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Powerful Game Changing Ratio to Monitor in Tough Times

An often-overlooked ratio to track is a combination of three other ratios…

Once you calculate the other three you simply add the three to get this Turbo Ratio that I recommend all businesses with accounts receivable and inventory track.

So, what is it called?

It is called…

Your Cash Conversion Cycle

It is the measurement of how many days on average it is taking your company to convert sales into cash.

It is the combination of three separate ratios:

  1. Days Receivable – the number of days on average it takes to collect your accounts receivable.
  2. Days Inventory – the number of days on average it takes to sell your inventory.
  3. Days Payable – the number of days on average you take to pay your bills.

Let us go through each of these three ratios…

Your Days Receivable

Here the lower the number of days the faster you are converting your receivables in cash.

You need the following numbers to calculate your days receivable ratio:

  1. Opening balance of your accounts receivable, at the beginning of the month
  2. Closing balance of your accounts receivable at the end of the month
  3. Your monthly sales on credit (non-cash sales)

Add your opening accounts receivable balance to your closing accounts receivable balance and divide by 2.

Take that number and divide by your total credit sales for the month.

Multiply that number by the number of days in the month.

Accounts receivable opening balance = $100,000

Accounts receivable closing balance = $200,000

Average accounts receivable balance = ($100,000 + $200,000)/2 = $150,000

Sales for the month = $300,000

Days in the month = 30

$150,000/$300,000 x 30 = 15 days

Now let us look at the next ratio…

Your Days Inventory

Here as well, a lower number of days is better for your cash-flow.

You need the following numbers to calculate your Days Inventory ratio:

  1. Opening balance of your inventory, at the beginning of the month
  2. Closing balance of your inventory, at the end of the month
  3. Your Cost of Goods Sold for the month.

Add your opening inventory balance to your closing inventory balance and divide by 2.

Take that number and divide by your total Cost of Goods Sold for the month.

Multiply that number by the number of days in the month.

Inventory opening balance = $300,000

Inventory closing balance = $600,000

Average inventory balance = ($300,000 + $600,000)/2 = $450,000

Cost of Goods Sold for the month = $750,000

Days in the month = 30

$450,000/$750,000 x 30 = 18 days

On average it is taking you 18 days to turn your inventory over. In other words, to sell it.

Now let us look at the next ratio…

Your Days Payable

For this ratio, a higher number is better! Why? Because you are taking longer (i.e. more days) to pay your bills on average which means you are preserving cash for a longer period.

You need the following numbers to calculate your days payable ratio:

  1. Opening balance of your accounts payable, at the beginning of the month
  2. Closing balance of your accounts payable at the end of the month
  3. Your monthly Cost of Goods Sold

Add your opening accounts payable balance to your closing accounts payable balance and divide by 2.

Take that number and divide by your total Cost of Goods Sold for the month.

Multiply that number by the number of days in the month.

Accounts payable opening balance = $250,000

Accounts payable closing balance = $350,000

Average accounts payable balance = ($250,000 + $350,000)/2 = $300,000

Cost of goods sold for the month = $900,000

Days in the month = 10

$300,000/$900,000 x 30 = 10 days

Now, let us put it al together…

Your Cash Conversion Cycle

The formula for your cash conversion cycle is:

  1. Days receivable
  2. Days inventory
  3. Less – Days payable

Using our numbers from above we have:

Days receivable = 15 days

Days inventory = 18 days

Days payable = 10 days

Your Cash Conversion Cycle is 15 plus18 minus 10=23 days

Although this is a very crude measurement what it tells you is that on average you will convert your sales into cash in about 23 days.

In Closing

Remember the lower the number the better. Why? Intuitively you will want to convert accounts receivable and inventory to cash as quickly as possible. Less days to do so means cash is hitting your bank account more rapidly.

One other thing to keep in mind is that the Days payable number is more beneficial the higher it is! That is why it is subtracted in the Cash Conversion Cycle Formula.

The longer you take to pay your bills the more cash you have available to run your business. Here you will want to operate with integrity and not take too long to pay your suppliers. After all, they are essentially your partners in your business.

That said, it is fair if you take advantage of longer payment terms and wait as long as possible to pay.

Thank you for reading….

 

 

 

9 Principles of Managing Accounts Receivable

Selling something, whether a product or a service, and not getting paid is brutally painful.

