J Nicholls & Associates

Category: Credit Management

  • “Why isn’t there more money in my bank account?”

    cash flows like water
    cash and water both flow. You need to control it.

    This is one of the most common questions business owners ask when we first meet. Their business is successful but it doesn’t seem to be reflected in their bank balance. Or if the business is doing less well “why am I putting all this effort in for so little money?”

     
    It seems a simple question. The answer is less simple because your cash depends on the following:
     
    • how much profit you have made,
    • changes in level of working captial,
    • new investments (fixed assets) made,
    • Increases in financing (loans, overdrafts etc) and
    • dividends or drawings you’ve taken out.
     
    For those who like equations:
    Cash = P – ∆WC – I +∆F – D
     
    For those who are more visual: It may help to think of cash as a stream. It flows into your business as profit from operations. It flows into pools and ponds (working capital), some of these pools are stagnant. It may leak away or evaporate (inefficiencies, bad investments) before finally making into the lake you want it in (your bank account). From there you take what you need (dividends/drawings).
     
    So there is a lot to go wrong before the cash reaches you.
     
    Looking at these factors one by one and in reverse order:

    Dividends/Drawings 

    We all know how much money we’ve taken out, don’t we?
    Surprisingly the answer is generally “no”. And when you do find out it can be a shock.
    It is difficult to really know everything you are taking out of the business. The information is hidden in lots of places. Dividends are not shown on the Income Statement. Salaries and benefits (health care, car …) are often mixed with those of staff etc…. It is very rare for a business to have a report showing exactly how much you have extracted.
    And that means that owners often underestimate this. So it should be one of the first things to look at.

    Financing 

    This can be either in the form of loans or as new investment. Both increase cash in the bank. Both come with strings attached. Loans need to be paid off, come with covenants and you have to pay interest. Investments put other pressures on your business – different owners may have different priorities, new investors get a share of all future profits (for ever) etc. Your share and control of the business is diminished. The good news is your need for external financing will be lower if you follow the advice in this blog.

    Investments and fixed assets

    Have you bought a new car or computer (system) or moved to new premises? This does not immediately affect profit but it does hit your cash. If you paid by cash you will have taken money out of your bank account.
    Or you may have taken out a loan to pay for it. That’s often the best way to do things and it reduces or even eliminates the impact on your cash in bank. But it increases your financial obligations going forwards.
     

    Change in working capital

    In nearly every company I see, there are issues in how working capital is managed. The strength of working capital management can be a good indicator of how well a business is managed. 
    The good news is that this is where small changes can have a big impact on both cash and profitability.
    The components of working capital you need to manage are:

    Receivables (debtors)

    You may need to give credit to get a sale. That means money tied up with your customers is not in your bank account. Tips for improving your management of debtors:
    1) Don’t give more credit unless you need to, and don’t give more than you need to.
    2) If you do give credit, make sure your customers pay when the debt is due. Late payment uses up even more cash and increases the chance you don’t get paid.
    3) If a customer is struggling to pay, work with them to create a payment plan.
    I recently did some work for a highly rated consultancy. It was growing and profitable. A major customer had been allowed to build up a substantial debt. That is not uncommon. The mistake they made was they continued to do work for this customer which eventually went bust which very nearly destroyed the consultancy.  

    Payables (creditors)

    That is how much you owe to suppliers, staff etc. A few tips:
    1) Include credit in your negotiations with suppliers before you buy anything. This is the point they are keen to sell and are most likely to be flexible.
    2) Pay when the debt is due not before. Some business owner like to pay early. That is not a great idea – you use up cash and you lose the ability to get better prices that early payment could afford.
    3) Keep track of how much you owe and when. If you do not do this you may not have the money to pay on time. Stories of businesses driven into receivership by an unexpected tax bill are all too common. Make sure you have a list of everything you owe and when you need to pay.
     
    When you look at your debts include:
    • stuff you owe but don’t have the invoice for (or you have the invoice but you haven’t entered it into your finance system). So if a supplier has delivered goods or done some work for you, you have a debt that you will have to pay (this is called an accrual).
    • What you owe to your employees (wages, bonus, pension etc)
    • What you owe the tax office (and this should never be a surprise). Make sure you know what you owe and put aside the cash to cover these liabilities.

