Why High Accounts Receivable Can Be Bad Business

by Mark Henricks

Keeping your accounts receivable high may not seem like a big deal. After all, a business needs to pay its bills. And the current ratio—which is calculated by dividing current liabilities by current assets[1] including accounts receivable—is a basic measure of bill-paying ability.

But customers often seek to improve their own cash flow by delaying payment to vendors, and it's unwise to let accounts receivable grow too high. When a business lets this happen, it can lead to unnecessary financing costs and, in severe cases, a cash crunch that forces closing the doors.

If this is happening in your business, it's time to re-examine your accounts receivables practices.

What Are Similar Businesses Doing?

The first thing any business looking at accounts receivable needs to know is the standard for its industry. How are other like businesses handling it? Unless you have a good reason otherwise, your company should be behaving the same way as similar firms. To compare to the standard, a business needs to know its own accounts receivable performance. Some important measures include average receivables, average turnover, average number of days to collect, and receivable-to-sales ratio.

Check out what companies in your industry are reporting as their key figures, such as ratio of receivables-to-sales and average turnover of receivables. There are trade groups and commercial business data providers that can supply this information for you.

You can calculate average receivables by adding the receivables balance at the start of the year to the receivables balance at the end of the year, and then dividing by two[2]. Calculate average turnover by dividing the dollar amount of sales made on credit for the year by the average dollar amount of receivables. Dividing the resulting number by 365 gives you the average number of days it takes to collect on receivables. The receivables-to-sales ratio is obtained by dividing total dollar sales by average receivables. Understanding and monitoring these averages will help you make decisions about your business's threshold and when to take action to improve it.

Improving the Invoicing Process

Once a business knows where it stands, it can look to improve by invoicing in an accurate and timely manner, and stating terms that are clear and definite. You can also consider the language you use in your billing. For instance, saying “Payable in 30 days" is preferable to “Due immediately."

Invoicing weekly, biweekly, or when a shipment goes out is better than simply invoicing once a month, and offering the ability to pay by credit card can help to improve cash flow significantly.

Improving customer quality can also help. Requiring credit applications for sales other than cash is a good move, and so is getting credit reports on new customers. But slow-paying customers should be considered candidates for cash-only sales in the future.

After You've Invoiced

Following up on unpaid invoices is just as fundamental. Mail reminders monthly and if invoices go unpaid longer than the industry standard, try following up with a phone call. Be firm, but polite and understanding. And don't forget to double-check your paperwork, since tardy payments are sometimes caused by invoicing errors on the seller's end.

Ideally, you don't want to find yourself in a cash crunch, so look for cash before you need it. If accounts receivables monitoring indicates money will not arrive before bills are due, arrange for a loan or line of credit in advance. Borrowing can take time and it is preferable to negotiate terms of a loan before the last minute.

But perhaps the best thing a business can do to keep accounts receivable healthy is to consistently provide high-quality products and services. Happy customers are more likely to pay on time.


About This Author

Mark Henricks

Mark Henricks is a freelance journalist covering business, entrepreneurship, technology, personal finance, health and fitness  for leading publications.


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Important Legal Disclosures and Information

  1. http://www.investopedia.com/terms/c/currentratio.asp

  2. http://www.exinfm.com/board/accounts_receivable_ratios.htm

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