Management of Receivables

Credit and collection starts with managing receivables. As the operator of a small business, you must extend credit to customers on competitive terms so that sales will not be lost. At the same time, you must avoid long overdue accounts so that your capital will not be tied up and you avoid the risk of the accounts becoming uncollectible. If you manage your accounts receivable as suggested in this article, you will realize the marketing advantages of credit extensions and avoid the common problems noted above.
Just as with any facet of your business, it is crucial to manage your accounts receivable. In this article you will learn:

• How to establish sound policies that will serve as guidelines in granting credit;
• Collection techniques that will minimize uncollectible accounts and reduce the volume of past-due accounts so that your credit sales are more quickly converted to cash;
• How to analyze your accounts receivable to determine whether or not a problem exists, if corrective action is needed, or if re-evaluation of your credit and collection policies is necessary;
• How to evaluate credit applications so that many problems can be eliminated before they occur;
• How to initiate a collection program with all accounts—the delinquent and the not-yet delinquent;
• How to follow up by mail and telephone to accelerate collections and the flow of cash to your business; and
• When to resort to external resources such as collection agencies or the courts and how to use them to your advantage.

If you apply the techniques you learn in this section to the management of your business, you can reduce the dollars tied up in accounts receivable which allows for profitable application elsewhere and helps reduce credit losses.

Credit Extensions

Many potential credit problems can be eliminated before they happen through investigation and prudent judgment when granting credit to customers. The need for sound judgment is particularly critical since credit extension policies should be neither too liberal nor too restrictive. Overly liberal policies invite excessive receivables and uncollectible accounts while overly restrictive policies cause lost sales.

Investigation

Before you decide, get the facts. Thorough investigation of credit requests protects you from the fraudulent applicant who has no intention of paying or the applicant who is extremely slow in paying.

Credit Applications

The basic source of information for decisions on credit extensions is the credit application. There are three major factors to consider when evaluating a credit applicant. The first is the applicant’s ability to pay, based upon income and obligations. The second is willingness to pay, which can be determined from the applicant’s credit history. The third factor is potential profitability of the account. You stand to lose your cost of the product or service sold to the customer if you cannot collect an account. If your cost is relatively high compared to the selling price, then you have to be particularly careful in assessing credit risks.

Application Evaluation

Your evaluation of any credit application will depend upon a number of factors. In the case of an individual applicant, you will want to consider the following:

Information Verification

Information on credit applications must be verified to ensure that it is correct, current, and complete. A good place to begin is the place of employment to verify that the applicant is employed and that income and time on the job have been reported accurately.
Bank references should also be verified. While laws restrict the amount of information that banks can disclose, checking on this information can protect you from obvious fraud and may give you some indication of the applicant’s ability to pay. Most banks will confirm the existence of an account and disclose a broad idea of the average balance. The bank may also indicate whether or not the account has been satisfactory.

Credit Bureaus

An important source of information for retail credit is the local credit bureau, which generally provides information on credit applicants to firms that are bureau members. Annual membership fees usually depend upon the size of the business.
Besides the membership fee, there is a nominal charge for each inquiry on a credit applicant. Your local credit bureau will provide you with details about services and costs.

Stability

In situations where the time or cost of a comprehensive credit check is prohibitive, professional credit managers have often found that a quick evaluation can be made based upon the applicant’s stability. Stability is determined by the length of continuous employment and residence. This assumes that the person who has been employed for several years on the same job will most likely continue to be employed and therefore will be able to pay. Similarly, continuous residence indicates a desire to maintain standing in the community.

Summary

There are no hard and fast rules that can tell you who is a good credit risk and who is not. There are cases where the poorest of people pay their bills promptly, while the wealthy ignore them. As the owner of a small business, you must combine facts about the applicant with common sense to determine those risks that appear reasonable.

Commercial Credit

Commercial accounts should complete an application similar to that used for personal credit. Unlike individual credit applications, it is often difficult to verify information on income and expenses for businesses. It is also more difficult to make estimates of these factors for commercial accounts. There are situations where it may be reasonable to request a financial statement from the commercial account before extending credit, but these situations are not typical. Instead, you must rely more heavily upon references such as banks and suppliers with whom the applicant does business, the applicant’s reputation in the industry, identity of officers, and so on.
The application should note the names of individuals who are authorized to purchase for the account so that fraudulent purchases can be detected. There should also be an indication of purchase order requirements so that you will be protected in the event of an unauthorized purchase.
Frequently, the commercial applicant with a marginal credit rating will list only those suppliers with whom a satisfactory relationship has been maintained. However, you can often use your own judgment and knowledge of your industry and locale to determine other suppliers with whom the applicant may have done business. If there is any doubt in your mind as to the credit worthiness of the applicant, it is always a good idea to contact these other sources to find out what their experience has been.

Commercial Credit Services

Commercial credit services maintain financial information and credit services for large and small companies throughout the country. The cost of this service varies with the detail and depth of information requested on any applicant.

Problem Detection

A successful credit and collection policy requires that all problems be detected and acted on as early as possible. The sooner a problem is detected, the sooner it can be corrected. This is particularly critical in receivables management where the sheer passage of time can aggravate any problem that may exist.
An important indicator of the effectiveness of your credit and collection policy is your average collection period. The average collection period is a ratio that expresses the total amount of receivables outstanding in terms of an equivalent number of average daily credit sales.

Figuring the Average Collection Period

The average collection period is calculated as follows:

Or, viewed another way, the total amount owed by customers is equivalent to 45 days’ credit sales, on the average.
For example, if a business had average monthly credit sales of $6,000 and outstanding accounts receivable of $9,000, the collection period would be calculated as follows:

This indicates that, on the average, customers are taking 45 days to pay their accounts. (Some formulas for calculating the average collection period consider only net credit sales. These are determined by subtracting an estimated allowance for bad debts from total annual credit sales. While the result is mathematically more precise, it is being ignored here and the simpler formula, based upon total credit sales, is being used for instructional purposes.)