    Inventory (stock)

    This is one of the most difficult things to get right because you have to be good at so many different things:
    • You have to be able to forecast future demand at the right level of detail. That is by SKU (stock keeping unit). There is no point having 100 HB pencils and no ballpoint pens if people need ballpoint pens.
    • You have to time your buying so you have the stock available when you need it.
    • You need to know how much stock you have on hand and on Purchase Order.
    • And you need to be proactive about managing the stock you on hand and on order. If it looks as though you are going to have too much of any SKU, work out how you can clear it.
    You do not want to have all your cash tied up in stock. And badly managed stock can destroy your profits. It hits holding costs (storage), there is more chance of damages, it may become obsolescent (particularly true in food, fashion, electronics), the chance of theft increases, and you may only be able to sell with big discounts or even find you can’t sell the stuff.
    Too little and you miss sales opportunities losing potential profits and leaving your customers unsatisfied.
    More often than not businesses end up with too much of what they don’t need and not enough of what they do.
    Manage your stock right and you can transform your cash position and your profitability.
    One customer bought goods from overseas for web-based retail in the UK and EU. The business was successful, growing fast with a strong reputation. In working together it was clear there was tight control on buying so much so that goods were often out of stock. That hurt in three ways – customers weren’t able to buy goods that weren’t in stock so they lost profit, customers service ratings went down and their rankings on e-commerce sites were hurt hitting sales when they got the product back in stock. They calculated that the first factor alone meant sales were 30% below what they could be. 

    Work in progress (unbilled work)

    The longer the time between doing the work and billing for it the less cash you have. And unfortunately the greater the chance your customer will dispute your bill. So invoice often and on time.
    If you are working on a project which will take several months, negotiate to be paid in stages – say at the completion of each phase or substantial chunk of work. Ask for a prepayment. If you want to get paid at completion of each stage make sure you agree scope with your customer and get them to sign off the completion of each stage.
    Work in progress almost caused a successful and profitable car repair workshop I worked with to go out of business.  They had no money and consequently were unable to pay their suppliers on time. The owner was always “out” to avoid having to speak to creditors (think what impression that would create on potential customers). The business was hamstrung.
    At the same time, the parking area was full of unrepaired cars, so full I couldn’t find a space to park. If he’d had a magic wand to remove that backlog he could have solved his cash flow issues at a stroke. This is an extreme example but many businesses have money tied up in work they haven’t completed or billed for.
     
    Profit is not the same as cash. As a business owner you need to actively manage both to be successful. A couple of examples to illustrate the difference:
    1)  You buy £100 of goods on 60 days credit and sell them the next day for £80 cash. Your cash position is great – you have £80 in your bank. Profit less so – you’ve lost £20 on the sale. That type of business is not sustainable. You won’t have the cash you need to pay the supplier when the 60 days are up let alone any of your other business costs. This is not as extreme as it may seem. Many business owners don’t actually know whether they are making a profit or loss on their sales once they take all relevant costs into account.
    2) You buy those same goods for cash and sell them a month later for £120, so you have made a profit of £20 on the sale. But you have to find £100 to cover the fact that it takes you a month to sell that stock. This could be a good business but unless you can find that £100 to pay the supplier the business will fail. 
    So avoid using your bank balance as the only measure of how well your business is doing.
     
    The level of profit your business makes is itself is the result of many decisions:
    • The market you are in
    • What you sell and who you sell to
    • how you set your pricing
    • how much discount you give,
    • what are the costs involved in making and fulfilling that sale
    • how well you buy
    • how well you manage your fixed costs
    • how well aligned different parts of the business are
    • how efficient you and your business are
    • how quick you are to spot and address opportunities and threats, etc
     How well you make those decisions depends a lot on the information you have available to you and the quality of your financial management. It is not something you can afford to leave to chance.

    Summary

    So there you are. To have the cash you want you need to:
    1. have a viable business model,
    2. have the controls, reporting and management capability to ensure you are making the profit you should be making,
    3. actively manage your working capital,
    4. be careful about investments (and expenditure),
    5. get funding if needed,
    6. be aware of how much money you need to take out of the business and ensure your business can afford it.
    The cumulative impact of getting these right can transform your business.
     
    Contact me if you’d like to find out more about how you can improve profit, cash and make your work place a better place to work. Or if you’ve any questions about the content of this blog.

  • Everything you wanted to know about credit management but were afraid to ask …

    Everything you wanted to know about credit management but were afraid to ask …

    This blog gives a deeper dive into the themes brought up in my previous blog on Eight things you can do to make your business more profitable – 4. Tighten your management of debtors.

    Why give credit?

    Sample credit report

    The fundamental principle is that you give credit to win and grow you business. Keep this at the back of your mind. Customers can be tricky. They may use credit granted by one supplier to help get them fund the business with another or for something totally different altogether.

    We know that if we want to make a sale we often have to give credit. This may be because the balance of power is tilted in favour of the customer or because it is standard practice in the industry you are in.

    Sales negotiations are not just about price. If you raise credit early in the discussion you will be amazed at what is possible. If you raise it after all other details have been negotiated then you are unlikely to see any flexibility.

