Many business owners view accounts receivable as the natural result of growing sales and a very safe, readily-liquid asset, but that’s not the whole picture. While A/R serves some important functions, of all the assets a business could hold, it is among the worst. Here, we consider just a few facts about A/R.
Fact #1: 100% of the Time, A/R Depreciates in Value
Ben Franklin famously said, “Nothing in life is certain except death and taxes.” With all due respect to Mr. Franklin, he forgot to include the fact that 100 percent of the time, accounts receivable will do nothing but depreciate in value. Yes, it’s true that other assets like inventory and equipment may also depreciate over time, but unlike A/R, at least they are an investment in future sales. On the tail end of the sales cycle representing sales already made, A/R does nothing but decrease in value while it remains uncollected.
Every day a dollar sits out there as accounts receivable is a day that dollar is not working for your business. It is not a piece of equipment that churns out items to be sold at a profit, and it can’t pay for a building that saves the company rent and build long-term equity.
Fact #2: A/R is Just a Fancy Word for a Risky Loan
At the end of the day, A/R is an unsecured loan that your business makes to its customers at 0 percent interest. You deliver your goods and services in advance, and trust your customer to pay you for them at some point in the future. Of course, as a prudent business owner you make sure to extend A/R only to customers who you deem creditworthy, but can you ever really be sure they won’t default on your “loan?”
Just for fun, let’s do a little comparison. Commercial banks are in the business of making loans to small businesses, and there is a plethora of publicly-available data out there on them. According to data from 1985-2018 by the Federal Reserve, banks charged off an average of roughly 1 percent of their non-real-estate commercial loans. This means that for every $100 loaned out, $1 was written off as uncollectable.
If the experts in the business of commercial lending are writing off 1 percent of their loans, what should the typical small business expect? Unless your company is underwriting its customers to the level of a commercial bank, securing its A/R with collateral and regularly monitoring the financial performance of its customers, a 1 percent loss rate is probably wishful thinking.
Fact #3: Unlike a Fine Wine, A/R Only Gets Worse with Age
The longer you carry a receivable, the more risk you expose your company to. That risk increases not on a linear basis, but exponentially. If you think about it, every day that passes where one of your customers owes you money is a day that customer’s financial health could be negatively impacted by any number of factors. Simply put, the longer it takes for your customer to pay you, the more reason you have to wonder if they ever will.
While the typical small business offers its customers 30-day payment terms, the reality is the average small company’s sales outstanding is 67 days. That means that on average, small businesses have over two months of sales sitting out there uncollected.
This is not to say that accounts receivable is all bad. It serves some important functions, and offering customers payment terms by carrying A/R allows a company to make sales that it likely could not otherwise make. If you are interested in learning more, our team of Business Bankers at Elevations are highly-trained in financial analysis and would be happy to advise you or help explain accounts receivable and your other options.
Elevations Credit Union is a member-owned not-for-profit financial institution serving Colorado’s Front Range. With a consultative approach to solving your business banking needs, Elevations local business bankers can help you improve your cash flow, reduce your borrowing needs or decide whether a term loan or line-of-credit is best, including quick-turn credit decisions. Click here to learn more about Elevations business banking or schedule an appointment.