Comparisons
The average collection period can be compared with any of the following bases to determine whether or not a problem exists:

• Payment terms. If your terms of sale specify payment within 30 days and your average collection period is greater than this, it indicates that creditors are not complying with your terms and a problem exists.
• Past history. Comparison with your experience in previous periods indicates whether or not collections are improving or declining.
• Industry averages. Comparison with the experience of other companies in your industry will determine whether or not your credit and collection policies are as effective as those of your competitors. (Industry averages are usually available at your library or trade association.)

Determining the Extent of the Problem
The extent of the receivables’ excess can be measured by comparing your actual receivables with a target level. For example, assume that your terms of sale specify payment within 30 days, and your industry average collection period is approximately 30 days: A suitable target for your receivables would then be 30 days’ average credit sales.
If your average daily credit sales are $200, you could then calculate a target for receivables as follows:

Average daily sales x collection period = Receivables

$200 x 30 = $6,000

If your actual receivables were $9,000, you would then know that you had an average of $3,000 ($9,000 –$6,000) in receivables that require attention.

Corrective Action
A relatively high average collection period indicates that a problem exists and corrective action must be taken. Prompt attention should reduce the collection period, speed conversion of receivables to cash, minimize your capital tied up in accounts receivable and, at the same time, reduce the risk of uncollectible accounts.

Aging of Receivables

Analysis of your average collection period will help you identify and measure receivables problems in total. However, immediate corrective action requires identification of individual problem accounts.
Problems in individual accounts can be detected through analysis of your receivables by aging. A receivables aging divides each customer’s account into amounts that are 0-30 days old, 31-60 days old, 61-90 days old, etc.
The longer an account is past due, the more serious the problem. These can be identified quickly by aging, and corrective action can be initiated promptly.
For example, examine the receivables aging below. The first account shown, L. Brown, has a total outstanding of $775.02. Of this amount, $317.91 is 0-30 days old, $222.63 is 31-60 days old, $156.32 is 61-90 days old, and $78.16 is over 90 days old. Some prompt action seems required.
Totals are entered for each age group. It is often useful to calculate the percentage of total receivables in each age group to alert you whenever overdue receivables become excessive. For example, if you knew from past experience or from industry averages that receivables more than 90 days past due were seldom more than 5% of total receivables, the 19.9% would instantly alert you to a dangerous situation that requires immediate correction before your business is faced with possible serious losses.

Internal Collection Procedures

The fundamental rule of sound receivables management is to minimize the time span between the sale and collection. Any delays that lengthen this span cause receivables to build to unnecessarily high levels and increase the risk of uncollectible accounts. This is just as true for delays caused by your billing and collection procedures as it is for delays caused by the customer.

Invoices
Proper collection procedures begin with invoice preparation. Invoices should be prepared promptly and accurately. Promptness eliminates one possible source of delay. Accuracy prevents those delays that occur when the customer disputes the invoice and returns it for correction, triggering a chain of events that is time-consuming and often costly.
Invoices should clearly state payment terms. Is payment due within 10 days? 30 days? Are the days measured from the receipt of goods? Receipt of invoice? End of the month?

Cash Discounts
When selling to large accounts such as commercial, industrial, institutional, and governmental buyers, collection is often accelerated by the offer of a cash discount. The discount, usually 1% or 2%, is offered for payment within 10 days. Most large organizations take advantage of all such discounts. In so doing, they can sharply reduce your commitment of capital-to-accounts receivable. If your competitor offers cash discounts, it may be necessary for you to include the same provision to maintain your competitive position.

Specifying Payment Terms
Payment terms normally include discount terms and dating terms. Discount terms describe the discount available, if any, for prompt payment. Dating terms specify the time when payment is due.

Discount terms are usually described as follows: 2/10

The number before the / is the discount percentage, in this case 2%. The number following the / is the number of days within which payment must be made in order to take advantage of the discount. In the example, the customer can take a 2% discount for payment within 10 days.
This leads to the next question, 10 days from when? And, if the customer lets the discount period pass, when is the net amount due? The answers to these questions are specified in the dating terms. Extending our previous example a little further, the terms might be expressed as follows:

2/10 – n30

The “n” is an abbreviation for net. The “30″ indicates that payment is due within 30 days. If no other date is specified, the 30-day period begins with the invoice date. For example, if the terms above appeared on an invoice dated September 2, the customer would be entitled to a 2% cash discount for payment by September 12. If the customer does not pay within this period, the net amount is due within 30 days, or by October 2.

Special Conditions
Large accounts often specify certain requirements for invoice preparation. They may require reference to a purchase order, proof of delivery, or a certain number of copies. Be certain that these conditions are met when the invoice is first prepared and submitted in order to avoid delays and duplication of effort.

Statements
To keep customers advised of their account balances, monthly statements should be submitted to all open accounts. The statement should summarize the amount owed and any activity in the account within the month.

Abbreviations are used to specify the beginning of dating periods that are different from the invoice date. Two common abbreviations are “EOM,” End of Month and “ROG,” Receipt of Goods. In the first case, EOM, the discount and net periods begin at the end of the month, regardless of the invoice date. In the second case, ROG, the periods begin when the customer receives the goods, regardless of the invoice date.

Assume that an invoice issued on September 15 had the following terms:

2/10 – n30 EOM

The customer would be entitled to a 2% discount for payment by October 10. If the discount is forfeited, the net amount would be due October 30.
Your choice of payment terms will often depend upon customary practices in your business. In order to stay competitive, it is often necessary to offer payment terms that are equivalent to those offered by your competitors.

