What is a Reasonable Percentage of Accounts Receivable to be Past Due?

What is a Reasonable Percentage of Accounts Receivable to be Past Due?

The efficiency of a small business hinges quite heavily on its ability to make optimal use of all its resources. Finances being one of the most critical resources, the business needs to ensure that every dollar it invests is yielding the right value at the right time. This is where the question, ‘What is a reasonable percentage of accounts receivable to be past due?’ arises.

Typically, as long as the business has complete control over where its dollars are being used, it is reasonably easy to maintain efficiency at all levels. But, once the product or service is purchased by a customer, the business no longer has a great deal of say in the matter at all.

Thinks of it this way: Your business makes product A and one of your largest customers buys 1000 units of product A on the usual credit you allow, which is 45 days. Now, product A still represents a financial investment for your business when it shipped out to the customer because payment for the product is not yet received.

In fact, until the payment is received by you, 45 days after the shipment, as agreed by both of you, you have essentially locked up a portion of your finances in the order. Now, this is an inevitable process for businesses that wish to retain their customers because the credit period is just one way to make the buying process easier for them, prompting them to continue buying from the business. It is a price paid to earn the loyalty of the customer.

However, when the customer abuses your trust and fails to pay on due date, you are in trouble. Now, the money that is locked up in the purchase order is no longer being utilized optimally. In fact, you do not know if it can ever be used for your business until you recover the funds. This is something you want to avoid at all costs because every resource, and in particular, money, is a valuable one that can translate into an asset for your business in some way or another.

To maintain efficiency in the business, the accounts department ensures that these cases are minimized at all times. It is fairly impossible to eliminate all of them and every business has its share of unpaid dues but it is possible to keep the level of these dues under strict control. To know whether or not things are under control in this area, the accountants need a measure that lets them quickly identify when control is slipping away. This brings us to the past dues- accounts receivables relationship.

Accounts Receivables- Why they are not always an indication of trouble

Accounts Receivables refers to the money that is owed to your business by your customers, at any point of time (see our article on Accounts Receivable Metrics). When customers buy your product or service, the amount becomes due. Until the payment is actually received by you towards these purchases, they are part of your Accounts Receivables. The customer may or may not have used your product; he is still expected to pay as per your terms of payment.

Now, your business may have some huge Accounts Receivables, that is, payments pending, but this is not necessarily a bad thing. This is why: Customer A, who is your biggest customer, has taken delivery of his $10,000 order today but he will send in his check only tomorrow, as is his regular practice. This does not indicate that you have a $10,000 loss, just that you have a $10,000 Accounts Receivable, which will remain on books until the payment is received by you. If you have a couple of big clients placing and taking their orders at the same period, your books may seem to be skewed, financials wise. However, this is not the case.

Substantial Accounts Receivables do not always indicate that you have a lax credit policy or that your unpaid dues are out of control. They may only indicate a sudden influx of orders, meaning that your business activity is intense, which is a good thing for you. So Accounts Receivables are not always an indication of trouble, but there are situations when they can turn into problems for the business.

And then, there were Past Dues….

In any business, there are customers who pay upfront, some who pay by check, meaning they may have a one or two day leeway, some who make credit card payments and others who get credit. Typically, the business may allow a 30 to 45 day credit period for its best and biggest customers.

Some may get a shorter credit period while others get a longer one, depending on the relationship they have with the business and the credit policy of the business. Irrespective of what the credit policy extended to a customer is, his dues become past dues when he fails to pay on the due date.   So, if customer A has a 45 day credit and his bills remain unpaid on day 50 after purchase, they are past dues. But, for customer B who has a 10 day credit period, unpaid bills on day 15 are past dues.

Now, the ideal thing is for businesses to get cracking on past dues instantly, as soon as they become due but this often does not happen because the process of collection tends to be long winded and time consuming. And, recovering payments from an unwilling customer or from a customer who is unable to pay is often a task that needs the special skills of professional debt collectors.

Debt collectors charge you a fee or a percentage of the debt which means an additional cost for your business. You need to consider the viability of hiring professionals, keeping this in mind. Essentially, when you have past dues and you are hiring someone to go after them you may be pouring in more good money after bad money.

