It’s happening more and more often. Businesses which are fundamentally sound are finding it harder and harder to pay their bills at the end of each month.
But why? As far as their Profit & Loss Statements are concerned, the enterprise is achieving healthy margins and posting good profits. So how come there’s no money in the bank?
More often than not, you’ll find that it’s because of poor cash flow management – and these days, with suppliers demanding payment sooner and customers paying later, that poor management can mean absolute disaster.
“Profitability is important … but cash flow is critical”.
At the end of the day, in terms of survival, it DOESN’T MATTER whether you’ve got a profitable business. There are literally thousands of UNprofitable businesses out there trading right now – just like they have been for the past umpteen years – and they’ll continue to trade for as long as their owners keep pumping additional funds into them and foregoing their full salaries, and so forth. The REAL decider about whether you’ll live to trade another day is NOT whether you’re profitable … but whether or not you can pay your bills.
If you can’t pay … you WILL get wound up, regardless of how profitable your business might actually be – so it’s critically important that you take control of 3 basic factors, known as AR (Accounts Receivable or ‘Debtor’) Days; AP (Accounts Payable or ‘Creditor’) Days and Stock (or Inventory) Days.
Each of these factors provides a measure of how many days worth of money is tied up in that area. Obviously, you should aim to keep our AR Days (money owed to us) down to a minimum. Stock Days (the amount of money tied up in stock) should also be kept to a workable minimum … and AP days (money owed to suppliers) should generally be kept to the limit of the suppliers’ credit terms, unless there is some incentive for earlier payment. By doing this, by ‘collecting early and paying late’, we will maximise the amount of cash we hold at any one time.
Obvious enough, but very few business people have a real grasp on this. (By ‘a real grasp’, I mean that they do not know on a DAILY basis EXACTLY what their AR, AP and Stock Days figures are.) Instead, when we ask most business people what they think their AR Days is, for instance, they refer to the Terms and Conditions on their invoices. In other words, if their invoice says something like ‘Terms: 30 Days’, then they figure they are getting paid in around that time. Big mistake.
The REAL state of play can be determined by applying the following formula: Debtors ÷ (Sales ÷ Days).
For instance, let’s say there’s around $175,000 owed to your organisation. Let’s also say your business is turning over $1,000,000 in sales per year. On that basis, your AR Days would be $175,000 ÷ ($1,000,000 ÷365). This works out to $175,000 ÷ $2,739 … which in turn works out to 63.9 days.
In other words, the amount of money owing to you is worth over two months’ worth of trading revenue.
As a general rule, that’s too much money to have outstanding for so long. (Especially given that debt collection experts work on the basis that at least 45% of debts are uncollectable after 60 days, and around 80% are uncollectable after 90 days).
More to the point, by tightening up on your invoicing procedures, credit checks and debt collection protocols and by tying sales commissions to receipt of payment, it’s likely you’d be able to quickly reduce the average amount of time taken to collect payment from 63.9 days to, say, 50 days. That alone would improve the business’ cash flow by $38,072 (being 13.9 days at $2,739 per day). Reduce the collection period to the 30 days stated on your invoices and cash flow would suddenly be improved by $92,852 – which would make a worthwhile difference to the overdraft.
As always, though, the old rules apply, ‘you can’t manage what you can’t measure’, so begin to measure your AR Days … as well as your AP and Stock days. (Email us if you don’t have these formulas)
Once you’re able to monitor the figures, do so on a regular basis … and set goals to improve them. That alone will produce significant improvement – or, if not, it will draw your attention to other issues which need to be addressed.
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