Delinquency Charge
In some businesses, a delinquency charge for late payment is used to discourage customers from allowing their accounts to become long past due. The delinquency charge normally involves a finance charge or service charge of 1% to 1.5% per month on all balances more than 30 days past due. For example, if a customer’s statement at the end of June indicates a total balance due of $630, of which $417 is more than 30 days past due, the finance charge for June would be calculated as follows (assuming a 1% delinquency charge):

$417 x .01 = $4.17

Most people recognize that a charge of 1% per month represents an annual interest expense of 12% (12 x .01). A charge of 1.5% per month represents an annual interest charge of 18% (12 x.015).

Follow-up
The best time to initiate pursuit of outstanding balances is immediately. As an account gets further behind, the balance often increases, while the chances of collection decrease. The person who owes a few hundred dollars today is not likely to be in better shape to pay next week or the week after than right now. Now is the time to start enforcing a rigid collection policy, making whatever arrangements are necessary to be sure that you receive the money due to you in a reasonable period of time.

Don’t Be Reluctant
Many businesses are reluctant to enforce strict collection procedures. The reasons for this are several and none of them are valid. Some people simply are embarrassed to ask for money even though it is owed to them. Others express concern that they might alienate a “good customer” and perhaps lose an account. The opposite is true. How good is an account if the bills are not paid? Even more important, the customer owing you a large balance may be reluctant to do more business with you until the account is cleared. You have not only lost your money, you have also lost a customer.
Some companies feel that rigorous enforcement of a collection policy can damage their reputation. Viewed logically, would you conclude that a person who owes you money is likely to spread this news around town?

Collection Follow-Up

Whether or not your business chooses or use cash discounts or delinquency charges, a systematic follow-up procedure should be employed with all past-due accounts. Usually, this will take the form of a series of letters or telephone calls or both, as required.

First Collection Letter
When an account becomes approximately 15 days past due, the customer should be sent the first collection letter. Since the account cannot be considered seriously delinquent at this time, the tone of the letter should be moderate. Later letters should establish a firmer tone so that the customer is made aware of the seriousness of the situation.
The 15-day past-due letter should read about as follows:

Dear Mr. Adams:

Very truly yours,
Jim Madison

Second Collection Letter

If no response has been received from the customer, a second letter 30 days later might read as follows:

Dear Mr. Adams:

Very truly yours,
Jim Madison

Third Collection Letter
If this is unsuccessful, a stronger letter should be sent in 30 days:

Dear Mr. Adams:

Very truly yours,
Jim Madison

As you noticed, the tone of each letter became progressively stronger with suggestions of more serious action introduced in each case. The tone that you would want to establish in such “dunning letters” will often depend upon the type of relationship that you maintain with your customers. However, the ground rules should be clear. Past-due accounts should not be ignored.

Telephone
Frequently, an even more persuasive approach is through use of the telephone. The ground rules are basically the same. You must become progressively firmer with each call and indicate that stronger measures will be used if necessary to ensure prompt payment.

The telephone has the added advantage of flexibility since you can be more direct with better knowledge of the individual account.
You acquire this knowledge through asking questions such as the following:

• “What seems to be the problem? We never had difficulty with your account in the past.”
• “How much would be a reasonable amount for you to pay each month? Perhaps $50 or $60?”
• “How soon can we expect payment of this amount?”

Try to avoid questions that can be answered “yes” or “no.” If the creditor gives you an answer such as, “I’ll mail it today,” answer with: “I appreciate that. Then I can expect it in two or three days. If I don’t have it by then, I’ll call you back.”
Be sure that the creditor realizes that you are totally aware of the situation and that you do not intend to ignore it.

External Collection Resources

If your own collection efforts fail, there are two courses of action that are left to you—the collection agencies and the courts.

Collection Agencies
Collection agencies are businesses established to collect past-due accounts receivable on behalf of creditors. The primary advantage that collection agencies offer is their superior knowledge of persuasive collection techniques. Additionally, creditors are usually anxious to clear invoices referred to collection agencies rather than further damage their credit ratings.
The collection agency’s fee is usually based upon a percentage of each account collected. The percentage ranges from 25% to 50% depending upon the size of the account or the total dollar volume of accounts referred to the agency for collection. This approach, while often effective, can be expensive.
A business is committed to paying the agency’s fee on any account referred for collection, whether payment is made to the agency or to the business. Although some creditors may resent making payment to a collection agency and prefer to pay the company directly, the company is still committed to pay the fee when the account is collected.

Courts
If the collection agency fails, your final recourse is through the courts. The matter may be resolved in a small claims court if the amount owed is small. For larger amounts, you may have to file suit to collect. In either case, you are faced with a costly and time-consuming procedure.
The best way of avoiding these procedures is to take prompt, strong action on your own as early as possible. In the long run, you will be doing not only yourself a favor but also the creditor. While your creditors may be unhappy at the time, you will have spared them costs, time, and the loss of their credit ratings.

Credit Cards

Many problems associated with credit can be avoided through the use of credit cards. In many businesses, particularly in the retail and consumer service fields, credit arrangements for customers are available through the use of these cards. Under these plans, there is little or no commitment of the business’s own capital, and the costs and risks of administration and collection are almost entirely the responsibility of the credit card company or bank.
Credit card service is available from your regular commercial bank. Receipts from bank credit card purchases can be deposited daily and are immediately credited to your checking account. The bank assumes all credit risks provided that you follow instructions for approval of credit card purchases. Typically, these instructions require that you check the validity of the card against a master list of canceled cards and contact the credit service before accepting the customer’s card for purchase above a certain limit.
Credit card services are particularly vital for businesses with a large number of relatively small accounts. They eliminate the need for credit approval, invoice preparation, record maintenance, and collections. They also minimize your commitment of capital and virtually eliminate the risk of uncollectible accounts. From a marketing standpoint, the availability of instant credit could often encourage a customer to buy immediately, rather than postpone the decision to a later date or bypass it completely.
Credit cards are most often used for retail accounts. However, they have also been used successfully in selling to small commercial accounts. Businesses such as repair shops, supply firms, and stationery stores, which have a mixture of consumer and commercial accounts, often find it convenient and economical to extend credit card service to small commercial accounts.