Of course, if you take enough care to hire a skilled debt collection attorney, your past dues story is more likely to have a Happy Ending. However, this does bring us to the critical question of ‘What is a reasonable percentage of accounts receivable (A/R) to be past due?’.

Is there an ideal percentage?

Actually, this a tricky question to answer. Ask business acquaintances and you are likely to get some really varied answers about their A/ R to past due ratio. The business owner who has 2% of his A/ Rs in the Past Due category may seem to be as happy about the state of affairs as the one who has a 10% Past Dues percentage. Why is this? Well, there are many factors that go into making up your past due percentage, such as these:

Cultural difference       

Let’s begin with the one that is most often ignored and overlooked. The payment term and norm varies significantly from country to country. For instance, Germans are strict about paying on time so if your client base has a number of large German clients, your Past Dues situation should look really good with minimal outstandings.

The French tend to take a more relaxed view of this aspect so if you have many French clients, your Past Dues may be a more startling figure. The culture of payments within a country also matters a lot.

Given that a number of small businesses today leverage the power of the internet to capture international clients and cater to them, this point also holds relevance here. This may be particularly relevant to small business that offers services that can be provided online rather than products that may shipped over a limited geographical area.

Credit policy

The credit policy you have, that is, how many days of credit do you extend, what billing amounts get credit from you, do you have a policy of credit only for known, long standing customers etc, makes a difference. First of all, a tight, well thought out credit policy minimizes your chances of running up huge past dues. Also, your credit policy may be very different from your neighboring business’ which is why your past dues may look very different too, despite all other similarities.

For example, you have a policy of extending a maximum credit of 30 days while they extend credit for 60 days. The same client has a matching bill from you and them but the amount falls under your Past Dues from Day 30 onwards whereas, for the other business, it becomes Past Due only from Day 60. In effect, your policy does make a difference.

Liquidity of business

Businesses that are cash rich and that have a huge capital, can afford to be more flexible with their credit and that means the Past Dues may be lower than a business that has limited liquidity and favors quick payment of dues. There are annual periods when a business needs additional liquidity (to address seasonal demand, for example) and periods when it can afford its customers a bit more slack. The business’s liquidity requirements at any point of time dictate its ability and willingness to allow past dues to accumulate.

Industry norms/ conventions

All industries are not equal when it comes to the credit terms that are conventionally followed. A business in one niche needs to toe the line when it comes to these industry norms otherwise it cannot survive especially if its competitors are following a more lenient policy that is far more favorable to clients. This does impact the past dues percentage of A/ R. This is why it may not be a smart move to compare your business’ past dues percentage with that of a business functioning in entirely another arena.

Nature of business

The nature of business you are engaged in, much like industry norms, has an impact on your credit policy and your past dues situations. All businesses cannot demand payment upfront and all businesses cannot afford to have a lengthy credit extension to all customers. The kind of business you do does play a key role in determining both these aspects and this is why past due percentage may vary dramatically when you compare one kind of business with an entirely different one.

What is a reasonable percentage of accounts receivable to be past due?

This is the critical question and as we have explained above, there is no rule set in cement that a business needs to have a fixed X%. However, your business is doing exceedingly well in the debt collection area if your dues to A/ R percentage is less than 5%.

Anywhere around 10 to 15% is standard for a business while 30% should be absolute limit that you should allow under any circumstances. Anything beyond 30% and your accounts department needs to buckle down and gain control over the unmanageable unpaid debts.

A good understanding of the consumer credit laws in force is essential to develop a credit policy that factors in the limitations that will come to bear on you if you have to recover dues that remain unpaid. The FTC governs these laws that are designed to protect your debtors from abusive debt collection practices and failing to follow them can bring the law down upon you.

Don’t forget to factor in your industry niche, the industry norms, your liquidity requirements and your credit policy when you are trying to find the perfect answer to ‘What is a reasonable percentage of accounts receivable to be past due?’ for your business.

The ideal way to manage your A/ R and keep your past dues percentage within reasonable limits is to tweak and tighten your credit policy so that there are no loopholes or excessive flexibility offered anywhere. A good credit policy is one that lets your business grow unfettered while your risks are always evaluated and addressed with objectivity. A system of tracking payments and ensuring that all customers adhere to their agreed terms is also necessary. This means an efficient accounting team should be actively engaged in A/ R management at all times to ensure that your financial transactions are going the way you want them to.

 

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