Challenging and chaotic business environments teach us important lessons — if we are willing to learn them. For example, in 2020 the COVID-19 pandemic taught us that humans crave social interaction, parents generally don’t make very good math teachers, and your household should always have an ample stockpile of toilet paper.
But there is one critical lesson from 2020 that seems nearly forgotten already, even in a world of complex financial structures and interest-rate escalation: Cash is king. Amid anxiety about the economy and media headlines about layoffs and bank failures, is your finance organization doing all it can to increase its cash reserves? Benchmarking and tracking your uncollectible balances is one way to ensure you’re keeping a close eye on your cash flow.
Through its Customer Credit and Invoicing Open Standards Benchmarking survey, APQC finds that uncollectible balances — that is, bad debt in the form of payments owed that will never be collected from customers — represent 0.55% of revenue for organizations at the 25th percentile. Organizations at the 75th percentile, meanwhile, have uncollectible balances equal to 0.81% of revenue.
These percentages may appear small but they add up quickly, especially for larger companies. For example, at $50 million dollars of revenue, the cash reserve difference between 75th and 25th-percentile companies would be $130,000 dollars. At $500 million dollars of revenue, 75th percentile companies lose $1.3 million dollars more than the 25th percentile companies as a result of uncollectible balances. The differences are significant at any level of scale.
Uncollectible Balance Warning Signs
In times of broad economic distress like a recession or global pandemic, it is reasonable to expect that uncollectible balances will creep up across the board. But customers could potentially lose their ability to pay you at any time for a wide variety of reasons. Fortunately, there are at least three things you can do to ensure that uncollectible balances don’t spiral out of control.
1. Benchmark Uncollectible Balances Internally
While APQC frequently recommends benchmarking against peers and competitors, it’s also important to benchmark internally and track your company’s data over time. For example, do you know where you stand on uncollectable balances relative to three months or a year ago? Benchmarking not only reveals the presence of bad debt but can also help you to discover patterns and trends that enable you to make better cash flow decisions.
2. Benchmark Your Revenue-to-Cash Ratio
As you internally benchmark your uncollectible balances, you should also be paying attention to leading indicators like your revenue-to-cash ratio. Ideally, this ratio should be as close as possible to 1:1. If a company reports one million in sales for one month, it should also bring in the same amount (or close to it) in cash in the subsequent period. If the subsequent period’s cash collections are 80% of the prior month’s reported revenue, ask yourself where that gap is coming from. Today’s gap could very well signal tomorrow’s uncollectible balances.
3. Know Your Customers
A third way to stay on top of uncollectible balances is deceptively simple: Know your customers. A company that does will be well-positioned to know which customers are likely to have challenges paying.
For example, if your company sells component parts to aircraft manufacturers and you know the industry is in a downturn, you should know what’s likely coming and be ready to extend terms, write off that bad debt, or tighten your credit policies as needed.
Bring Cash In the Door
If your uncollectible balances are higher than you’d like them to be, the good news is that there are plenty of proactive, holistic strategies at your disposal. For example:
Invest time and training into your collections effort. The right people with the right training will know how to stratify and prioritize accounts for collection, how to work with customers, and who might be worthy of extended payment terms.
Require deposits upfront. Deposit payments give you insight into your customer’s payables, provide immediate cash to your company, and insulate you from a total loss, should your customer not pay the remaining balance.
Leverage credit holds until your customer pays the existing balance.
Offer early pay discounts, which incentivize the customer to pay sooner.
Provide customer self-service portals, which accelerate the speed at which customers can research and resolve disputes to bring money in more quickly.
While all of these strategies should be on the table, you should also think carefully about how flexible you’re willing to be for your most important and strategic customers. While you certainly shouldn’t sabotage your own bottom line, keeping a high-value customer might make it worth accepting slower or lower payment for now.
Perry D. Wiggins, CPA, is CFO, secretary, and treasurer for APQC, a nonprofit benchmarking and best practices research organization based in Houston, Texas.