Credit And Collection Policies

The establishment and execution of credit and collection policies can minimize problems associated with accounts receivable. As with all policies, they must be re-evaluated from time to time in order to determine their effectiveness. If your business already has policies for receivables management, evaluate them according to the check list on the following pages. If you do not presently have credit and collection policies, you can use the check list as a guide in establishing policies.
Your answer to all questions should be “Yes” or “Not Applicable.” If you have any “No” answers, you should consider revising your policy or have a strong and valid reason for not doing so. For example, you may have a “No” answer to the question, “Do you offer a cash discount?”
If your accounts are primarily personal, this might be a valid answer. If your accounts are primarily major industries, a “No” answer would suggest that you consider the possibility of offering a cash discount.

CREDIT AND COLLECTION POLICIES CHECK LIST

Credit Approval
+ Is a written application required with every credit request?
+ Do you have a standard form for credit applications?
+ Is it completed personally by the applicant?
+ Is it reviewed for completeness?
+ Is all information verified for accuracy and timeliness?
+ Are applicants checked out with a credit bureau?
+ Does your evaluation consider income?
+ Does your evaluation consider fixed obligations?
+ Does your evaluation consider job stability?
+ Does your evaluation consider residential stability?
+ Does your evaluation consider credit history?
+ Does your evaluation consider bank balances?
+ Does your evaluation consider other assets?

Invoices
+ Are invoices prepared promptly?
+ Is invoice preparation always accurate?
+ Are payment terms clearly stated?
+ Are customers’ special instructions followed carefully?

Terms of Sale
+ Do you offer a cash discount?
+ Do you use a late payment penalty?
+ Is the time limit for payment clearly stated?

Statements
+ Are monthly statements submitted to all open accounts?
+ Are statements prompt and accurate?

Problems of Identification
+ Do you determine your average collection period on a regular basis?
+ Do you compare your collection period with industry averages?
+ Do you compare your current collection period with your previous experience?
+ Do you compare your collection period with your payment terms?
+ Do you have a monthly aging of all outstanding accounts?
+ When a problem is identified, is corrective action prompt and firm?

Follow-up
+ Do you have a systematic procedure for follow-up on slow accounts?
+ Is there a standard sequence of follow-up letters?
+ Is the tone of these letters progressively stronger?
+ Do you use the telephone to contact delinquent accounts?
+ Is your telephone technique effective?
+ Do you offer special arrangements for collecting past-due accounts?
+ Do you have a late-payment penalty?
+ Do you put delinquent accounts on a C.O.D. basis?

External Resources
+ Do you have a working relationship with a collection agency?
+ Are accounts turned over automatically after a specific time period?
+ Do you refer the most serious delinquencies to an attorney?

SUMMARY
Sound policies for credit and collection can eliminate many problems before they occur and minimize those that do occur. In this article, you have learned the techniques of receivables management. If you apply these techniques to your own business, your profit will improve and your cash position will be strengthened through fewer credit losses and lower costs of credit administration. Capital will be freed so that you will be able to meet your own obligations promptly and invest in those assets that offer a significant profit potential.

Making a profit is the most important (some might say the only) objective of a business. Profit measures success. It can be defined simply: Revenues – Expenses = Profit. To increase profits you must raise revenues, lower expenses, or both. To make improvements in your company’s bottom line, you must know what’s really going on financially at all times. You have to watch every financial event without any kind of optimistic filter.

This financial management analysis guide is a series of questions with comments to help you analyze your profits, their sufficiency and trend; the contribution of each of your product lines or services to profits; and help you determine if you have the kind of record-keeping system you need. The questions and comments are not meant to be definitive presentations on the subjects but are meant to point to areas where further study might be, well, profitable.

Are You Making A Profit?

Financial Analysis of Revenues and Expenses
Since profit is revenues less expenses, to determine what your profit is you must first identify all revenues and expenses for the period under study.

1. Have you chosen an appropriate period for profit determination?
   For accounting purposes firms generally use a twelve month period, such as January 1 to December 31 or July 1 to June 30. The accounting year you select doesn’t have to be a calendar year (January to December); a seasonal business, for example, might close its year after the end of the season. The selection depends upon the nature of your business, your personal preference, or possible tax considerations.
2. Have you determined your total revenues for the accounting period?
   In order to answer this question, consider the following questions:
   • What is the amount of gross revenue from sales of your goods or services? (Gross sales)
   • What is the amount of goods returned by your customers and credited? (Returns and rejects)
   • What is the amount of discounts given to your customers and employees? (Discounts)
   • What is the amount of net sales from goods and services? (Net Sales = Gross Sales – Returns and Rejects + Discounts))
   • What is the amount of income from other sources, such as interest on bank deposits, dividends from securities, rent on property leased to others? (Non-operating income)
   • What is the amount of total revenue? (Total Revenue = Net Sales + Non-operating Income)
3. Do you know what your total expenses are?
   Expenses are the cost of goods sold and services used in the process of selling goods or services. Some common expenses for all businesses are:
   • Cost of goods sold (Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory)
   • Wages and salaries (Don’t forget to include your own—at the actual rate you’d have to pay someone else to do your job.)
   • Rent
   • Utilities (electricity, gas telephone, water, etc.)
   • Delivery expenses
   • Insurance
   • Advertising and promotional costs
   • Maintenance and upkeep
   • Depreciation (Here you need to make sure your depreciation policies are realistic and that all depreciable items are included)
   • Taxes and licenses
   • Interest
   • Bad debts
   • Professional assistance (accountant, attorney, etc.)

   There are of course, many other types of expenses, but the point is that every expense must be recorded and deducted from your revenues before you know what your profit is. Understanding your expenses is the first step toward controlling them and increasing your profit.

