July 2005                            return to newsletter contents page

Lowering the Bar on A/R

by Dr. Albert D. Bates

AVDA distributors provide their customers with a wide array of services and do so gladly. Such services include a broad assortment of products, the immediate availability of products, a knowledgeable sales force to aid in product selection, competitive prices, delivery and strong guarantees. Again, distributors provide these services eagerly.

There is one important exception to this service profile, though, and that is credit. It is not stretching things to say that in most distribution organizations, across virtually every line of trade, credit is not viewed as a service, but as a necessary

evil. Such a perspective is encapsulated by this recent comment, seen in a major trade journal:

Success in distribution today requires being more selective in extending credit, billing promptly, and dramatically tightening up collection procedures. This allows firms to greatly reduce their investment levels and increase cash flow.

This report will suggest that most AVDA members are giving up profit dollars by being more conservative than they should be with regard to accounts receivable. The report will not say that distributors should avoid monitoring the credit worthiness of their accounts. It will certainly not say distributors should seek out poor credit risks. What it will say is that the economics of credit clearly favor a somewhat more aggressive credit policy rather than a tighter one.

In doing so, two key issues will be reviewed:

• The Economics of Credit—Much of what is known about the impact of both accounts receivable and bad debts on distributor profitability is not just wrong, it is very wrong. This section will attempt to put the economics of credit into proper perspective.

• Controlling Cash Flow—This reviews how distributors can have their cake and eat it too. It will examine the specifics of controlling the investment in accounts receivable without incurring the painful reductions in sales that frequently follow.

The controversial nature of the subject mandates an explanatory paragraph before proceeding. I have been writing Profit Improvement Reports for fourteen years. Like this one, they have all been third-person, dispassionate reviews of the industry. The unconventional position presented in this report requires a first-person response to one question: “Dr. Bates, are you out of what little mind you once had?” I hope not. While virtually everything discussed in this report seems counter-intuitive, it is, in fact, based upon the economics of the industry.

The Economics of Credit

Exhibit 1 presents financial results for the typical AVDA member. Typical means that half of the firms will perform below the results shown in the exhibit and half will perform above the results. According to the most recent PROFIT Report, this typical firm generated $100,000,000 in sales volume, operated on a gross margin of 20.5%, and produced a pre-tax profit of $2,000,000 or 2.0% of sales.

From a credit perspective, the $100,000,000 in sales required an investment of $12,161,290 in accounts receivable. The firm also experienced bad debt losses of 0.1% of sales or $100,000.

Finally, the major expense items other than bad debts can be broken down into variable expenses and fixed, or overhead, expenses. The variable expenses were estimated to be 3.5% of sales or $3,500,000. Of much greater significance, fixed expenses were $14,900,000.

The second column of number looks at how the typical firm would have fared if it had been more aggressive with regard to its credit operations. This specific example examines the impact of adding 5.0% more sales through somewhat less stringent credit policies.

Any number could have been chosen for this exhibit—5.0%, 1.0% or 10.0%, it makes no difference. What is critical is the impact that such incremental business has on expenses and investment. The figure of 5.0% was chosen as simply a round number that allows for ease of calculation.

With the additional sales, there are four key factors that will change:

• Variable Expenses—These continue to be 3.5% of sales on the additional revenue generated, just as they were on the base revenue.

• Fixed Expenses—There is no such thing as truly incremental expenses. At the same time, additional sales have a modest impact on expenses. It is assumed that the 5.0% increase in sales will cause fixed expenses to increase by 2.5%. This is classic expense leveraging.

• Bad Debts—These were estimated to be five times as high on the additional sales. That is equal to 0.5% of sales on the additional volume versus 0.1% on the base sales volume.

• Accounts Receivable—The additional sales were assumed to require twice the number of days to collect. A 5.0% sales increase will require 10.0% percent more accounts receivable with an associated interest rate of 6.0%, driving interest costs up by $72,968.

In short, the exhibit skews everything to make the additional sales as unprofitable as possible. Even so, the results are startling. The 5.0% increase in sales causes profit to increase by 19.0%. This does not say that firms should rush out and find marginal accounts. What it says is that the true costs of servicing additional accounts must be weighed against the additional sales and gross margin they will generate. Rational analysis absolutely must replace emotionalism.

Controlling Cash Flow

Distributors will argue, quite correctly, that in a tight cash-flow world it is difficult to find the funds to invest in additional accounts receivable, regardless of the potential profit payoff. That is an undeniably true statement. Consequently, it is imperative that distributors focus on the reasons why accounts receivable get out of control in the first place.

Most research in the area suggests that both the customer and the distributor are partially to blame. From the distributor’s perspective, three key causal factors lead to longer collections:

• Billing Errors—A single incorrect line on an invoice can cause the entire payment process to grind to a halt.

• Late Billing—If target dates for billing are not met, then days are added slowly and systematically to the average collection period.

• Failure to Follow Up—When accounts receivable become past due, it is time for a review with the customer at that point, not ten days later.

In too many instances these three items slip out of control, almost unnoticed. If they can be cleaned up, then the funds for an increased use of credit should be readily available.

Moving Forward

It is unlikely that distributors will ever eagerly anticipate the opportunity to invest more in accounts receivable. However, firms must be aware that the economics of credit, from a profit perspective, actually favor greater rather than lesser use of credit. If this reality can be married with proper control of accounts receivable balances, AVDA members should be able to increase profits without incurring dramatic increases in investment levels.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2005 Profit Planning Group. AVDA has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.

A Managerial Sidebar on the Sales Needed to Offset a Bad Debt Loss

One of the most widely misunderstood issues in all of financial management is the sales increase required to offset a bad debt loss. In seminar after seminar, the equation is presented as (assuming a $20,000 loss for illustrative purposes):

If this equation were true, firms would be advised to never offer credit to anybody. Even the most minute loss would require a massive increase in sales to offset. In fact, the correct equation is a variation on the basic break-even formula:

This formula does acknowledge that a substantial amount of sales activity must take place to offset a bad debt lost. However, the amount is much smaller than conventional wisdom suggests.