Sloppiness in your billing process will cost you. The ultimate cost is not getting paid.

As I have written about many times before, the cost of a bad debt is more than the actual dollar value lost.

What do I mean?

Consider a bad debt of $1,000. Did you lose just a $1,000? Yes, you did lose $1,000, but…

You need to recover that $1,000, right?

Let us say that you sold a computer for $1,000. The computer cost you $800. That leaves $200 to cover your overhead. That is called your gross margin.

To recover that $1,000 lost as a bad debt how many computers do you need to sell?

Five. Yup, gulp, five.

How so? Do the math.

5 computers sold @ $1,000 each = $5,000

The cost of those computers is 5 @ $800 = $4,000

The difference is $1,000. The bad debt has now been recovered only after selling an additional 5 computers.

So, is the bad debt just $1,000, or $5,000? I say $5,000.

9 Principles of Managing Accounts Receivable

  1. Develop a clear, internal accounts receivable procedure.
  2. Understand your new customer.
  3. Credit check your new customer
  4. Mutually agree terms with your customer before delivering goods or services
  5. Issue the invoice immediately after delivery of goods or services.
  6. Politely chase your customer before the invoice is due to ensure they are on track for payment.
  7. Continue politely and persistently chasing your customer for payment if they have not paid by the due date.
  8. Optional – for truly troublesome customers, go ‘nuclear.’
  9. Thank your customer for payment as soon as possible after receiving it.

4 Cornerstones of Your AR Procedure

  1. Schedule invoice chasing time every week.

Book the time out in your calendar in advance. Never cancel it, never miss it.

  • Maintain invoice communications histories.

Log all communications with every customer about every invoice. Emails, phone calls, letters, meetings – log it all

We use a cutting-edge program with our clients called Chaser. All communication gets logged in a portal for each customer.

  • Regularly assess problem invoices

For larger businesses, this may mean holding credit control meetings. For smaller businesses, this should be covered in regular finance meetings. Always complete bank reconciliation on the day of the meeting to ensure you are working with the most accurate and up to date info.

We stay on top of our bank reconciliations for all our clients daily. For clients who pay by cheque it is critically vital to deposit cheques received within a day.

  • Inform the business of bad payers!

If assessing problem invoices reveals customers with poor payment trends, let other departments in your business who have touch points with them know. This may be sales reps or account managers.

4 Questions You Must Ask New Customers

  1. What information do you need to make payment?
  2. Who should I speak to in order to settle payment on this invoice?
  3. When do you make your payment runs?
  4. What are your business details for invoicing purposes?

By getting answers to these 4 questions, you will avoid:

  1. Getting paid late
  2. Having to re-do invoices, resulting in more internal labour costs

If you are struggling with accounts receivable, message me, we can help.

Thanks for reading…

6 Ways to Increase Cash-Flow

Two weeks ago, I talked about the timing of your sales pipeline. Last week I wrote about your cash conversion cycle…

As a refresher, your Cash Conversion Cycle is the number of days – on average – it takes for you to convert working capital to cash.

You start with the number of days it takes to collect your accounts receivable. Then you add that to the number of days it takes to sell your inventory. Finally, you subtract the number of days you take to pay your vendors.

Business A Business B
Days to collect receivables 40 25
Days to sell inventory 15 35
55 60
Less – days to pay vendors (15) (25)
Cash Conversion Cycle 40 35

 

Quiz – which is better, Business A, or Business B?

Business B. Why? Because it takes only 35 days, compared to 40 days to convert working capital to cash.

How can Business B get even better? By managing inventory better! It is 35 days on average to sell and only 15 days for Business A.

How can Business A improve? By getting paid quicker, and/or paying vendors a bit more slowly. It is taking 40 days to collect its receivables versus 25 for Business B.

Here are 6 ways to increase your cash-flow:

Way # 1 – Order Inventory Later

Inventory is money on the shelf.

I remember touring a warehouse once, years ago, and was shocked to see so many items laying on the floor. Other items were collecting dust. I said, “you know, if those were gold bars, would you treat them like that?”

Ordering the wrong stock too soon is going to tie up your working capital.

Order the wrong stock and you have trouble selling.

Too soon, (before people need or want), and again you have money sitting on a shelf.

An example of “too soon” is buying stock for Christmas in March. That said, if you get a great deal that could be a good business decision.

