We all know the cycle all too familiarly:
1. Cash
2. Business inputs
3. Sales
4. Account receivable.
When you run a small business, we all know how vital cash is to the business. We’re no multimillion dollar corporation with millions of dollars worth of credit line from Goldman Sachs or Macquarie Bank. So cash management is one of the most vital components of business macro management. In Australia we have the One Tel case, a paper describing its birth, growth & eventual collapse can be found here. One Tel involved two big Australian household names; Packer & Murdoch. The business was founded in 1995 and met its demise in 2001 a mere six years. The business was profitable although it had its problems, the relevant problem here is their cashflow. They didn’t have sound cashflow management and let business transaction costs go appallingly over budget. They provided credit terms of 120 days in which they subsequently cut them to 30 days. This will lead us to the tip I picked up over the years regarding cashflow and credit terms for both creditors and debtors.
A simple cashflow cycle of a business was mentioned above. When we purchase business inputs, some businesses will be purchasing using cash on hand. For most businesses they will be operating on a credit term, usually 30 days. And the same businesses will usually apply the same credit terms to their debtors. The credit terms for creditors and debtors balance out. Perfect!
NOT!
Most often than not, things that sound perfectly logical and correct in theory are quite the opposite. Look at communism and finance theory for investing. They make sense but do not necessarily work once applied. The reason? Too many assumptions and the ‘x factor’; people. If all people acted out rationally and how they are expected to act this world would be absolutely boring to the hilt. People would not gamble, smoke, drink or take any other unnecessary risk. It’s the same with businesses, since the people who aren’t totally rational or perfect are heading these companies, we know businesses are going to make wrong decisions or would be lacking in management. To mitigate this risk when dealing with creditors and debtors we need to evaluate and profile all our vendors and clients.
Firstly, we can review our debtors’ timeliness in paying the bills. Do a late payment day average; (sum of days debtor has paid early/late divided by # of bills issued). This will show us on average how late our debtors are. With discretion, those with reasonable timeliness should receive a reasonable cut to their credit terms if is it currently 30 days. Debtors that are horrifyingly late, you should consider moving them to a COD (cash on delivery) or CBD (cash before delivery) payment terms. If debtors aren’t too happy about that, which I suspect some of them won’t be, then we need to evaluate the percentage of sales/gross profit they are providing to the business. A debtor that is consistency and greatly overdue on bills that only bring in 10-15% of the revenue may not be worth the trouble. You could focus your efforts elsewhere. If you are adamant about keeping all customers on board then I’ll strongly encourage you to consider factoring. Factoring is where business’s sell their accounts receivable at a discount to debtor collection firms. This is a great way to keep cashflow strong so that you can allocate your resources to productive and revenue generating areas. Bear in mind, if you are transacting in low margin products or services your trading off your margins for cashflow. Wouldn’t it be wise to consider negotiating different payment terms with your repeat offender or even consider dropping this customer entirely?
A popular cashflow method for speeding up account receivables is discounting for early payments. It works, to a degree. If our debtor is having issues pay on time, suspecting they are having cash issues too, would a 2% discount really provide the monetary incentive required to tip them over to front up cash within 14 instead of 30 days?
If we review and action some fundamental changes in credit terms so that debtors have 14 days and we pay our creditors within 30 days, possibly negotiating a discount rate from our creditor if we pay within 21 days. This would be a very sound foundation to build upon for our cashflow management.
My favorite, automation. We can use an auto-debit payment system for our debtors. I understand their are transaction costs involved with credit cards but these are costs we can inform and pass onto our debtors if they agree. We can direct debit funds from our debtor’s cash account but customers they have poor macro & cash management would want to hold onto their cash for operating expenses. So if we provide them the option of direct debit from the company credit card. More often than not a 1.0-2.2% surcharge is worthwhile for the debtor to hold onto their beloved cash. If they refuse all methods you present, it shows the lack of cashflow discipline the business has. And wouldn’t they indicate you should review your trading relationship with them? After all, their cashflow problems aren’t yours. And if they aren’t going to discipline themselves with CF management, are they going to survive in this rapidly changing and competitive marketplace?ilpulcinobirichino
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