by MHolland | Apr 24, 2024 | Accounts Payables, Accounts Receivables, Cash Flow, Cloud-based Accounting
Last week I wrote about how the three main financial statements of your business contain five sections as follows:
- Assets (the things you own)
- Liabilities (what you owe)
- Equity (what’s leftover for you)
(the above 3 sections are on the Balance Sheet)
- Revenues (the inflows into your business)
- Expenses (the outflows from your business)
(the above 2 sections are on your Income Statement)
To understand the story of your business month by month, year by year you need a sharper focus.
That sharper focus can begin with ratios.
Last week I wrote about liquidity ratios and profitability ratios.
To recap, liquidity ratios – the main one being your current ratio – tells you how well you are able to pay your bills as they come due.
The profitability ratios include your Gross Profit Margin, your Net Profit Margin and Return on Equity. These tell you how profitable your business is and what your return on investment is.
This week I will write about…
Activity Ratios
There are three main activity ratios:
- Average days inventory
- Average days receivable
- Average days payable
The above three ratios can be summarized in what is called your Cash Conversion Cycle.
The intent of the above ratios is to show you how quickly you sell your inventory, convert your accounts receivable to cash and the time you take to pay your bills in order to conserve cash.
First, let us look at…
Average Days Inventory
To calculate this ratio, you first take your opening inventory for the period (month or year) and add this to your closing inventory. Then divide by two.
Take this average and multiply by the days in the period (for example 30 or 31 for a month) and divide this by your Cost of Goods Sold for the same period.
The smaller the number the better. A smaller number means you are selling your inventory more quickly. A longer number of days means your cash is tied up in inventory.
The next ratio is….
Average Days Receivable
This measures the average number of days customers take to pay for your goods or services.
For example, if you give your customers terms of 30 days, and your days receivable are running at, say, 25 days, then you are doing great.
You calculate your days receivable as follows:
Opening Accounts Receivable at beginning of the period (month for instance) plus Closing Accounts Receivable at end of the period divided by two.
Now, take the average accounts receivable times the number of days in the period (30 or 31 for a month) and divide that number by your Revenue for that same period.
Even if you have a small number, which is great, it is important to review each aged account receivable.
This is because fast payers can bring the average down, hiding slow payers.
In a tough economy, you are only as successful as your clients are successful.
The other thing to keep in mind is that your accounts receivable is what your customers will want to stretch out as long as possible. Your account receivable is their accounts payable!
The best way to get your receivables paid fast is persistent, constant communication. The cliché “the squeaky wheel gets the grease” applies here.
A large bad debt could cripple your business.
Now, let us examine…
Average Days Payable
This is a measurement of how long you take to pay your supplier bills, on average.
For this Key Ratio, longer is better.
Why? Because it means you are holding onto your cash longer.
However, you will not want to jeopardize your relationships with your suppliers.
You calculate average days payable as follows:
Opening accounts payable plus closing accounts payable (for the period) divided by two.
Take the average as above times the number of days in the period and divide that by the Total Cost of Goods Sold for the period.
Now, we can summarize all three of the above ratios into one number…
Cash Conversion Cycle
Your cash conversion cycle is the number of days, on average, it takes to convert your working capital into cash.
Here is how you calculate this ratio:
You simply add your Average Days Inventory to your Average Days Receivable and then subtract your Average Days Payable.
Let us assume you take 60 days on average to sell your inventory, and 20 days on average to collect your receivables, and 40 days on average to pay your supplier bills.
Your Cash Conversion Cycle is 60 + 20 – 35 = 45 days.
Is it possible to have a negative Cash Conversion Cycle?
Yes!
Let us say you turn your inventory every 20 days and collect your accounts receivable in 15 days and take 40 days to pay your bills.
Your Cash Conversion Cycle will be: 20 + 15 – 40 = negative 5 days.
This is awesome, and the sign of an extremely healthy business.
Thanks for reading…
by MHolland | Apr 18, 2024 | Accounts Payables, Accounts Receivables, Business Tips
Your monthly financial statements tell you a story….in the language of numbers…
Every business has three main financial statements:
- The Balance Sheet
- The Income Statement
- The Statement of Cash Flows
The Balance is the main statement. What? Not the Income Statement?
Yes, it is true that most businesspeople will focus most of their attention on the Income Statement.
They do this because the Income Statement shows the results of activities over a period of time – a month, a quarter, a year.
The Balance Sheet has all the information to determine the heath of a business at a specific point in time.
Did you know that the Income Statement and Statement of Cash Flows are each derived from the Balance Sheet?