Inventory management is an art. It is related to three things:

  1. Timing of purchase
  2. Ability to re-sell the inventory quickly.
  3. Availability from suppliers
Way # 2 – Get Deposits from Customers Upfront

I believe Dell Computers had a negative cash conversion cycle because you pay for the computer upfront. Only then do they build/assemble it for you.

When I suggest getting deposits upfront to businesspeople the response is often – “I cannot. My customers will not accept that”.

How do you know? Who sets the terms?

If Michael Dell had asked his customers I am sure they would have said – “we prefer to pay on delivery”.

Michael Dell set the rules and grew a massive global cash-machine as a result.

Way #3 – Get Accurate Invoices Out Fast

The longer it takes for you to issue an invoice the slower the payment. This one needs no explaining, right? 

Way #4 – Chase Those Receivables

Once you have sent your invoices – chase them with a system.

We use software that is incredibly friendly, powerful, and consistent. It is fully automated to chase our clients receivables for them.

This shortens the days your receivables are outstanding before becoming cash in the bank.

Way #5 – Only Sell to Credit Worthy Customers

It makes no sense to sell to someone who is a credit risk.

When they do not pay, you have lost more than the receivable.

As I have written about before, you lose the entire Gross Profit on that sale.

A bad debt of $1,000 is not $1,000. Take that and divide by your Gross Profit %.

$1,000/30% = $3,333.33.

To understand the philosophy behind this, please read this blog:

Top 7 Mistakes People Make in Managing Their Accounts Receivable

Way #6 – Take a Wee Bit Longer to Pay Your Payables

If you can, pay a wee bit more slowly.

Big companies and the government are notoriously slow payers to their vendors.

Develop a policy. Too many businesses just pay, well, whenever. The “whenever” is when a vendor screams loudly!

By all means, pay small vendors faster. For bigger ones, certainly pay a couple of days before due. Not sooner. BC Hydro will not need your money early. Pay it close to the due date.

Conclusion

Doing the above 6 things will lower (remember less is more) your cash conversion cycle.

Thanks for reading…

Now, More Than Ever, It is Time to Chase Your Receivables

Selling on credit is risky…

Businesses closed in the pandemic.  Meaning they cannot pay you. Or, you cannot reach them, as offices closed.

What to do?

Three things.

Number One – Re-Set Your Credit Terms

It is better to have no sale than a bad debt.

A bad debt is awfully expensive. It is not just the cash loss. It is the recovery cost.

Imagine you have a 30% gross margin percentage. This means if you sell something for $100 that item cost you $70 ($100-$70 = $30). $30 divided by $100 = 30%.

With me so far?

A bad debt of $6,000 translates to $20,000 in new sales required to re-coop it.

Do the math. $6,000 is lost – the bad debt. Divide that by 30% to get $20,000.

Now work it backwards. You sell $20,000 x 70% in costs = $14,000. Subtract your costs of $14,000 from $20,000 in sales leaves you with a gross profit of $6,000, or 30%.

That is what you must do in sales to get back to where you were before the $6,000 bad debt.

I hope that makes you cringe a little.

Re-set your credit terms. You get to say. If your customer refuses, they do not want to do business with you.

Number 2 – Chase More Aggressively

Go after those accounts owing fast.

Call days after you send the invoice. “Did you receive my invoice? By when can we expect payment?”

Use a system to chase them with persistent and professional emails.

We use a software program for our clients designed to do only this.

And, it works. Our clients have lower “days receivable” as a result.

Follow up aggressively, and persistently.

Following-up for sticky ones should be done at the highest level. The owner.

Why? No one feels the pain more of that loss than the owner. That pain will come through in the “tone” on that call.

Number 3 – Do not Use Your Bookkeeper to Make Calls

Your bookkeeper is a bookkeeper. They like bookkeeping. Making calls is not fun for them. Why? They are introverts.

You can force them to do it.

Remember, they did not set your credit terms; nor do they choose your customers.

How can they possibly be responsible for collections?

There are professional accounts receivable collection experts. You can hire an expert in-house. Or, you can outsource it.

Outsourcing is not cheap – usually a percentage of the amount collected is billed.

To Summarize:

  1. Update and tighten up your credit terms
  2. Aggressively pursue amounts owing to you. Use a system for email chasing. Follow-up with phone calls
  3. Use a professional – not your bookkeeper. Or you, as the owner, make the calls.

Thanks for reading…