STREET SMARTS

What Are You, a Bank?

You probably lend your customers more money than you realize. Have you checked lately?

Norm Brodsky is a veteran entrepreneur.

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So at last we know why people were able to get "subprime" mortgages on ridiculously easy terms for all those years. We were in the middle of a credit bubble, which finally burst this past summer. Suddenly, it has become a lot more difficult to get a loan than it was just a few months ago. I have no idea how long the crunch will last, but I do know what it means for all of us who bill our customers after we've delivered whatever product or service we happen to sell: Now is the time to take a good hard look at our receivables.

When credit is tight, you need to find other sources of cash, and your receivables are the place to start. They are, in effect, loans you've made to your customers. Whether you realize it or not, you're sort of a banker, and you need to start thinking like one. You need to assess the quality of your loan portfolio. Is it taking you more time to collect than it should? Do customers need to be called more often? Are some of them struggling because they have problems of their own? Or are people taking advantage of you, in which case you might want to apply additional pressure--or maybe even terminate the account?

Of course, if you're borrowing against your receivables through a bank or an asset-based lender, I suspect you already have a pretty good idea of the shape they're in. Your lender is no doubt making sure that you track them closely. But even without that incentive, we should all be tracking our receivables as if we had a lender looking over our shoulders. Unfortunately, it's easy to lose that discipline, particularly if you have strong cash flow and money in the bank.

I discovered that danger during the due diligence process we went through last year as we negotiated the possible sale of our businesses, including the records storage business. After looking at our receivables, the buyer wanted to increase our reserve against bad debt by about $400,000, which would have reduced the purchase price by $4 million. "What are you talking about?" I said. "Our receivables are all good. We have the customers' boxes. They can't get their records back without paying us."

"Yeah, well, your own records show that about 40 percent of your receivables are more than 120 days old," the auditor said. "That's a big number. A lot more of them may be uncollectible than you've made allowance for."

I was shocked. Even though we do a lot of business with hospitals and government agencies--which pay reliably but slowly--it was a much bigger number than I would have guessed. We had a good system in place for tracking receivables. The problem was, I hadn't been paying attention. It wasn't as if we'd been having cash-flow problems, after all. We were paying our bills on time and had plenty of money left over. The thought that we might have a receivables problem had never entered my mind. But the prospect of losing $4 million on the sale of my business got my attention. I assured the buyer that almost all of the 120-day receivables were collectible and that we'd prove it. We spent the next few months doing just that.

We began by looking at the breakdown of our receivables month by month for the previous three years--that is, the monthly percentage of receivables that were current, 30, 60, 90, and 120 days or more outstanding. It turned out that the 120-day number had been creeping up steadily. The average monthly increase may have been only half a percent, but that translated into 6 percent a year. At that rate, you could start out with, say, 10 percent of your receivables in the 120-day category--the acceptable amount depends on the kind of business you're in and the type of customers you have--and wind up with 28 percent by the end of the third year. That's more or less what happened with us.

Part of the problem, we realized, was that the collections department was overworked and understaffed. So we hired an additional person--not to go after the long-term nonpayers we already had but to keep their number from growing. That's the first step in problem solving: Make sure you don't keep repeating your mistakes going forward (see "Problems, Problems," February 2004). Then you can go back and deal with what happened in the past. Accordingly, we next turned our attention to collecting the money we were owed by customers that hadn't paid us in more than four months.

Because we weren't in a money crunch, we were able to avoid two common mistakes made by people desperate for cash. When you need cash right away, you naturally go to the customers most likely to pay you quickly--namely, your best accounts, those that already pay on time. You put pressure on them to pay early or you ask for favors, neither of which helps build good relationships with the people who are most important to your company's success. The second mistake is to have your accounting people do the collecting. They don't know the customer nearly as well as other employees do, and they don't have the personal relationships that they could use to avoid inadvertently antagonizing people who should be allies. A salesperson, a customer service person, or an operations person who interacts regularly with the customer may know a better way to make the request or may be able to offer a favor in return for a favor.

With that in mind, we divided up the 120-day accounts among our sales, service, and operations employees and began contacting customers. What came next was a revelation. Some people blamed us for their failure to pay for the services that we'd performed. "Sure, we'll pay you," said one customer, "but why did you wait so long to call us? You shouldn't have let it get this far." It turned out the customer had a problem in his accounting department that was discovered only when we asked for our money. Who knows? Maybe he had a point. In any case, we apologized and moved on.

With other customers, we found that we had to modify our procedures. One hospital group, for example, had a purchase-order system that we weren't fitting into. Without knowing it, we were forcing the group's accounting people to adapt to our system, rather than making our billing process work with their payment process. When we asked how we could get paid more quickly, they showed us what information they needed from us and in what form. We made the appropriate changes.

Then there were instances of our bills not reaching the right people. We discovered that we weren't updating our contact information often enough. We'd get the information and check it again when the contract came up for renewal in five years. In the meantime, there could be changes in personnel, departments, procedures, even in the company's name and location, and we wouldn't know about them. Or maybe our collectors knew about the change, but our billing people didn't, because--for security reasons--we don't allow anyone who handles money to make changes in our system. So we developed new procedures for coordinating the exchange of information and making sure the bills wound up where they were supposed to go.

We also came across some customers we didn't want. They were mainly small customers we had to hound constantly for payment. It would take six months to a year for us to collect from them, and then they would pay only because they needed to retrieve a box. That type of customer literally takes money out of your pocket. To begin with, you don't have the use of the money that the customer owes you and promised to give you when you signed him up. Let's say his outstanding bill is $1,000. If he doesn't pay on time, you may have to get the cash somewhere else--probably from your bank. If you're paying 9 percent annual interest on your loans, that's $90 per year. So the $1,000 you think you're due is really just $910. Meanwhile, your accounting person is spending half an hour each month calling this guy and listening to lame excuses and false promises. That's six hours a year. If you pay the accountant $25 an hour, the slow payer costs you an additional $150 annually, meaning the $1,000 is now down to $760.

Look at what that does to your gross margin. If you're fortunate enough to operate in a high-margin industry like mine, you would expect an account that small to have a gross margin of at least 40 percent. So, on $1,000, you should be earning gross profit of $400. But because he takes a year to pay--and makes you spend $240 on interest and labor that you wouldn't have to spend otherwise--your gross profit is $160. That's a 16 percent gross margin. I don't know about you, but if we had too many accounts like that, we'd be out of business. We decided to make those accounts pay up or leave.

In four months, we were able to reduce by more than 50 percent the share of our receivables that hadn't been paid for 120 days or more. The would-be buyers could hardly believe it. They insisted on sending in their auditors again, and they confirmed that we had, in fact, shrunk the number by that amount. Not only did we address the immediate problem, we also implemented new procedures that will keep it from arising in the future, and we did it before the credit bubble burst. Our receivables are in great shape right now. For that I have to thank the people who almost bought my business. We couldn't have done it without them.

Norm Brodsky is a veteran entrepreneur who also writes The Morning Norm at Inc.com. His co-author is editor-at-large Bo Burlingham.

Last updated: Nov 1, 2007

NORM BRODSKY | Columnist

Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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