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Small business owners often miss how critical receivables management is to maintaining cash flow and controlling costs.

There are several strategic ways to go about this:

Reducing days sales outstanding (DSO).  In my last blog, I talked about how to calculate the valuable DSO number.  The most important thing you can do is start measuring your DSO regularly and consistently.  Decreasing your DSO can free up more cash than you realize.  Increases in your DSO can mean your customers are less satisfied than they were before.  UPS, the shipping company, calculates DSO by customer.  If they see a downward trend they immediately make a customer service call.

Your AR department is your most important customer service team. They are always dealing with your customers’ money and people are sensitive about money, even in a business situation.  Developing the skills within your organization to take the emotion out of the AR process improves customer service.  Every aspect of the sales cycle from order to collection is influenced by customer service.  Recurring sales are often influenced by customer relationships; your AR department can cost you if it is not professionally monitoring and managing collections and customer relations.  More often than not, the small business owners we talk to feel they should make the collections calls themselves.  We feel that this is not a best practice – more about that in an upcoming blog.

Carefully reevaluate the assumptions behind your AR to collections policies. You may never make collections calls before 60 days because you assume your customers will be offended if you follow up before then.  Would your aging improve if you made calls at 15 days to verify receipt of the invoice?  Most non-payment is due to a dispute. The sooner you know about disputes, the more quickly they can be resolved, reducing the negative impact on your cash flow.  What other assumptions are keeping you from successfully converting receivables to cash effectively?

Get creative. You know your business better than anyone.  What can you do to decrease accounts receivable overhead and processing costs?  Can you standardize price lists and proposals?  Are you requiring written quotes?  Can you standardize collection strategies by type or value of customer?  Are you able to process alternative forms of payment?  Is there any way to reduce sales cycle time?

Improving your AR management can lead to significant financial gains, something everyone wants for Christmas.

Let’s face it, cash is king.  As a business owner, you know it is in your best interest to collect outstanding receivables as quickly as possible.  Quickly turning sales into cash allows you to put the cash to use again to reinvest and make more sales.  So which accounting calculation is your friend in helping you see if you are being effective at bringing money in?  DSO or Days Sales Outstanding is the most widely used measure of back office efficiency by credit executives.

Without boring you like Charlie Brown’s teacher, I will explain why knowing it can ultimately help you improve your cash flow in the future and, then, let’s get to the meat of how this little equation works.

Why do you care about DSO?

When used consistently, this calculation can help you answer a variety of questions such as:

  • What is the effectiveness of my credit and collection policies?
  • Are my credit terms in line with competitors?  The Credit Research Foundation (CRF) does a quarterly study, the National Summary of Domestic Trade Receivables (a.k.a., the DSO Survey), that is an examination of the condition of AR for U.S. companies. The results of the complete study are available to CRF members and those participating in the survey.
  • Are my collections procedures successful in meeting my goals?
  • Is my customer base risky?
  • What is the real reason for the changes within my receivable balance?  Was it a fluctuation in sales during that period, or are promotional discounts, seasonality or selling terms making the impact?

Unleash the DSO.

Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accounts receivables into cash. There are several ways to calculate DSO.  Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be called the Standard DSO formula. The key to making effective use of any of these tools is consistency.  Select the method s that work best for you and stick with them.

  • The Standard DSO calculation provides an average (aggregate) time in days it takes to convert accounts receivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks

DSO = (Ending Total Receivables / Total Credit Sales) x Number of Days in Period

  • Best Possible DSO utilizes only your current (non-delinquent) receivables to calculate the best length of time you can achieve in turning over receivables. It should be compared to the standard calculation above, and be close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.

Best DSO = (Current Receivables / Total Credit Sales) x Number of Days

  • True DSO calculates the actual number of days credit sales are unpaid by tracking individual invoices to the month of sale.

True DSO = (invoice amount / net credit sales for the month in which the sale occurred) x number of days from invoice date to reporting date

Of course, if your DSO shows it is time to reign in those receivables, there are several strategic ways to go about this.  We’ll delve into that next week . . . to be continued . . .