The Balance Sheet is the fulcrum of the three statements.
The Big Picture
The story that your financial statements are telling you starts with the big picture.
Let us break it down…
Your Balance Sheet has three main sections:
- Assets
- Liabilities
- Equity
Assets are what you own.
These can be further segregated into Current Assets, Fixed Assets, and Investments and Intangible Assets.
Liabilities are what you owe.
They can be segregated into Current Liabilities (due within one year), and long-term liabilities.
The difference between your assets (what you own) and your liabilities (what you owe) is your equity.
A simple way to envision this – imagine all you own is a house. You paid $300,000. This is your asset, what you own. You have a mortgage of $210,000. This is your liability, what you owe.
Your equity is simply the difference between the two, or $90,000 in this example.
You sell your house for $300,000 and pay off your mortgage of $210,000 and you pocket $90,000.
Simple!
Your Income Statement is made up of two main sections – revenue (the inflows into your business), and expenses (the outflows from your business).
The difference between the two is your Net Profit.
Recap
So, now we have a Big Picture emerging – by knowing these five main sections of these two financial statements.
By looking at the Balance Sheet, we can determine what we own (assets), what we owe (liabilities), and the difference between the two (equity).
In examining the Income Statement, we can see what revenues flowed into our business, and what expenses flowed out of our business, and lastly how much profit we made.
That is the Big Picture…
Now let us get more detailed…and talk about ratios…
Ratio Analysis Deepens the Story
By looking at ratios in your business, we can start to interpret the “story of your business.”
Ratios come from the main sections of your financial statements. They tell us specific details about your business that we cannot glean from just looking at the five main sections…
By understanding exactly what they mean we can determine the overall health of our business.
From there we can make decisions to improve it.
What are the main ratios we should be looking at for most businesses?
Liquidity Ratios
Liquidity Ratios provide an early warning for a business unable to meet its current liabilities when they come due.
A current liability is defined as something due within one year. These include things like wages payable, accounts payable, taxes payable, and loan payments.
A current liability is paid with a current asset. Current assets are either cash in the bank or things that will convert to cash quickly. For example, accounts receivable collected and inventory when sold.
The current ratio is simply your current assets divided by your current liabilities.
One rule of thumb is that a current ratio of 2:1 or greater is extremely healthy.
A 2:1 current ratio means that for every $1 in current liabilities you have $2 in current assets to pay them. It means you are liquid.
Another way to think about it is that by being liquid you have enough current assets to pay your current liabilities as they become due.
By having $2 for every $1 in current liabilities means you are well covered.
Now let us look at…
Profitability Ratios
Three important profitability ratios are:
- Gross profit margin
- Net profit margin
- Return on equity.
Gross Profit Margin
Gross profit margin is the amount of profit left over after deducting your direct costs of producing or purchasing your goods and services.
Gross profit is needed to pay for your operating overhead. It needs to be high enough to cover all your overhead plus a profit.
Every industry will have a different gross profit margin percentage that will be normal in that industry.
Things that can lower your gross profit margin to a dangerous level include:
- Sales discounting
- Inefficient production costs
- Venders for your purchases that are charging too much.
- Venders delivering goods with poor quality.
Every business must measure their Gross Profit Margin by product line. In this way, you can monitor which product lines are most profitable in terms of both sales volume and the gross margin percentage.
Things that can increase your Gross Profit Margin include:
- Price increases especially when there is no loss in sales volume.
- Outsourcing manufacturing especially to a low-cost jurisdiction.
- Eliminating quality issues in either production in house or from your venders.
Next, we will look at…
Net Profit Margin
Every business needs to have overhead to run. These are indirect costs that are usually fixed in nature.
Some examples of overhead include:
- Management salaries.
- Rent.
- Insurance.
- Office Supplies.
Your Gross Profit must be enough to cover all of these fixed overhead expenses plus your profit.
Ways to increase your net profit include:
- Turn fixed expenses (as much as possible) into variable expenses.
- Find venders who will give you the same result for less money.
- Outsource as much as you are able to low-cost jurisdictions.
One of the things that happens to all businesses over time is that the fixed costs creep upward. And they also can be sticky.
By “sticky” I mean when businesses enter into longer term contracts that bind them to certain requirements that may no longer be needed.
What can happen is that you incur a fixed cost that you needed in the past, and now no longer do.
By not frequently examining your vendor relationships and agreements you may find you have fixed costs that are no longer even being used.
These can include things as expensive as office leases (more people are now working from home for instance) or software subscriptions for former employees that were not cancelled.
