The Importance of Collections and How Receivables Turn
Turnover is a financial ratio which quantifies the speed at which a business collects its accounts receivable (A/R). For lenders, turnover relates to collections as opposed to the days sales outstanding (DSO) metric that many businesses use, and is calculated as the balance of the A/R at the beginning of the month divided by collections in the month multiplied by the number of days in the month. The resulting turnover rate is the measure of how quickly customers pay their bills, and while there is no set standard, the lower the number, the better.
Turnover rates typically follow trends and when the trend (or pattern) changes, that should send a red flag to all parties concerned. There are a number of reasons why turnover rates can change: some are very innocent such as changes in personnel with new employees not knowing how to do collections, or less emphasis is placed on collections for fear that pushing customers will lead to a loss of business; other reasons may not be as innocent and include such things as problems with sales, a change in terms, the diverting of cash from the lender. But whether the reason is innocent or not is not as important as how quickly it can be identified and rectified.
Let’s look at a couple of examples:
Company A’s A/R was turning in the low 40s. This is usually a pretty good rate and as it was consistent over the past few months, all seemed fine. When you looked back over two years, however, A/R was turning in 25 days and then began creeping up; not a good sign. The reason: the owner was diverting collections gradually and then posting to show that agings were current. This is a good example, especially for seasonal businesses, that you have to look at the current trend over a longer period of time than just a few months, and pay attention to even small changes.
Company B’s A/R was turning in the upper 50s one month then almost doubled the next month. The trouble was on the invoicing side: sloppy recordkeeping and no proper back-up so customers didn’t have the paperwork needed to pay and close an invoice. In addition, the company was delivering the product late and would get hit with a late fee. That late fee, coupled with rebates and promotional discounts customers were already receiving, significantly reduced what the customers had to pay so they ended up not paying anything. This owner was running his company so poorly that it, in essence, just got away from him.
The bottom line and the one constant: the trend that never lies is turnover. If turnover changes from what’s been “normal,” it’s typically the first sign of trouble and there’s always a reason for it. Whether it’s lack of attention, a change in personnel, a change in terms, something going on with the customer base, something going on with sales, or if cash is being diverted, the quicker a change in the turnover trend is identified, the quicker whatever is “wrong” can be remedied. And hopefully, this occurs before the damage to the company or to the lending relationship is irreparable.