Financial Ratios

A financial ratio is an expression on the relationship between two items selected from the income statement or the balance sheet. Ratio analysis helps you evaluate the weak and strong points in your financial and managerial performance.

4. Do you know your current ratio?
   The current ratio (current assets divided by current debts) is a measure of the cash or near-cash position (liquidity) of the firm. It tells you if you have enough cash to pay your firm’s current creditors. The higher the ratio, the more liquid the firm’s position is and, hence, the higher the credibility of the firm. Cash, receivables, marketable securities, and inventory are current assets. Naturally you need to be realistic in valuing receivables and inventory for a true picture of your liquidity, since some debts may be un-collectible and some stock obsolete. Current liabilities are those which must be paid in one year.
5. Do you know your quick ratio?
   Quick assets are current assets minus inventory. The quick ratio (or acid-test ratio) is found by dividing quick assets by current liabilities. The purpose, again, is to test the firm’s ability to meet its current obligations. This test doesn’t include inventory to make it a stiffer test of the company’s liquidity. It tells you if the business could meet its current obligations with quickly convertible assets should sales revenue suddenly cease.
6. Do you know your total debt to net worth ratio?
   This ratio (the result of total debt divided by net worth, then multiplied by 100) is a measure of how company can meet its total obligation from equity. The lower the ratio, the higher the proportion of equity relative to debt and the better the firm’s credit rating will be.
7. Do you know your average collection period?
   You find this ratio by dividing accounts receivable by daily credit sales. (Daily credit sales = annual credit sales divided by 360.) This ratio tells you the length of time it takes the firm to get its cash after making a sale on credit. The shorter this period the quicker the cash flow is. A longer than normal period may mean overdue and uncollectible bills. If you extend credit for a specific period (say, 30 days), this ratio should be very close to the same number of day. If it’s much longer than the established period, you may need to alter your credit policies. It’s wise to develop an aging schedule to gauge the trend of collections (without adequate financing charges) hurt your profit, since you could be doing something much more useful with your money, such as taking advantage of discounts on your own payables.
8. Do you know your ratio of net sales to total assets?
   This ratio (net sales divided by total assets) measures the efficiency with which you are using your assets. A higher than normal ratio indicates that the firm is able to generate sales from its assets faster (and better) than the average concern.
9. Do you know your operating profit to net sales ratio?
   This ratio (the result of dividing operating profit by net sales and multiplying by 100) is most often used to determine the profit position relative to sales. A higher than normal ratio indicates that your sales are good, that your expenses are low, or both. Interest income and interest expense should not be included in calculating this ratio.
10. Do you know your net profit to total assets ratio?
    This ratio (found by dividing net profit by total assets and multiplying that result by 100) is often called return on investment or ROI. It focuses on the profitability of the overall operation of the firm. Thus, it allows management to measure the effects of its policies on the firm’s profitability. The ROI is the single most important measure of a firm’s financial position. You might say it’s the bottom line for the bottom line.
11. Do you know your net profit to net worth ratio?
    This ratio is found by dividing net profit by net worth and multiplying the result by 100. It provides information on the productivity of the resources the owners have committed to the firm’s operations.
    All ratios measuring profitability can be computed either before or after taxes, depending on the purpose of the computations. Ratios have limitations. Since the information used to derive ratios is itself based on accounting rules and personal judgments, as well as facts, the ratios cannot be considered absolute indicators of a firm’s financial position. Ratios are only one means of assessing the performance of the firm and must be considered in perspective with many other measures. They should be used as a point of departure for further analysis and not as an end in themselves.

Sufficiency Of Profit

The following questions are designed to help you measure the adequacy of the profit your firm is making. Making a profit is only the first step; making enough profit to survive and grow is really what business is all about.

12. Have you compared your profit with your profit goals?
13. Is it possible your goals are too high or too low?
14. Have you compared your present profits (absolute and ratios) with the profits made in the last one to three years?
15. Have you compared your profits (absolute and ratios) with profits made by similar firms in your line?
    A number of organizations publish financial ratios for various businesses, among them Dun & Bradstreet. Robert Morris Associates, the Accounting Corporation of America, NCR Corporation, and the Bank of America. Your own trade association may also publish such studies. Remember, these published ratios are only averages. You probably want to be better than average.

Trend Of Profit

16. Have you analyzed the direction your profits have been taking?
    The preceding analysis, with all their merits, report on a firm only at a single time in the past. It is not possible to use these isolated moments to indicate the trend of your firm’s performance. To do a trend analysis performance indicators (absolute amounts or ratios) should be computed for several time periods (yearly for several years, for example) and the results laid out in columns side by side for easy comparison. You can then evaluate your performance, see the direction it’s taking, and make initial forecasts of where it will go.
17. Does your firm sell more than one major product line or provide several distinct services?
    If it does, a separate profit and ratio analysis of each should be made:
    • To show the relative contribution by each product line or service;
    • To show the relative burden of expenses by each product or service;
    • To show which items are most profitable, which are less so, and which are losing money; and
    • To show which are slow and fast moving.

Mix Of Profit

The profit analysis of each major item help you find out the strong and weak areas of your operations. They can help you to make profit-increasing decisions to drop a product line or service or to place particular emphasis behind one or another.

Records

Good records are essential. Without them a firm doesn’t know where it’s been, where it is, or where it’s heading. Keeping records that are accurate, up-to-date, and easy to use is one of the most important functions of the owner-manager, his or her staff, and his or her outside counselors (lawyer, accountant, banker).

Basic Records

18. Do you have a general journal and/or special journals, such as one for cash receipts and disbursements?
    A general journal is the basic record of the firm. Every monetary event in the life of the firm is entered in the general journal or in one of the special journals.
19. Do you prepare a sales report or analysis?
    1. Do you have sales goals by product, department, and accounting period (month, quarter, year)?
    2. Are your goals reasonable?
    3. Are you meeting your goals?

