Unless your chosen profession is to manage accounts receivable you would find it difficult to believe that accounts receivable have a shelf life. It is this shelf life that becomes the shackles of many organizations when they seek to optimize the resources from their operating line of credit. As a continuance to my contribution, I Need More Money; Give Me More Value! I will continue exploring the management of an operating line of credit through the management of accounts receivable.
Anyone who has read my contributions knows that I am a strong proponent of timely collections of accounts receivable. My colleague, Ed Poll in his book, Collecting Your Fee¸ contends that the collections process begins at the time of the initial meeting handshake. Failing to collect outstanding receivables not only causes the organization to profit on the engagement, but in addition the costs of production are also forfeited. Additionally, as the organization allows the receivable to age, they are penalized through the covenants of their operating line of credit on the value placed on the receivable.
Several years ago, a colleague of mine wrote an article, Accounts Receivable, Asset or Liability? In this article, he alluded to the hidden liability of an accounts receivable which manifests with age. This shelf-life or best before date of receivables is often not known by the credit manager. The probability of a receivable going from an asset to a liability is based on many factors; risk being the greatest. In an earlier contribution I expounded on risk analysis as a basis for credit management.
Organizations that use their receivables as a means of securing an operating line of credit are under even more pressure through the covenants of the agreement. Based on my earlier contribution the following covenant exists for ABC Ltd. Receivables are valued at 70% for all those who are not more than 90 days past normal due date. For ABC, whose terms are N30, the limit is 120 days.
i. Excess Delinquency: Where a single client has an amount of receivable in excess of 120 days which is at least 25% of the total due – the entire account has no value
ii. Credits: All credits over 120 days are excluded from valuation
iii. Concentrations over 10%: Where a single client represents more than 10% of the total receivable their entire receivable has no value.
It is clear that immediately after billing, the financing company will extend to ABC Company only 70% of the value of the billing. This limitation is the first in the financier protecting their investment. They know, through statistical analysis, that there are probabilities of default for every receivable. It is this knowledge that so many organizations use to buy and sell receivables through the factoring process.
To ABC, the bill of today has a finite valuable life; 120 days. After that date, the financier considers the risk of default beyond its risk tolerance level and the valuation of the operating line of credit pays the price for it. This black cloud of 120 days past due also acts to draw in potentially good receivables. In section i, the financier indicates that if any 120 past due amount is at least 25% of a customer’s entire receivable, the entire receivable is removed from the allowable operating line.
With this said a seriously delinquent receivable now immediately devalues all receivables for that customer and removes the proportionate amount from the operating line. The organization can reasonably increase its available operating line, by clearing up these extremely past due amounts. As I have said in the past, receivables go unpaid because of a disconnect in the transaction between what occurred and what was expected to occur. Therefore, in working receivables it is imperative that accounts never reach their bank imposed expiration date. The organization must be sensitive to the effect these delinquent receivables have on their short term operating line. As a result, organizations must work diligently to resolve the issue and remove these items from their books.
Several years ago, I had the opportunity of working with an organization whose client base was uninsured doctors. The credit manger at the time explained how highly lucrative the practice was, however after 60 days if a bill wasn’t collected – it was written off. It was known that the probability of collection of the bill beyond the 60 day mark was almost impossible and that timeframe put considerable limitations on the firm’s operating line of credit.
A receivable portfolio littered with credits is an indication of ad hoc business practices. Where the credits go unapplied into the covenant trigger date tends to mask the hidden issues of seriously delinquent bills. It is for this reason that banks disallow credits based on the same date thresholds as valid bills. It is to the organization’s advantage to first notify the client of the credit. Secondly, the organization must ensure that the credit is taken and properly applied. A credit beyond a 120+ days past due, acts to disqualify valuable accounts receivable simply because of its age.
Concentrations of client receivables will act to seriously hamper the availability of an operating line of credit. To the financier, such concentrations bring a certain amount of risk to the organization. Should a concentrated customer default on the entire account, the remaining receivable portfolio may be beyond the risk tolerance of the customer. How to manage such concentrations is the responsibility of the company who needs to use that value in their operating line of credit.
One of the best ways for preventing receivable concentration by the client is to provide incentives for the client to quickly reduce their outstanding balance. I am in no way suggesting offering discounts for early payment as the cost of which becomes nothing short of extortion. What I am suggesting is the crafting of the relationship wherein the client may be offered preferential margins for a certain volume of business paid on a certain schedule.
Recently I had the opportunity of having an in depth conversation on receivable concentrations with the credit officer of an electrical component supplier. As it turns out the company, sold electrical components to the big box retailers and as an inevitable offshoot they had concentration points in their receivables. I was amazed to find that supplier took a two pronged approach for dealing with these concentrations and as a result, freed up over $2M in their operating line of credit. The electrical supplier provided the big box retailers with very attractive pricing and terms, provided that the payments were made in a very short window following billing. In addition, they also undertook to build their client base to such a degree that the big box retailers were no longer considered concentrated receivables.
The moment a bill is created it battles the forces of being an asset or a liability. When an operating line is present, the bill is immediately devalued. Then with each passing day its probability of being a liability increases; as the chances of getting paid decreases. Once the bill hits its best before date, it will eradicate value from conceivably good receivables. Remember all receivables have value and a best before date; however greatest value is had before the best before date.