Smart business growth means balancing sales growth and accounts receivable risk. Sales growth often comes with increased accounts receivable, both from new customers and from extending more credit to increase business with existing customers. However, if accounts receivable are growing at a faster rate than your sales, which can occur especially if you have extended payment windows in your credit policy, you may start running into cash flow issues.
Factors to Consider When Evaluating Accounts Receivable Risk
As you consider new (or current) credit policies to expand sales, evaluating your accounts’ credit risk is an important step. Factors to consider include:
- Collections Timeline – Collecting accounts receivable in a reasonable timeline means your cash flow isn’t compromised, and you can meet your company’s financial obligations. The longer you allow accounts receivable to go uncollected, the higher the risk you will not be able to collect on them or may only collect on them partially. Setting a reasonable collections' timeline, acting quickly by contacting customers on the first day their payment is late, simplifying your collections process by offering more ways to pay and even considering payment plans can help you avoid lags that compromise your cash flow.
- Cash Flow Projections – As you grow, you don’t want to end up owing more than you can pay, so creating a cash flow projection is important. Begin by assessing how quickly you receive payments from your customers and when your payments to vendors are due. Then, begin tracking:
- The operating cash you have at the beginning of each month
- Each source of cash flow for that month
- Your likely business expenses (payroll, rent, loans, vendor payments)
If your cash flow projection exceeds your expenses, you’re on the right track. If not, take a deeper look at your accounts receivable.
- Industry Averages – It’s a good strategy to compare your average accounts receivable collection period to the industry average. Often, the terms “accounts receivable collection period” is used interchangeably with “days sales outstanding” (DSO). Regardless of whichever your organization calls this period, if your ratio is higher, you may need to reexamine your credit policies and more carefully assess your customers’ creditworthiness. Divide your total accounts receivable by your average daily credit sales and compare that ratio to other businesses in your industry.
- Accounts Receivable Concentration Ratio – Your accounts receivable concentration ratio can be determined by adding the squares of each of your customers’ percentage of your overall accounts receivable balance. Expressed as a decimal, this value will be between zero and one. A value closer to zero shows that your accounts receivable portfolio is less concentrated. Less concentration is ideal because it means your risk on nonpayment or late payment is spread out – one customer is not a make-or-break source of income.
- Accounts Receivable to Sales Ratio and Accounts Receivable Turnover Ratio – Your accounts receivable to sales ratio measures what percentage of your sales occur on credit. Too large a percentage may indicate potential cash flow risks.
Your accounts receivable turnover ratio evaluates the average amount of time it takes your company to collect your accounts receivable. Based on this ratio, you can evaluate how effectively your company uses and manages the credit it extends to customers and how quickly debt is collected or being paid.
How to Calculate Accounts Receivable to Sales Ratio
Most companies have both cash and credit sales. Your accounts receivable to sales ratio measures what percentage of your sales occur on credit. If that percentage is too large, you may be at a greater risk of cash flow issues. A very high ratio may affect your company’s ability to make payments and may indicate that you don’t have much cash on hand to fall back on if you face slower sales or other economic challenges. A low accounts receivable to sales ratio is typically ideal, though the range of those ratios varies based on your industry.
You can calculate your accounts receivable to sales ratio by dividing your accounts receivable balance by all of your company’s sales during that accounting period. If you see a decreasing ratio year to year, it means you’re making more cash sales and improving your business’ liquidity. If it’s increasing, you may need to take a closer look at your credit policies.
What is a Good Accounts Receivable Turnover Ratio?
If you’re measuring an accounts receivable turnover ratio on a scale of 1 to 10, based on the result of the formula above, if the formula gives you a turnover ratio between 7-8, it’s on-par or average. A result of 5 or lower is good or excellent in terms of an accounts receivable turnover ratio. However, on the flip side, If your calculations give you a result of 10, that’s a high number and may merit re-evaluating and rebalancing your clients to yield a better ratio overall.
In this case, a higher ratio is ideal. A declining ratio may be due to changes in your company's credit policy or increasing problems with customers paying on time. If you see a decline, it’s a good time to investigate if your credit policies are too flexible and assess the creditworthiness of your existing customers.
How to Mitigate Accounts Receivable Risk and Grow Sales
The health of your accounts receivable, a good indicator of your company’s overall financial stability and growth potential. Taking a closer look at potential issues can help you mitigate risk.
Conduct Credit Risk Analysis of New & Existing Customers
Regularly evaluating the creditworthiness of your new and existing customers can protect your business from late or nonpayment on invoices. To conduct a credit risk analysis, you should:
- Assess customers’ or prospective customers’ financial health with the help of big data
- Run a business credit report on each customer
- Request trade references, when possible
- Request and review the customer’s financial statement
- Evaluate the customer’s financial statements to better understand the company’s strengths
- Investigate regional trade risks, when appropriate
Diversify to Reduce Concentration Ratio
As mentioned above, your accounts receivable concentration ratio is calculated by adding the squares of each of your customers’ percentage of your overall accounts receivable balance. A value closer to zero means that your portfolio is less concentrated. That said, a less-concentrated and more diversified portfolio mitigates your risk for nonpayment or late payment by customers. By diversifying your client roster, you lower the risk of having an unbalanced ratio that could negatively impact your accounts receivable. If your ratio is on the higher end, you can reduce your concentration ratio and your risk by trying to initiate more sales with new customers and offering incentives for early payments with existing large customers.
Maintain & Establish Effective AR Collection Procedures
To mitigate your accounts receivable risks, you also need to examine your internal collection processes. Effective accounts receivable management enhances your company’s cash flow by preventing nonpayment or late payment. Contact management systems and accounts receivable management systems can help you process, review and access documents faster, and more easily track and report on status. Setting up and maintaining standardized collection procedures is also essential for mitigating your risk. Make sure that invoices are sent out regularly by adhering to a repeatable process.
Once an invoice is 14 days past due, reach out via an accounts receivable collections email summarizing the details of the past-due invoice, including invoice tracking number, the principal amount, any interest or fees and a description of what the original balance is for — including dates and locations. Then, thank the recipient for swift payment or a call to discuss terms.
Institute new policies, as needed, to protect your business, and set a calendar reminder now to revisit your accounts receivable process regularly to evaluate results and optimize the process.