    If you aren’t meeting your goals, try to list the likely reasons on a sheet of paper. Such a study might include areas such as general business climate, competition, pricing, advertising, sales promotion, credit policies, and the like. Once you’ve identified the apparent causes you can take steps to increase sales (and profits).

Buying and Inventory System

20. Do you have a buying and inventory system?
    The buying and inventory systems are two critical areas of a firm’s operation that can affect profitability.
21. Do you keep records on the quality, service, price, and promptness of delivery of your sources of supply?
22. Have you analyzed the advantages and disadvantages of:
    1. Buying from several suppliers,
    2. Buying from a minimum number of suppliers?
23. Have you analyzed the advantages and disadvantages of buying through cooperatives or other systems?
24. Do you know:
    1. How long it usually takes to receive each order?
    2. How much inventory cushion (usually called safety stock) to have so you can maintain normal sales while you wait for the order to arrive?
25. Have you ever suffered because you were out of stock?
26. Do you know the optimum order quantity for each item you need?
27. Do you (or can you) take advantage of quantity discounts for large-size single purchases?
28. Do you know your costs of ordering inventory and carrying inventory?
    The more frequently you buy (smaller quantities per order), the higher your average ordering costs (clerical costs, postage, telephone costs etc.) will be, and the lower the average carrying costs (storage, loss through pilferage, obsolescence, etc.) will be. On the other hand, the larger the quantity per order, the lower the average ordering cost and the higher the carrying costs. A balance should be struck so that the minimum cost overall for ordering and carrying inventory can be achieved.
29. Do you keep records of inventory for each item?
    These records should be kept current by making entries whenever items are added to or removed from inventory. Simple records on 3 x 5 or 5 x 7 cards or as individual tabs on a computer spreadsheet can be used with each item being listed on a separate card or worksheet. Proper records will show for each item: quantity in stock, quantity on order, date of order, slow or fast seller, and valuations (which are important for taxes and your own analyses.)

Other Financial Records

30. Do you have an accounts payable ledger?
    This ledger will show what, whom, and why you owe. Such records should help you make your payments on schedule. Any expense not paid on time could adversely affect your credit, but even more important, such records should help you take advantage of discounts which can help boost your profits.
31. Do you have an accounts receivable ledger?
    This ledger will show who owes money to your firm. It shows how much is owed, how long it has been outstanding and why the money is owed. Overdue accounts could indicate that your credit granting policy needs to be reviewed and that you may not be getting the cash into the firm quickly enough to pay your own bills at the optimum time.
32. Do you have a cash receipts journal?
    This journal records the cash received by source, day, and amount.
33. Do you have a cash payments journal?
    This journal will be similar to the cash receipts journal but will show cash paid out instead of cash received. The two cash journals can be combined, if convenient.
34. Do you prepare an income (profit and loss or P&L) statement and a balance sheet?
    These are statements about the condition of your firm at a specific time and show the income, expenses, assets, and liabilities of the firm. They are absolutely essential.
35. Do you prepare a budget?
    You could think of a budget as a “record in advance,” projecting future inflows and outflows for your business. A budget is usually prepared for a single year, generally to correspond with the accounting year. It is then, however broken down into quarterly and monthly projections.
    There are different kinds of budgets: cash, production, sales, etc. A cash budget, for example, will show the estimate of sales and expenses for a particular period of time. The cash budget forces the firm to think ahead by estimating its income and expenses. Once reasonable projections are made for every important product line or department, the owner-manager has set targets for employees to meet for sales and expenses. You must plan to assure a profit. And you must prepare a budget to plan.
    By taking just a few of these steps outlined above, you will set your business on a more secure financial footing; over time and with more of the steps implemented, you’ll tighten operations, improve cash flow and reap higher profits.

Balance Sheet Ratio Analysis Formula
Important balance sheet ratios measure liquidity and solvency (a business’s ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors’ funding). They include the following ratios:

Liquidity Ratios
These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.
Current Ratios: The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

The main question this ratio addresses is: “Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?” A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.
If you decide your business’s current ratio is too low, you may be able to raise it by:

• Paying some debts.
• Increasing your current assets from loans or other borrowings with a maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

Quick Ratios: The Quick Ratio is sometimes called the “acid-test” ratio and is one of the best measures of liquidity. It is figured as shown below:

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: “If all sales revenues should disappear, could my business meet its current obligations with the readily convertible ‘quick’ funds on hand?”
An acid-test of 1:1 is considered satisfactory unless the majority of your “quick assets” are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

Working Capital: Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:
Working Capital = Total Current Assets – Total Current Liabilities

Bankers look at net working capital over time to determine a company’s ability to weather financial crises. Loans are often tied to minimum working capital requirements.
A general observation about these three LIQUIDITY RATIOS is that the higher they are the better your company’s financial health, especially if you are relying to any significant extent on creditor money to finance assets.

Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner’s equity):

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis
An important statement-of-income ratio is the gross margin ratio, which measures profitability by taking into account the business’s gross profit in relation to net sales.
The gross margin ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company. Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business.
First you must calculate your gross profit (net sales minus cost of goods sold). Then calculate the gross margin ratio as follows:

Net Profit Margin Ratio
This ratio drills down even further into your business’s financial health. It is the percentage of sales dollars left after subtracting the cost of goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company’s “return on sales” with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The net profit margin ratio is calculated as follows:

Management Ratios
Other important ratios, often referred to as management ratios, are also derived from balance sheet and statement of income information. These are inventory turnover, accounts receivable turnover, return on assets, and return on investment ratios.

Inventory Turnover Ratio
This ratio reveals how well inventory is being managed and is a good indicator of vibrant sales. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The inventory turnover ratio is calculated as follows:

Accounts Receivable Turnover Ratio
This ratio indicates how efficiently accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired.
Calculate the company’s daily credit sales first as follows, then use that figure to calculate your accounts receivable turnover ratio.