    There will be circumstances when you should not grant credit. If the customer has no track record or a poor credit history or low credit score. In these situations you would be in your rights to demand CBD or COD(cash before/on delivery).

     

    Why is credit management so critical to the success of my business?

    Businesses fail or are lack the funds to do what they need to do because of poor credit management. All businesses need to have strong credit management policies. Why?

    1. You have to pay the cost of funding it. This can be expensive – factoring can easily cost 15% of loaned amount (on an annualised basis). Cash tied up in credit cannot be used for growth or other initiatives.
    2. If you don’t address issues promptly you may have far greater losses as you continue to provide goods or services long after you should have taken action. What would have been a £10,000 loss can easily grow into a £20,000 or £30,000 loss.
    3. Losses go straight to the bottom line – you have to sell far more just to get back to where you started. If your Gross Profit (sales less all costs of the sale including shipping and commissions) is 25%, you will need to sell an additional £40,000 to make up for a £10,000 bad debt.
    4. It is a waste of time and management focus – well established credit procedures allow you to keep on top of credit. Once allowed to slip it takes a disproportionate amount of work to bring back under control
    5. You are likely to have nasty surprises. When problems surface you often find that you need to make significant write offs. Additionally if you are relying on that payment then you may not be able to meet your own commitments which can have serious consequences.
    6. It can poison your relationships with customers. Your conversations with your customers should be about how to develop the business not when you are going to be paid. Customers with a poor credit history with you will tend to feel guilty. As a rule people tend to avoid situations that make them feel guilty so … they are far more likely to work with somebody else.

    How do I know if I have a problem?

    A quick checklist.

    1. Do you produce a monthly (or weekly) aged debtors report? (see main image)?
    2. Do you review it each month (week)?
    3. Is most of the debt in the first column (Not Due) with little if any more than 30 days overdue?
    4. Do you know the reason for everything not in the first two columns?
    5. Do you have an action plan to make sure that you can get the money back?
    6. Do you check progress against the action plan and make people accountable?

    If your answers to any of these questions is “No” you probably have a problem.

     

    So how can I manage credit better?

    The foundations of any good credit policy are your Terms of Sale (or Sales Contract). Make sure it includes the following points:

    • Retention of Title – Ownership of goods or IP lies with you until the customer has paid
    • Payment terms (when debt becomes due) and Credit Limit are clearly shown
    • Customer is liable for debt recovery costs.
    • Interest to be charged on overdue invoices and interest rate to be used. 
    • Receipt of goods or services – customer is responsible for raising any issues with quality of goods or services within a few days of receipt. Customer is responsible for signing POD at time of delivery.
    • The Customer agrees to carry out reconciliations of account regularly and ad hoc if required.
    • Customer must provide remittance or payment advice to notify allocation of payments made to invoice/credit note received. In the absence of this FIFO will be used (ie payments used to settle oldest outstanding debts first).
    • Process for management and agreement of credit notes – can be a big issue with larger customers.
    • Acceptable payment methods including agreement as to when payment has been received – eg cheques to have cleared.

    You have two controls available to manage credit on an on going basis:

    Credit terms – the number of days after invoice date that payment becomes due. These are normally set by industry practice.

    Credit limit – the maximum amount of credit that you are prepared to extend to a customer. This depends on an assessment of risk (eg past experience, use of credit rating agencies) and size of business.

    A good ERP or order management system will check both of these automatically as you enter orders. It can be set to warn or to block these orders from processing further. It is then up to you whether you choose to release or not.

    Circumstances may require you to provide flexibility on either credit terms or credit limit (see section on exceptions). Relaxing both at the same time is almost always dangerous.

    What else do I need to do?

    You need to be scrupulous in your paperwork – don’t give your customer any excuse to delay or refuse payment.

    • Make sure you put details of customer PO (Purchase Order) on your delivery note and invoice. Sometimes customers will not pay if there is not a valid PO.
    • Send a delivery note with each shipment.
    • Get a signed POD (Proof of Delivery) for all shipments. If you are providing services have your customer to confirm receipt of services as stipulated (for example signing off each stage of a project). If not agree with them what you have to do to remedy the situation.

    If your customer pays monthly, send a statement showing what they owe a week before their payment run. Follow up with the customer to confirm they will be paying this amount. This will flush out any problems. They may say they don’t have a POD or claim that some goods were missing and use this as an excuse to not pay anything. I have seen too many cases where a major customer has delayed payment in this way.

    Carry out regular reconciliations with customers to make sure that you both agree what is outstanding (at an invoice level). How often you do this depends on the size and complexity of your dealings with the customer. You may choose every month for larger or more complex customers and once a year for the rest. If you fail to do this you will almost certainly have far more work at a later stage, weaken your position if you need to take legal action and more often than not find yourself writing off the difference between what they say they owe you and what you know they owe you.

