines and collection of debts.
Invoice discounting is an improvement on factoring as it provides immediate cash flow, usually up to 80 percent of sale value on issue of invoice, with the balance repaid on collection, and less fees for the facility. The business remains in control of its debtors/customer register and makes the decisions about credit limits and industry, size and type of client.
Debtor factoring and invoice finance are best for businesses that are growing or that don’t have assets on which to secure other types of funding, for example service businesses. As the business grows it can access the cash tied up in its debtors to pursue further growth.
As with all finance there is a cost for debtor factoring and invoice financing. Some businesses may find that once they are of a certain size they are better able to control debtors internally and achieve the same results.
Inventory finance is a relatively new finance product that can help businesses acquire stock for resale. Finance is provided against the value of creditor invoices on stock purchases up to 90 percent of the value. Repayment is required, subject to approval, in line with the cash flow generated from sale of the stock.
his type of financing is most appropriate for businesses that deal in large quantities of stock that must be acquired prior to sale to the end customer. Changes in market demand will have a greater impact on these businesses if they are exposed to debt over their stock. The advantage is the ability to use stock on the balance sheet to secure cash flow. The disadvantage often revolves around the value placed on the stock by the financier. An often overlooked benefit of using such financing techniques is the extra discipline it places on managing funding which often helps to avoid costly mistakes.
The more information the business manager has about cash flow, the better they will be able to manage it.
* Matthew Gardiner is a partner with accountants and business and financial advisers HLB Mann Judd, Sydney.