For businesses seeking small business loans or working capital loans, the process may seem like a Catch-22, or no-win situation.     Generally, loans are secured by collateral such as accounts receivable, inventory, real estate, and other assets.  But, according to the Wall Street Journal’s article, Collateral Damage in Lending, the collapsing value of assets such as inventory and equipment is causing a collateral gap and resulting in many businesses falling short of loan eligibility.   Thus, these small businesses must still pledge the usual collateral, but, increasingly, small business lenders are requiring cash or other highly liquid assets as secondary sources of repayment.   The Catch-22 is that often these cash requirements are equal to the loan request amount.   As a result, small business owners find themselves asking, rhetorically, “If I have the cash, why do I need the loan?”  

Accounts receivable remain one of the most important assets of a company.  They are the primary generator of cash.  Tighten and reduce your cash conversion cycle by reducing your business’s accounts receivable days outstanding to generate more cash.   To do this, consider your business’s complete revenue cycle from customer acquisition to invoicing to payment receipt.  Is your business following accounts receivable best practices?  What is the propensity to pay and credit worthiness of your customers?   How does the business handle aging receivables?  

Companies such as Ftrans offer complete accounts relievable and credit management solutions that help businesses address cash and revenue cycle concerns.   Implementing these best practices enables accounts receivable funding for your business without a Catch-22.

As reported by the Wall Street Journal, small and medium size businesses continue to have limited access to credit.   According to Federal Reserve Chairman, Ben Bernanke,

“The formation and growth of small businesses depends critically on access to credit,” Mr. Bernanke said in the text of his remarks. “Unfortunately, those businesses report that credit conditions remain very difficult.”

Absent credit availability in the form of small business lending, businesses must actively manage their cash conversion cycle, which is the time it takes to convert a business’s cash consuming activities into cash payments.   In other words, businesses must manage to a low cash conversion cycle which means having cash tied up in business operations for as few days as possible.  Clearly, a shallow credit market highlights the importance of managing to a low cash conversion cycle as this may be one of the few ways for businesses to have the liquidity necessary to fund their operations.   

How do you manage your cash conversion cycle?   Focusing on revenues and expenses is important.   However, equally important, and perhaps more complex is developing a better understanding of your business’s working capital situation.   Analyze your accounts receivable and accounts payable outstanding days, including inventory, to understand how movements in each affect your cash conversion cycle.   Good cash cycle conversion management equates to better revenue cycle management which equates to an increase in the health of a company.   For more information on cash cycle conversion, click here.   Additionally, consider solutions from companies such as Ftrans which provide full accounts receivable management solutions.

This is the first post in a series on funding small and medium sized businesses; first-hand accounts from people who have been through it from knocking down SBA loans hurtles, to how venture capitalists and private equity partners think, to what’s new in getting an old school line of credit. 

In this one-on-one, I spoke with Michael King, serial entrepreneur.  He’s currently a Regional Sales Manager with Ftrans, helping small business owners finance their growth opportunities with accounts receivable financing.

The small business owner is an American icon.   All kinds of Americans dream of owning their own business.  How did you get started?  What personally lured you?

When I started in the importing and wholesale distribution industry in the mid 80’s, going to China and India and Asia was exotic and different and not that many people did it.  From about 1986 to 2006 I was involved in importing products for the home, seasonal decorations and gift products, eventually owning two businesses in that space.  We sold to independent retailers and to major big box retailers as well.  We hired designers, went to factories in Asia to make our products and sold them to retailers in America. 

I’m interested in hearing more about the business you started from scratch.  Looking back, how well were you able to predict your cash needs?

Having gone through the ups and downs of owning a business before, and successfully handling it, I thought, with the right partners, we could grow to a decent size.  Our target was $1 million in the first year which we reached. 

In that industry, even with a lot of experience and very competent partners, you have to find the right product and get in front of the right customers.  Product lifecycles last maybe three years.  It’s almost a fashion industry.  You might have $6 million in sales one year and if you don’t guess right on a trend, your sales might be $1 million the next year.  When you start out, you plan for the worst case scenario –and the worst case may actually be selling a whole bunch.  You’ll owe a lot to your vendors for inventory and you can have your cash all tied up in accounts receivable.

You bootstrapped this business.  What was that like?

They call it bootstrapping  because you’re pulling your business up by your own bootstraps.  Even with an industry reputation, if you want your business to stand on its own, you have to prove that you have the management skills, the need and the collateral in the form of receivables to be able to get lines of credit.   