Return on Assets Ratio
This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The return on assets ratio is calculated as follows:

Return on Investment (ROI) Ratio
The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. The return on investment calculation takes into account the shareholders’ equity stake in the business. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:

These liquidity, leverage, profitability, and management ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. Using these valuable measurement tools will help the owner determine the business’s relative strengths and weaknesses in key areas.

Decision-making
Profit and loss information comes from the bookkeeping of a business and is an important aid in decision-making. Information gathered from a review of the bookkeeping system can indicate past trends in a company’s operating effectiveness. This historical data can be used to answer specific questions about the change in profitability over time, the volume of sales at different times of year, the level of employee turnover, etc. This historical perspective can be especially useful to the owner/manager in decisions about future courses of action. Information generated from the records keeping system can provide a baseline for setting future goals and directions.
Another aid to owner/manager decision-making derived from a good bookkeeping system is the ability to compare the business with similar businesses in the same industry; for instance, the figures derived from a bookkeeping program or spreadsheet can determine how many times a year the inventory turned over which can then be compared to an industry average. Or a bookkeeping system could be used to determine a business’s net profit as a percentage of sales which, again, could be compared to an industry average to tell the owner/manager if the business is thriving or needs improvement in certain areas.
The value of a good records keeping system is immeasurable. Accurate and timely information can be used by the owner/manager to make decisions that give an edge in maintaining or gaining a competitive advantage—more specifically, a good bookkeeping system can make the difference between success and failure.

Governmental Regulations
Another purpose for maintaining records (and the reason complained about the most) is to satisfy governmental regulations. A well designed records keeping system will simplify the process of complying with regulations, provide an audit trail for verifying that specific transactions have occurred, and serve the information needs of the owner/manager as well.

A Record for Others
Yet another purpose for maintaining records is to provide information for other people. Many small businesses are essentially one-person enterprises—a single individual is the catalyst for most activity. It is imperative that this type of business maintain complete and detailed records. If something happens to the key individual, often no one else knows what has gone on in the past. With no records system to provide continuity, the business may be forced to close or be sold for less than it is worth.

Effective Accounting Bookkeeping Factors
Records keeping, as presented in this section, can be defined as the process of identifying what records need to be kept, how they are entered and maintained, and how they can be used effectively. A record is defined as basic information which documents financial, personnel, inventory, supply or customer activities. This information is normally recorded as the result of a transaction or event in the course of conducting the business.
A good records keeping system should be designed and used with the following factors in mind:

• Simplicity
• Understandability
• Reliability
• Accuracy
• Consistency
• Timeliness

Simplicity
The records keeping system should be simple to use. One of the major reasons for the dramatic acceptance of personal computers today is the fact that they are very easy to use. A records keeping system should be designed with consideration for the employee(s) who will be recording the information. Complicated forms may be only partially completed and complicated processes avoided in favor of shortcuts that result in incomplete data. A good records keeping system should be designed to gather appropriate information as simply as possible.

Understandability
Ease of understanding is another important attribute of a good records keeping system. The system itself, the way to record information, and what the recorded information means must all be easily understood. Confusion, error, and, obviously, misunderstanding can result if records that are not clear and concise.

Reliability
“Reliable” has a specific meaning in accounting. The term generally means that a particular type of transaction is recorded in the same manner each time it occurs, in keeping with accounting guidelines.

Accuracy
The necessity for maintaining accurate records seems obvious, but cannot be overemphasized. Care should be taken to ensure the accuracy of all records. A good bookkeeping system will stress accuracy through built-in procedures for checking and rechecking entries. A common error found in bookkeeping records is when people inadvertently transpose numbers when entering them. Methods for improving accuracy include double checking all entries, taking frequent trial balances, requesting client/customer verification, and stressing the need for accuracy to all employees.

Consistency
Sometimes there are several ways to record a particular piece of information. Inventory records, for example, can be maintained on an item-by-item basis, on the basis that the last item is the first item sold (LIFO), or conversely, on the basis that the first item is in the first item sold (FIFO). Consistent records keeping means choosing one method for recording inventory, using it consistently, and not changing it arbitrarily. This does not mean that you cannot change your approach, but it does mean that changes should only be made for good reasons and that the changes in the records keeping process should be clearly identified and communicated to appropriate personnel. Keep in mind that consistent records keeping is essential for comparing records over time.

Timeliness
Timeliness is an important element in a good records keeping system. Consider the statement, “I made $5,000.” Without the element of time, this statement has little meaning. Add “in one year” and the statement has more meaning. Or add “in one week” and the meaning changes dramatically. The more obvious reason for timeliness is the need of the owner/manager to receive information as early as possible in order to make informed decisions that affect the business.

Minimum Records Required
There are four basic records that a business must maintain:

1. Sales Records
2. Cash Receipts
3. Cash Disbursements
4. Accounts Receivable

Sales Records
A record of all sales must be kept. If you use a cash register, a combined sales and cash receipts record may be kept. Sales may result from a single primary activity or may result from different types of activity and be recorded in sub-categories. For example, a business might record three kinds of sales: wholesale, retail, and services.
It is important to record all sales as they occur. Remember that a sale may result in cash or arrangements may be made to receive payment at a later time. In either case, the sales records should reflect that the sale has occurred.

Cash Receipts
Cash is received by a business at the time of the sale or as payment on account for a credit sale. In any case, all cash should be recorded as it is received. A small business without a cash register can enter each transaction in a sales and cash receipts journal showing the date, name, invoice number, and the amount of the sale.
Deposit all cash receipts for the day in the bank. Do not pay out small amounts directly from cash receipts. Instead, establish a petty cash fund to pay small amounts not covered by invoices. By depositing all cash receipts daily, you have a basis on which to verify the daily balance in the cash receipts book.

