Many businesses extend credit to customers, to provide the services and products they need.
According to a 2019 report on the economic well-being of U.S. households, 33% of adults are either unable to pay their bills or are one modest payment plans setback away from hardship. 4 in 10 adults would have serious difficulty covering a $400 expense, and most commonly make payments on credit cards or borrowing from friends or family.
It can be difficult to turn away customers in need, and additionally difficult to turn away a customer who can pay at least on credit. However, carrying accounts receivable on the customer’s behalf will undoubtedly have a negative effect on a business.
When the business extends credit to customers without having a solution to collect accounts receivable, they take on administrative costs, opportunity costs, and the risk of heavy debt among other cost elements, according to a study by the Harvard Business Review.
Let’s take a look at the different costs of carrying accounts receivable and how they negatively impact a business.
Collect Accounts Receivable
Administrative and Time Costs
To manage your accounts receivable, a business owner or their staff will need to spend hours every week to manage accounts, call customers with overdue payments, update balances, and calculate the costs for your business. Especially for small companies, a sole proprietor or business with a small staff cannot afford to use time and resources on collection and accounting. In addition to labor costs, your business would have expenses for postage, paper billing, and payment processing.
The cost to carry every dollar of accounts receivable highly increases over time. At 30 days, the cost to carry accounts receivable is around 1.82%, according to the Harvard Business Review, which is relatively minimal. At 60 days, it increases to 10.29%. At 90 days, it hikes up to 19.74%. By 120 days, the true cost rises to over 15.00%. At that point, you essentially have a lost receivable.
The opportunity cost is another factor to consider when determining the true cost of accounts receivable for your business. If your customer makes their payment earlier, your business can invest the money to generate more revenue. The more your customer delays paying their debt, the higher the opportunity cost will be.
To calculate the opportunity cost of the receivable, you can use this formula:
[(Accounts receivable x Rate of return)/365] x Days Sales Outstanding
When you calculate the opportunity cost, you can see how much this negatively impacts your company to carry accounts receivable. To lower the day’s sales outstanding, you can lower the cost for your business.
Risk of Bad Debt
If your business is unable to manage the accounts receivable, you’ll experience a higher loss due to customer default. Your company will need to write off the invoices as bad debts. As we can see in the chart, the longer you carry accounts receivable, the higher the risk of bad debts.
What can you do to protect your business and collect accounts receivable?
If your business already has a high volume of accounts receivable, we have some tips on how to protect your business in the future as well as how to collect on overdue payments:
- Set clear payment terms and policies. This will help protect your business and let the customer know the terms of agreement — and consequences if they do not make timely payments. Additionally, make sure to only provide services after you’ve received valid forms of payment. Keep a signed agreement and copy of ID of the cardholder.
- Hire an accountant. If you’re struggling to manage your customer accounts and overdue payments, hiring an accountant can take a load of stress off you and free up your time. An accountant can handle your payment so you’ll know what payments you’re owed and how it is affecting your business. However, you’ll need to consider the cost of taking on a full-time accountant or possibly paying a firm to take care of your accounts part-time.
- Provide the option for multiple payment methods. Your customer may not be able to pay in full immediately for the products or services you provide, but you can offer payment options so you don’t have to extend credit on the entire payment. This way, you can at least get partial money down and not risk a total loss if the customer defaults.
- Use Automated Accounts Receivable to collect overdue payments.
- Denefits offers the option for businesses to automatically collect accounts receivable using our innovative software. This service is completely free for businesses to use. For a limited time, you can add existing customers with outstanding payments to collect accounts receivable and Denefits will guarantee your payments.
- Hire collection services. As a small business owner, you likely do not have the time to continuously call customers week to week to collect payments. You can solve this problem by hiring professionals to collect for you. However, just like with the accountant option, you’ll have to consider whether you can afford to hire collection services and if this is a viable option for your business.