Starting out, to get us through the first six months, I used my own money.  I used credit cards.  I went to my family and I was fortunate enough to get some money there.  My other partners did the same.   But to fund the business cycle of buying inventory and selling it to customers on account, we had to get our vendors to let us pay on terms, too.   We had a track record and a bit of a reputation in the industry that helped as well. 

After about six months, we’d had good results and at that point we were able to use our AR to get financing with Ftrans.  That worked for us because in addition to getting access to capital more quickly, Ftrans took over many of the administrative burdens of managing our receivables. 

What were some of the decisions you made early on that you think had an impact on your ability to be successful?

We planned big, but we tried to keep internal costs variable.  Using  outsourcing is a good way to do that; we used third party warehouses and accounts receivable outsourcing.  Try to be as efficient as you can.  Empower the employees you have with the right technology so you get the most out of a few employees.  You try to maintain as much flexibility as you can from a cost standpoint so that you can maintain your profitability at whatever sales level you hit. 

Experience is important.  It pays to know who is going to buy your product, how to talk to them and to know what their needs are.   If I didn’t have certain skills in my own skills set, such as design or sourcing skills, for example, I was willing to bring in partners who did.

I always hear about small business owners who are constantly scrambling to find cash.  How were you getting stretched cash wise?         

The industry normal is net 30 days and they don’t get too worried about paying you for 45 days or so.  My DSO was 47 to 50.  Target demanded net 90 on new stores and net 60 for established stores.  I‘ve heard stories of retailers demanding even longer than that.   It helped that one of our partners was well known by one of our big vendors and they sold to us on terms.  It was like an interest free loan.

You mentioned that some of your capital came from family and I’m curious about that.  Was it in the form of a loan or as an investor?  What would you tell someone who was going to invest with a family member? 

Well, you have to be very careful about that!  In my case it was in the form of a loan.  Fortunately, I was able to pay it back.  Obviously, you take a lot of risk in damaging your personal relationships in doing that type of thing.   It wasn’t a ton of money, in my case, but it was some money and it was very important.  Obviously, if you can find partners or get debt financing, I would always suggest doing that before approaching family members or friends.  Personal relationships are too important to ruin over some type of business venture and I’ve seen it happen.

If someone in your family approached you and said “I’m starting a business and I’d like you to invest.”  As a former small business owner, what would persuade you to invest?

It would be more now than it used to be!  I realize what is needed in terms of properly managing the financial side, having good internal cost controls and financial skills and savvy.  Not just having a good idea with market demand and a differentiating competitive advantage, but the ability to run the business side of it.  And I wouldn’t give more than I could comfortably lose. 

Was there ever a time when you thought, “This is not going to work?”  When it became a real gut check?   What did you do?

I went to my vendors and tried to get better terms.  I always tried to be respectful and keep a mutually profitable relationship with my vendors, but I explained that it would help me grow my business and help my loyalty with them.  Sometimes you have to not take salary yourself.  There were times I did have to reduce staff.  There were always hard choices. 

There’s nothing like real life business experience.  If you planned to start another business, what did you learn from your initial experience that you would always have in mind?

I would look at private equity or the angel environment and try to get bigger faster rather than relying on retained earnings or debt to grow the business.  I wouldn’t try to do it all myself.   I would be more careful about picking a business with strong margins, smarter about analyzing competitive pressures.  I got in the import business because I liked to travel and I did a lot of that.  I lucked into a way to make money but I don’t think that space exists now the way it did then.

You think you’d ever start another business again?

Absolutely!  I plan on it!  I’d definitely be an entrepreneur again.  I liked wearing a lot of different hats.   I don’t know about the stock market being the path to retirement.   I’m probably going to have a couple of small businesses that are running well.   I come from a family of business owners; it’s in my blood a little. 

More on Bootstrapping:

The Art of Bootstrapping

Bootstrapping Your Start Up 

 

Sandra Chesnutt is a Marketing Senior Manager with Ftrans.  Ftrans combines outsourced accounts receivable management with fast and affordable access to funding – providing small and medium businesses the cash they need to grow and take advantage of market opportunities.

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