In the first installment of this blog series, we learned about the critical role the balance sheet plays in managing a high-performing company. Then we looked at what good inventory management looks like. This month we’re sitting down with Mike Thomas, CEO of Alpha Widgets, to see if there is anything we can teach him about accounts receivable. After just a few minutes, it’s pretty apparent that Mike has always looked at Alpha’s steadily-growing A/R as a good thing, commenting that from his perspective, it’s the natural result of growing sales and seems like a very safe, readily-liquid asset. While this perspective is not a surprise at all given that most business owners see A/R exactly the same way, the reality is that of all the assets a business could hold, A/R is among the worst.
I know, you and Mike Thomas are both thinking this sounds completely absurd, and while he is madly thumbing through his contacts looking for a new banker, you’re probably wondering if it’s even worth reading the rest of this post. In the hope that it helps change both your minds, I’d like you to consider just a few facts about accounts receivable.
Fact #1: 100% of the Time, A/R Depreciates in Value
Ben Franklin famously said, “Nothing in life is certain except death and taxes.” With all due respect to Mr. Franklin, he forgot to include the fact that 100 percent of the time, accounts receivable will do nothing but depreciate in value. Yes, it’s true that other assets like inventory and equipment may also depreciate over time, but unlike A/R, at least they are an investment in future sales. On the tail end of the sales cycle representing sales already made, A/R does nothing but decrease in value while it remains uncollected.
Every day a dollar sits out there as accounts receivable is a day that dollar is not working for your business (in fact, it’s actually working for your customer’s business as a payable). It cannot be invested back into your company’s growth or pay for needed staff. It cannot pay off debt or pay for systems that could drive operational efficiency, and it cannot be distributed to the company’s shareholders. It is not a piece of equipment that churns out items to be sold at a profit, and it can’t pay for a building that saves the company rent and build long-term equity. It is dead weight, and your goal as a business owner should be to drop it as quickly as you possibly can.
We can easily calculate how quickly a dollar tied up in A/R loses value over time. As an oversimplified example, if Alpha Widgets earns a 15 percent annualized return on every dollar invested in its growth, uncollected A/R will lose 1 percent of its value after only 26 days. Thanks to the power of compounding, it takes only 24 more days to depreciate 2 percent (which happens on day 50) and 23 more days to hit 3 percent.
Would you want to invest your money in an asset guaranteed to do nothing but lose value every day?
Fact #2: A/R is Just a Fancy Word for a Risky Loan
At the end of the day, A/R is an unsecured loan that your business makes to its customers at 0 percent interest. You deliver your goods and services in advance, and trust your customer to pay you for them at some point in the future. Of course, as a prudent business owner you make sure to extend A/R only to customers who you deem creditworthy, but can you ever really be sure they won’t default on your “loan?”
Just for fun, let’s do a little comparison. Commercial banks are in the business of making loans to small businesses, and there is a plethora of publicly-available data out there on them. According to data from 1985-2018 by the Federal Reserve, banks charged off an average of roughly 1 percent of their non-real-estate commercial loans. This means that for every $100 loaned out, $1 was written off as uncollectable.
If the experts in the business of commercial lending are writing off 1 percent of their loans, what should the typical small business expect? Unless your company is underwriting its customers to the level of a commercial bank, securing its A/R with collateral and regularly monitoring the financial performance of its customers, a 1 percent loss rate is probably wishful thinking. In fact, data shows that on average the typical small business writes off 4 percent of total sales in bad debt. For a company generating $5 million in revenue, that’s a $200,000 expense! Your goal as a business owner should be to get those 0 percent unsecured loans to your customers paid off as quickly as you possibly can.
Fact #3: Unlike a Fine Wine, A/R Only Gets Worse with Age
The longer you carry a receivable, the more risk you expose your company to. And to make matters worse, that risk increases not on a linear basis, but exponentially. If you think about it, every day that goes by where one of your customers owes you money is a day that customer’s financial health could be negatively impacted by any number of factors. Simply put, the longer it takes for your customer to pay you, the more reason you have to wonder if they ever will.
While the typical small business offers its customers 30-day payment terms, the reality is the average small company’s sales outstanding is 67 days. That means that on average, small businesses have over two months of sales sitting out there uncollected, more than half of which is past-due.
When a receivable ages to 90 days past invoice date, statistics published by the U.S. Census Bureau show that on average 26 percent of the total amount will have to be written off. Bump that up to 180 days and the uncollected amount climbs to 70 percent. At 12 months, it increases to a staggering 90 percent. Perhaps it’s time to start paying more attention to those aging receivables!
I want to be clear that I am not saying that accounts receivable is all bad. It serves some important functions, and offering customers payment terms by carrying A/R allows a company to make sales that it likely could not otherwise make. But when you look at A/R in its entirety, you can see why it is a bad investment of your company’s capital. Therefore, your goal as a business owner should be to constantly seek to replace it with a lower-risk, higher-returning asset as quickly as possible.
Rather than seeing it as a badge of pride or a relatively safe bet, perhaps it’s time to start looking at A/R as what it is: a necessary evil.
Our team of Business Bankers at Elevations are highly-trained in financial analysis and would be happy to advise you or help explain accounts receivable and your other options. In fact, helping our business members optimize their financial performance is exactly what we do, and it’s how we set ourselves apart from the competition!