Cash Disbursements
Just as all cash receipts should be deposited, nearly all disbursements should be made by check. The petty cash fund, as stated earlier, should be used only to make out-of-pocket payments on small items.
When writing a check, use an invoice or bill to support the check. In the checkbook, record the purpose of the check, the date, name, check number, and the amount of the check. Bank charges should be recorded in the same manner as a check except, of course, they would not have a check number.

Accounts Receivable
The fourth basic record to be maintained is for credit sales. If a business provides a product or service to a customer and agrees to accept payment at a later time, it has created an account receivable. An account receivable record normally contains information pertinent to billing and receiving payment from a customer.
Every effort should be made to ensure that accounts receivable are kept current. Bills should be prepared promptly and mailed to correct addresses. At the end of each month, accounts receivable should be “aged.” Aging means listing all accounts unpaid for 30 days, 60 days, and over 60 days. Special action should be taken to collect older overdue accounts. Extraordinarily large accounts should be watched carefully.
For delinquent accounts, try to get the customer to promise payment on a specific date. Then, if payment is not made on that date, contact the customer to find out why payment was not made. Be persistent, it’s your money.

Records Keeping Process
A small business involved in ordering and selling merchandise should have a records keeping process that reflects the flow of that merchandise through the business.

Ordering and Receiving
The process begins when a business orders merchandise. An order can be written or oral. Oral orders should be documented with a written record. Copies of all orders should be retained.
When merchandise is received, it should be checked for quantity and condition, checked against the packing slip, and checked against the original order. Any discrepancies should be noted and the supplier notified as soon as possible.
The merchandise is then recorded on a receipt log listing quantity, description, and source. The receipt log serves as the basis for additions to the inventory list, which is a complete record of all goods available for sale.
When an invoice (bill) is received from a supplier requesting payment, the invoice is checked for accuracy and verified against the receipt log and the original purchase order. A check should then be written to the supplier for the appropriate amount.

Sales
As sales of merchandise are made, goods are removed from inventory. If the merchandise consists of large, expensive items (e.g., automobiles, refrigerators, etc.), the inventory list may be maintained on an item-by-item basis with a sale resulting in the immediate removal from the inventory list of the item sold. On the other hand, many businesses sell a large number of inexpensive items; a small grocery store, for instance, might sell 200 boxes of cereal. For these businesses a periodic physical count of merchandise available for sale is the only realistic way to keep track of inventory.
Sales can be cash or credit. In either case, the sale is recorded at the point of sale. The sales slip serves two primary purposes. First, it is the original record of the sale used to record that transaction in a journal. When a cash register is used, the cash register tape and total at the end of the day serves as the sales slip. Second, sales slips are used to reduce the inventory listed, at least when a perpetual inventory (item- by-item) method is used.
Sales for cash are recorded as sales and as cash receipts. Sales on credit are recorded as sales and accounts receivable. Credit sales require that a customer credit account be established and maintained.

Completing the Cycle
The reduced inventory resulting from sales signals the need to order more merchandise. Purchase orders are written and sent to suppliers and the cycle of merchandise flowing through the business continues.
Much of the process of recording and tracking inventory today is done by computers and or computerized cash registers. However, these systems are only as accurate as the information which is entered into them and checks and balances for human error still exist. By utilizing a computerized system it is possible to know on a daily basis what the inventory and sales for each item are and to plan for re-orders of merchandise in a more effective manner. They also provide an efficient method for determining loss by “shrinkage and theft.”

10 ways to improve the positive side of the cash flow equation

1. Ask for all or a portion of payment up front: There are many products and services that you pay for on delivery or in advance. So why give your customers months to pay up? Asking for a deposit up front (at the very least) is a great way to jump-start your cash flow. And if you establish the policy fairly and properly, it shouldn’t alienate good customers.
2. Sign up for a merchant account: A merchant account is a credit card processing account, meaning that you can accept credit card payments. If you already have a merchant account, encourage customers to use this option more often. Sure, you pay a fee but for speedier cash flow, credit cards can’t be beat. You get your money fast and customers are accustomed to paying with plastic.
3. Pay bills only when you have to: That doesn’t mean you should be late … only that you needn’t be early. For bills due net 30, for example, why pay at day 12? Paying right at the deadline keeps vendors happy (you are not paying late) and will help your own cash flow crunch.
4. Manage receivables more closely: Create a detailed aging schedule of what you are owed, by whom and for how long. Call overdue accounts quickly, focusing first on the largest amounts due. Ask if there is anything you can do to expedite payment (such as take a credit card payment for a portion of that balance).
5. Create a cash-in/cash-out budget: Note specific due dates for payables as well as receivables. Although the balance between the two won’t always be predictable, the budget can give you a fairly accurate picture of where your business stands in the cash flow derby.
6. Revamp your invoice: A messy, unclear or inaccurate invoice is far less likely to be paid. Make sure that what you send out reflects care and attention to detail-just as you would in providing your product or service.
7. Offer a discount for overdue receivables: This can bring some quick cash in the door, but play this card only after you’ve called the customer to ask for full payment. Set a short deadline and make it a sweet enough deal (10-20%) for them to respond.
8. Accelerate your invoicing: If you invoice customers, do it quickly. Invoices can be prepared in advance, and sent out at the earliest possible moment. More and more small businesses are sending invoices as PDF files via email. This can save days of postal delays. Ask customers if they will accept invoices this way.
9. Cut expenses: Accelerating positive cash flow is great for your business, but slowing the negative cash flow has the same effect.
10. Set up a commercial credit line: Do this when times are good. Then tap the line when the need arises.

Sure, tending to your bottom line sounds b-o-r-i-n-g. But if you make the key moves to protect and cultivate positive cash flow for your business, you’ll find you’ll have more opportunities (a lot more) to truly enjoy the other aspects of your business-the ones that led you to start up in the first place.