Now we will examine…
Return on Equity
Return on equity is expressed as a percentage of how much the business is earning in relation to its owners’ equity.
It is calculated by dividing the Net Profit by the Shareholders Equity and then multiplying this by 100 to represent it as a percentage.
A higher percentage is of course better, and a measurement of the reward being earned for the shareholders’ investment risk.
In Summary
Looking only at the larger numbers in the five main areas of your financial statements – Assets, Liabilities, Equity, Revenues, and Expenses – can be difficult to see patterns.
By expressing them as ratios, often a percentage, and understanding what they mean you can start to guide your business better.
A great accountant is someone who will interpret the numbers for you. He or she is like your co-pilot and they can help you see things that are otherwise incomprehensible.
Next week I will talk about Activity Ratios and Leverage Ratios.
Thanks for reading….
by MHolland | Apr 9, 2024 | Accounts Receivables, Business Tips, Cash Flow
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 only $1,000? Yes, you did lose $1,000, however…
You need to recover that $1,000, right?
Let us say that your business sells computers. On average you sell a computer for $1,000.
The computer costs you $800. You have a Gross Profit of $200 ($1,000 less $800).
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, which is your Gross Profit.
This $1,000 bad debt has now been recovered only after selling an additional 5 computers.
So, is the bad debt just $1,000, or $5,000? The bad debt expense is $1,000, that is correct.
However, to get back to where you were before you incurred this $1,000 bad debt you must sell $5,000 worth of computers. Ouch!
9 Principles of Managing Accounts Receivable
- Develop a clear, internal accounts receivable
- Understand your new
- Credit check your new customer
- Mutually agree terms with your customer before delivering goods or services
- Issue the invoice immediately after delivery of goods or services.
- Politely chase your customer before the invoice is due to ensure they are on track for payment.
- Continue politely and persistently chasing your customer for payment if they have not paid by the due date.
- Optional – for truly troublesome customers, go ‘nuclear.’
- Thank your customer for payment as soon as possible after receiving it.
4 Cornerstones of Your Accounts Receivable Procedure
- 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 an innovative 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
- What information do you need to make payment?
- Who should I speak to in order to settle payment on this invoice?
- When do you make your payment runs?
- What are your business details for invoicing purposes?
By getting answers to these 4 questions, you will avoid:
- Getting paid late.
- Having to re-do invoices, resulting in more internal labor costs.
In Conclusion
The software we use for many of our clients is called Chaser.
Here are some of the key features of Chaser (great name, isn’t it?):
- It will send out personalized emails that fit your style of business.
- It sends these emails in a structured timed way designed to remind your client to pay.
- It will send text messages.
- You can use it to make phone calls and the history of all communication (emails, texts, phone calls) will now reside in one portal inside the Chaser software.
Thanks for reading…
**NOTE this blog post was first published by me in May 2021. I have updated it and am re-publishing it due to the critical nature of good accounts receivable management in an economically challenging time…
by MHolland | Feb 22, 2024 | Accounts Payables, Accounts Receivables, Business Tips, Cash Flow
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:
- Days Receivable – the number of days on average it takes to collect your accounts receivable.
- Days Inventory – the number of days on average it takes to sell your inventory.
- 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:
- Opening balance of your accounts receivable, at the beginning of the month
- Closing balance of your accounts receivable at the end of the month
- 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:
- Opening balance of your inventory, at the beginning of the month
- Closing balance of your inventory, at the end of the month
- 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:
- Opening balance of your accounts payable, at the beginning of the month
- Closing balance of your accounts payable at the end of the month
- 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:
- Days receivable
- Days inventory
- 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….
by MHolland | May 21, 2021 | Accounts Receivables
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
- Develop a clear, internal accounts receivable procedure.
- Understand your new customer.
- Credit check your new customer
- Mutually agree terms with your customer before delivering goods or services
- Issue the invoice immediately after delivery of goods or services.
- Politely chase your customer before the invoice is due to ensure they are on track for payment.
- Continue politely and persistently chasing your customer for payment if they have not paid by the due date.
- Optional – for truly troublesome customers, go ‘nuclear.’
- Thank your customer for payment as soon as possible after receiving it.
4 Cornerstones of Your AR Procedure
- 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
- What information do you need to make payment?
- Who should I speak to in order to settle payment on this invoice?
- When do you make your payment runs?
- What are your business details for invoicing purposes?
By getting answers to these 4 questions, you will avoid:
- Getting paid late
- 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…
by MHolland | Jan 21, 2021 | Accounts Receivables, Business Tips
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:
- Timing of purchase
- Ability to re-sell the inventory quickly.
- 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…
