Managing Accounts Receivable
Of major concern to a significant number of business owners is how to manage their accounts receivable, or, in other words, how to ensure that their clients pay promptly before the accounts payable are due. Before delving into some answers to this question, I’m going to start with a couple examples.
- Teresa is the owner of a consulting firm that provides custom advice to its clients. She has 9 consultants working for her on various specialty projects. Since Teresa is paying her employees for a standard work-week, she can handle about 400 hours of work per week, less any administrative overhead. If she pays each employee $1000 per week, then she needs $10,000 of revenue coming in each week after her other expenses.
- James is a sole-proprietor who manufactures clothing. He spends about $5,000 per week in supplies, which he converts into clothes to be sold to various distributors. James has determined that he makes a profit of about $5,000 per week, not including his labor.
In both cases, the issue is that there is a lien on the business owner to satisfy certain fiscal obligations, whether salary or suppliers invoices. Assuming that both Teresa and James planned wisely, they have a small surplus of funds which they use to help with cash flow. However, if either is not careful, they can end up without money in the bank and the debtors calling.
- Teresa might win a lucrative contract for an additional 40 hours of work per week for 6 months. While this sounds like it’s time to hire another employee, Teresa must remember that the new client is not going to pay until after the work is done (or at least not fully pay until then), meaning that the salary for the new employee is not actually covered by the work they’re doing.
- James might try to double his volume, but with his distributors paying their invoices 30 days after delivery, James must find a way to balance his suppliers against the delay in the cash flow.
What should be noted, of course, is that in both cases, the problem with cash flow is based on the fact that you owe money today, and are owed money tomorrow. While at the end of the week you’ll have enough money to pay all the bills, what are you going to do today?
There are, fortunately, a few options:
- If you plan ahead, then you might be able to build a sufficiently large reserve of funds to allow you to expand at a certain rate. For example, either business owner could set aside 5% of their earnings each week toward expansion, once they’ve paid all their dues. To avoid the temptation to spend it on anything else, place it in a separate account, or, to make it somewhat profitable, put it in a short-term investment such as a 6-month GIC or a Money Market Fund.
- You can get a short-term loan to get you over the initial delay. This will have a cost, but allows you to expand. This may be the best option for someone like James, who has a known debt (the $5,000 in additional supplies) and known accounts receivable ($10,000 from his distributors). Teresa could try this route, but she may have more difficulties with this since a new employee will require a salary for a longer period, and the time until the revenue comes in to pay for the salary is less certain.
- The additional work can be contracted out to a temporary worker. This is specific to service-oriented businesses, in which a temporary employee can come do the work, and issue an invoice when the work is done. While Teresa may end up needing to front money she hasn’t yet received, the length of time she runs at negative cash flow is reduced. Additionally, if Teresa is careful, she can hire someone for a lower fee than her regular employees demand, thus increasing her profit margin in the process.
What both Teresa and James need to be constantly aware of is not only how much revenue is earned over time, but as of this moment, how much is owed, both coming into the business and going out. A well-run business will always try to increase the former while reducing the latter. This knowledge can assist in determining how and when you are able to expand your business to bring it to the next level.