Getting some customers to pay their invoices can be like pulling teeth, but there are measures you can take to ease the process. These slow paying customers can put your cashflow under huge pressure. This can affect your ability to pay your staff and suppliers, buy the latest piece of equipment, or take that much needed holiday.
Strong processes around debt collection can help. The first step is to measure the average time it takes people to pay their invoices. Measurement helps you to set targets for where you need to get, and to monitor progress on a month-to-month basis.
Here’s the complicated bit: to calculate your average debt collection time, divide average debtors (accounts receivable) by total sales. Then multiply this by the number of days those sales were across (ie, 365 for a whole year, 31 for a month).
For example, say your beginning debtors for a month were $35,000 and closing debtors were $45,000 (average of $40,000). Your monthly sales were $25,000. The average debt collection time would be 49.6 days ($40,000 ÷ $25,000 x 31). This raises the question of what is the ideal collection period.
Your collection period will depend on the industry you’re in and your customer mix. For example, we’ve seen plumbers with collection periods ranging from 24 days (great) to 63 days (not so great). Your collection period will also be dependent on whether you’ve got a large number of small clients, or a small number of large clients. Obviously the lower the collection time the better.
A short collection period means you’ll be able to pay your suppliers on time, every time. You may then be able to negotiate better prices with them. You might also be able to take a regular wage out of your business, helping you to manage your home finances more easily. You’ll find it easier to put aside money for GST and tax payments, helping keep the taxman at bay. All in all, managing your business will become easier.
On the other hand, a lengthy collection time may push you into overdraft with your bank, resulting in additional interest costs. At the same time you may then struggle to pay suppliers. This could mean you’re less likely to get any discounts from them, hurting your bottom line. You’ll also struggle to take your regular drawings, making life outside work that much more difficult.
Unfortunately, keeping debt collection times under control is easier said than done. A starting point is to set clear expectations with customers about when you will be paid. Preferably these expectations are set out in writing and agreed to before commencing work. You should also set aside time each week to follow up your slow payers and deal with each of them in a consistent way.
Following up could involve the following steps:
- a phone call as soon as the invoice is overdue
- a letter four days later
- a personal visit three days after that
- referral to a debt collection agency in a further two days.
Although there’s a cost to involve a collection agency, you need to weigh this up against the cost to your cashflow of not using the collection agency. By sticking to this process, collection periods should reduce.
There are a range of other methods you can employ to decrease collection periods. However the key is monitoring your average collection periods and sticking to your follow up procedures. Overtime this should help you to enjoy the benefits of strong cashflow.