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Lowering The Bar on A/R

The economics of credit clearly favor a more aggressive credit policy rather than a tight one.

MHEDA distributors provide their customers with a wide array of services, including 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. Distributors provide these services eagerly.

One important exception to this service profile, though, is credit. It is not a stretch to say that most distribution organizations, across virtually every line of trade, do not view credit as a service, but as a necessary evil. Such a perspective is encapsulated by this comment, recently 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 article will suggest that most MHEDA members are giving up profit dollars by being more conservative than they should be with regard to accounts receivable. Distributors should not avoid monitoring the creditworthiness of their accounts, nor should they seek out poor credit risks. However, the economics of credit clearly favor a more aggressive credit policy rather than a tight one.

The controversial nature of the subject mandates an explanatory paragraph before proceeding. 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 on the economics of the industry.

The Economics of Credit
Exhibit 1 presents financial results for the typical MHEDA 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 2004 DiSC Report, the typical firm generated $13 million in sales volume, operated on a gross margin of 29.5 percent and produced a pre-tax profit of $195,000, or 1.5 percent of sales.

Exhibit 1      
The Change in Financial Results from a
More Aggressive Approach to Accounts Receivable
Net Sales $13,000,000 $650,000 $13,650,000
Cost of Goods Sold 9,165,000 458,250 9,623,250
Gross Margin 3,835,000 191,750 4,026,750
Variable Expenses 715,000 35,750 750,750
Bad Debts 26,000 6,500 32,500
Fixed Expenses 2,899,000 72,475 2,971,475
Change in Investment Costs 0 9,042 9,042
Total Expenses 3,640,000 123,767 3,763,767
Profit Before Taxes $195,000 $67,983 $262,983

Accounts Receivable

$1,507,037 $150,704 $1,657,741

From a credit perspective, the $13 million in sales required an investment of $1,507,037 in accounts receivable. The firm also experienced bad debt losses of 0.2 percent of sales, or $26,000.

The major expense items other than bad debts can be broken down into variable expenses and fixed expenses. Variable expenses were estimated to be 5.5 percent of sales, or $715,000. Of much greater significance, fixed expenses were $2,899,000.

The second column of numbers 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 five percent more sales through somewhat less stringent credit policies.

Any percentage could have been chosen for this exhibit; whether it is five, one or ten percent makes no difference. What is critical is the impact that such incremental business has on expenses and investment. The figure of five percent was chosen simply as to allow for ease of calculation.

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

  • Variable Expenses – These continue to be 5.5 percent 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 five percent increase in sales will cause fixed expenses to increase by 2.5 percent. This is classic expense leveraging.
  • Bad Debts – These were estimated to be five times as high on the additional sales. That is equal to one percent of sales on the additional volume versus 0.2 percent on the base sales volume.
  • Accounts Receivable – The additional sales were assumed to require twice the number of days to collect. A five percent sales increase will require 10 percent more accounts receivable with an associated interest rate of six percent, driving interest costs up by $9,042.

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:

Sales Increase Required = Bad Debt Loss / Typical Profit Margin.

Assume a $20,000 loss for illustrative purposes.

$20,000 / 1.5% = $1,333,333

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

Sales Increase Required = Bad Debt Loss / (Gross Margin % – Variable Expense %).

$20,000 / (29.5% – 5.5%) = $83,333

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.

In short, the exhibit skews everything to make the additional sales as unprofitable as possible. Even so, the results are startling. The five percent increase in sales causes profit to increase by 34.9 percent. 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 receivables 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.

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, MHEDA members should be able to increase profits without incurring dramatic increases in investment levels.

Material Handling Equipment Distributors Association
Meet the Author
Albert D. Bates, Ph.D., is president of Profit Planning Group, a distribution research firm located in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.

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