    Have a standard process for dealing with overdue debts. For example if a debt is 10 days overdue you call, if over 20 days overdue you may stop shipment, if 30 days overdue you may start threatening legal action.  Keep records of all communication – time, date, who you spoke to, what was agreed etc.

     

    My customers aren’t paying on time, what can I do?

    Have a credit exception policy.  There are always going to be times when a customer is not able to pay on time. You need to find out as early as possible that a customer is experiencing issues. That way you both have more options for managing the situation.

    Tip – Aim to link the granting of an exception to some benefit to you. They are getting a benefit from you and so should be prepared to give something in return. This has the side effect of putting a price on not paying on time. This will magically reduce the number of exceptions you have to deal with

    The first step is to speak to the customer to understand the reason and whether it is a one off short-term cash flow issue or something more serious. In order of increasing severity you have the following options:

    1. Ignore it – not a great idea unless short term exception and the amounts are not large.
    2. Payment plan – agree with the customer what they will pay and when until they are back within terms. In general such a plan will include:
    3. Payment before shipment – you can require that customer pays before you ship (or manufacture) any fresh orders.  This keeps the absolute size of debt unchanged but refreshes the age of the debt.
    4. Stop supply – if it is obvious the customer is unable or unwilling to pay then it may be necessary to cease supply of goods or services.
    5. Legal action – use this as a last resort. In most cases the threat of legal action will result in payment. Some customers wait until just before the case comes up in court to pay.
    6. Initiate proceedings to wind up the company – if all of the above don’t work then this may be the only option open to you. In general as an unsecured creditor you are unlikely to recover the debt in full.

    Be clear who can approve credit exceptions – for smaller companies it should probably be the MD or FD or both.

     

    Who should be responsible for managing credit?

    Great question and one that many people don’t ask. Many companies will give Sales this responsibility. Not smart. Sales people are targeted and rewarded on the level of sales they make. Credit control tends to be seen as something that gets in the way of them achieving their targets.

    In general the best place to put credit management is Finance or Customer Service (if not part of Sales). At the same time involve the Sales team in the management of credit. That way you are making credit decisions – terms, limits, actions – with an understanding of commercial factors – customer development plans, special considerations etc – rather than blindly following a policy.

    Tip – If you can link Salesperson commissions to money received on the basis that “a sale is not a sale until the money is in the bank”.  This can be done by freezing commissions on sales that are more than say 30 days overdue. This aligns the interests of Sales and the company.

     

    You may also find the advice given by the Federation of Small Businesses useful in their February/March 2013 edition of First Voice

  • FSB guidance on credit management

    The Feb/Mar 2013 edition of First Voice – the magazine of the FSB – contains an interesting article on credit management. It is largely prompted by the poor payment behaviour of large customers towards their suppliers. Some of which are now asking for suppliers to pay a discount to get paid on time. Hopefully this is something that lobbying and government will be able to change.

    The article also contains some useful tips on how to ward against late payment which are largely complimentary to what I’ve included in the original post. I have taken the liberty to reproduce here as I’m not able to link directly to the article.

    1. Re-visit your trading terms and conditions to ensure they are still fit for purpose and aligned with the type of companies that you do business with.
    2. Do a due diligence test of your trading practices. Look at your recent trading history and assess the risk of entering into other contracts of a similar nature.
    3. Carry out a credit check on your customers before doing business with them, get a bank reference, take up trade references, and get their full address.
    4. Consider setting a maximum credit limit for your customers
    5. If the customer is a limited company or a limited liability partnership, consider asking for the directors/partners to give personal guarantees.
    6. Always provide written terms and conditions and make sure these are agreed by the customer before any goods and/or services are provided.
    7. Set out what you’re doing, and when payment is due. Simply putting terms and conditions on the back of your invoice will be too little and too late.
    8. When goods and/or services are supplied, ask the customer to sign an acceptance form to minimise the possibility of a dispute arising later.
    9. Ensure the invoice goes on time, to the right person and sets out clearly what you’ve done, the amount owed and when it is due.
    10. If the customer is late paying, find out why and, if necessary, send a reminder with a timeframe.

    To this I’d add to check the website of the company to see whether the values talk about supporting local businesses, social responsibility, ethical standards etc. If you are experiencing systematic behaviour that seems to contradict these statements then one of two things are likely to be the case. Either these values are not filtering down through the organisation or the organisation has a conscious policy of not living by the values they espouse. In both cases the threat of escalation can help to resolve one way or the other. If it is deliberate policy then gently enquiring about the difference between words and actions can help to focus minds. Of course this needs to be done in a sensitive way to maintain and protect the relationship with the customer.