Debt collection is an essential part of any business and typically involves collecting money owed in a timely manner from debtors or accounts receivables. Poor debt collection practices may have serious ramifications for your business and may even lead to closure. In this particular article, we will take a look at how uncollected debts may have a bearing on your business’ future.
At the heart of debt collection is working capital management. Working capital can be defined as the capital used in day – to – day activities of the firm such as paying relatively small expenses or maintaining a float.
In accounting terms working capital may be calculated as a firm’s current assets less its current liabilities. Current assets may include the following:
- Cash and cash equivalents
- Short – term investments
- Accounts receivables
- Prepaid expenses
Current liabilities comprise the following:
- Accounts payable
- Accrued expenses
- Income tax payable
- Short – term notes payable
- The portion of long – term debt that is payable
We will come back to this later and how poor debt collection precisely affects a business. First, however, we will need an adequate understanding on the concept of the supply chain. The supply chain prescribes the interlinked activities between a company and its suppliers to manufacture and distribute its products to its customers.
For the typical manufacturer, this chain includes processes such as receipt of raw materials, machinery and labour to process the supplied materials and then packaging and finally storing the goods until they are sold to the end customer. The process may not be straight forward, as a manufacturer may require raw materials from different suppliers; as in the case of a clothes manufacturer who may require zippers from one supplier, cotton from one supplier and silk from another supplier. This specific manufacturer would have to ensure that the supplies arrive at a timely manner so as to ensure efficient manufacturing of the clothes.
To illustrate the effect of poor working capital management would best be explained through an example. Imagine the same clothes manufacturing company used in the previous paragraph. Imagine the company sells clothing that requires two distinct suppliers. One of the suppliers supplies raw materials more frequently than the other and as a result invoices the firm more often. Furthermore, the firm has sold a sizeable amount of clothes to a customer who has not paid their debts. Let’s take a look at how this applies to the above factors.
As mentioned above, current assets include cash, cash equivalents and accounts payable. Firm’s typically sell their goods on credit and as such go through the entire supply chain process. The manufacturing firm, in this case, will use its current cash balances to pay for purchases from the supplier who provides raw materials more frequently. However, since it has sold these goods on credit, the company’s accounts receivables (current assets) increases. So the company is still solvent.
However, once the firm fails to collect the debt it is owed, the firm is forced to write off the credit sale as a bad debt. This in itself begins a snowball event, in which one action is a direct consequence of the other. The firm then has to reduce its account receivables by the amount owed and thus reduce its current assets. Thus the firm’s solvency position worsens. Since the company did not receive the money it was expecting, it may not be able to pay for its supplies. This implies an increase in the company’s accounts payable. Yet again, the firm’s solvency position worsens.
To resolve this, the company may have to take on more debt in order to pay its suppliers. This further exacerbates the company’s solvency position. Creditors and suppliers will take note of the company’s poor liquidity position and may impose stricter controls and even higher prices for their supplies to protect. This reduces the company’s margins and the company may even have reduced sales. Overall, this may severely slow down growth of the company and may even lead to stagnation.
As shown above, writing off credit sales as bad debts impacts companies considerably. A common quote is that cash is king and really, if you are not making money then you might as well close shop. A company should strive to implement best practice when it comes to debt collection, lest they want to be out of business. Companies should strive to implement punitive measures for customers who are not paying their debts in time as well as have a clear cut outline for their policies on debt collection. They should also track customer behaviour in order to retain customers who honour debt obligations as well avoid business with customers with a poor history of debt repayment. Finally, as a last resort, companies should strive to have a debt collection agency ready to collect any troublesome debt.