A note about this article:
Last year I led an implementation of HighRadius Cloud Collections, one of the leading solutions for adding automation to the collections process.
I pointed out to the team that of all the customers implementing this solution, some would do it much better than others.
We wanted to ensure we would be in the top quartile of all their customers, so we ran a full transformation initiative that included developing our staff, taking a strategic approach, applying Lean principles, and using good change management techniques.
It began with the following article to bring clarity and alignment among the team.
The AR transformation initiative aims to reduce our outstanding AR and improve the productivity of the team through a combination of process improvements (applying lean finance principles), global harmonization and teamwork, and the implementation of best-in-class collections software.
The collections team has identified their primary job: to minimize overdue accounts receivable and write-offs (bad debt expense) as efficiently as possible.
The primary lag measure of efficiency for the team is the total cost of the credit & collections function including bad debt expense as a percent of the amount billed on credit.
The primary lag measures of effectiveness are:
1. Days Sales Outstanding (DSO).
2. The amount of overdue debt.
3. Bad debt expense as a percentage of revenue.
This AR transformation initiative is intended to deliver improvements to these measures.
Why improving accounts receivable is important
If we can reduce our outstanding receivables by $20 million, that’s $20 million less we need to borrow or $20 million more we can invest to create more profits.
When that $20 million is tied up in overdue receivables, we don’t earn anything on it, and it’s at increased risk of becoming uncollectible (lost capital).
Reasons for late payments
It’s important to understand and then address the reasons why customers pay invoices late.
Just as we want to collect the receivables so we can reinvest in our businesses that earn a profit, our customers want to invest capital in their businesses. They may not be able to borrow more than they already have, or they may just want to avoid the interest expense of a bank loan.
Many savvy Finance chiefs will try to use “vendor capital” by paying everyone late. For example, if a company has $10 million a month in expenses on 30-day terms, it can access an additional $20 million in capital by paying those bills in 90 days instead of 30.
Unfortunately for them, most vendors are capital conscious themselves and won’t allow late payments. But they can quickly find out where they can extend payments by seeing when the collections teams from their vendors start chasing the debt.
If we wait until payments are 60 days overdue to start chasing them, then we're the ones who are allowing two months of receivables to be invested in their business instead of ours.
The cure for this is to contact customers about overdue receivables as close to the first day they are overdue as possible. This trains the customer that we are paying attention and are capital conscious.
Customers also want efficient accounts payable. To achieve that, one has to keep one’s accounts payable team off the phone and not be distracted by emails about late payments.
One achieves efficient accounts payable by allowing the team to spend most of their time processing invoices and making payments before vendors call to follow up. We need to train our customers to expect that to happen the day after the due date.
There are more invoices to chase that are one day old than 60 days old. That’s where the improved efficiency of the new software comes into play. We want our software to tell us who just became overdue today and to facilitate contacting them with copies of invoices or statements.
If we get a promise to pay by a certain date, we want the software provider to tell us if they didn’t come through on that promise so we can follow up right away (they may be hoping we forget about it).
Another common reason for late payments is a problem with the invoice that prevented a three-way match in the customer’s accounts payable system.
A three-way match is generally required to pay an invoice: the invoice matches the PO and the receiver/packing slip. If we bill the wrong amount, ship the wrong product or quantity, or simply fail to put a required PO number on an invoice, it can cause a delay.
Customers will often skip those invoices and wait until we follow up to resolve them. Eventually, we call to ask why they haven’t paid an invoice, they explain that we charged them for two items but only shipped one, we research it, issue a credit memo or rebill, and eventually, they pay. These invoices tie up capital and cost us extra time (money) to resolve.
There are two things we want to do with this type of invoice.
Using some of our Lean Finance principles, we want to get to the root cause of these errors and work with other departments (sales, customer service, warehouse) to make changes to the processes that allow these errors. If we can reduce the number of faulty invoices, we collect them on time and save the cost of resolving them.
Second, we want to call about these invoices the day they are skipped. If a customer pays an invoice that is more recent than one they haven’t paid, we want to contact the customer and find out the problem with the skipped invoice. As we set up our accounts receivable automation software, we want to make sure the system will alert us to the skipped invoice.
Cash flow problems
The third reason customers pay late is that they simply don’t have the cash to pay on time.
Imagine you are running a finance department at a company that has financial difficulty. Every pay period you aren’t sure you’ll have the cash to make payroll and the unpaid bills are piling up. Stressful! You have to pick and choose who to pay and when.
If things don’t turn around soon, you may need bankruptcy protection to get the chance to reorganize or you might just go out of business without all your bills paid.
One of our objectives is to minimize our bad debt expense (the provision for uncollectible receivables). Our credit approval processes are designed to help us avoid extending credit to customers that may not pay it back. An ounce of prevention is worth a pound of cure.
However, it’s equally important to realize that whenever a company has cash flow problems, whether they go into bankruptcy or survive, there are relative winners and losers among its vendors.
Generally, the squeaky wheels get the oil. When the Head of Finance at a struggling company is deciding who to pay each week, the companies that have proactively contacted them and agreed to a revised payment schedule, or have simply followed up professionally and timely, tend to get paid faster. If we aren’t proactive, they pay somebody else (like our competitor).
Negotiated short payments
In addition to late payment issues, we also have losses related to short payments for various reasons. Sometimes, customers see an opportunity to get a reduction in a very old invoice in exchange for paying it!
When our documentation is not strong enough to make it clear our invoice is correct, we often make concessions to keep our customers happy. Customers sometimes take deductions claiming a problem with the product or they return damaged goods.
Short payments can add up. The first thing we want to do is to create an easy way to track and quantify the impact. Then we investigate the short payments and complete a root cause analysis of each.
Generally, we should find a short list of root causes. We can then categorize short payments as they happen according to the root cause, and use that data to determine which issues to attack first. We want to include in our transformation the efforts to address all the items that lead to losses or tie up our team’s time.
The purpose of this article is to get clarity and alignment on the items above. To keep it brief, I have oversimplified the issues you face and what it'll take to solve them. I don’t have all the answers. But together, we do.