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May 19, 2022
Financial wellness: collecting
9 min read

Financial Wellness Indicator: A business' ability to collect

How quickly you get paid for work completed – and how you manage your receivables – is an important factor in the health of your business.

Ok, so you know you need to spend money to make money. But did you know you also need to get money to….err…. get money? That’s because your ability to collect on your receivables doesn’t just impact the flow of cash coming in – it also affects your ability to access cash through a margined operating line of credit.

 

Here we connect with CWB’s Graedon Rust, Senior Relationship Manager, Commercial who’s based out of our St Albert banking centre, to get an overview of how to measure your business’ ability to collect on its receivables, what those calculations mean, and the link between collecting and credit.

 

Ability to collect

 

As opposed to say, retail or professional services where generally people pay for – and receive – the product or service in the same day, businesses in industries like construction and manufacturing need to keep a closer handle on receivables. 

 

Factors that affect it: Your process for issuing payment terms to clients and the things that affect how closely those terms are followed – such as your relationship with your clients and how strictly you uphold the terms.

 

How you measure it:  Receivable Turnover Ratio

“The standard calculation for measuring ability to collect is a Receivable Turnover Ratio,” says Rust. “The lower the ratio, the less efficient the collection process. Conversely, the higher the ratio, the more efficient your collection efforts.”

 

How you calculate it:

Net sales made on credit

________________________________

 

Average receivables

 

 

What the calculation tells you:

“In general, you want your ratio to be the same as your industry peers. That said, those ratios could have a wide range,” says Rust. “With this in mind, another way to use your Receivable Turnover Ratio is to determine your average turnover days and then compare that to the payment terms you currently give your customers. You can do this by dividing 365 by your Receivable Turnover Ratio to give you the average days that are outstanding on your receivables.”

 

Example: Using a Receivable Turnover Ratio of 10.

 

 

365

___    = 36.5

 

10

 

This 36.5 is the number of days on average that a receivable is out. So if your payment terms are say, 30 days, that means on average your customers are paying you 6.5 days late.

 

“Having a higher turnover ratio means you’re more conservative with your credit policies. Whereas a lower turnover ratio means you’re less conservative,” says Rust. “Both have their advantages. Being more conservative with receivables will have less credit losses, while being less conservative could open doors to new customers.”

 

About margined operating lines: 
Lenders can consider your accounts receivable as collateral, as this is an asset that can be converted into cash fairly quickly. In fact, most business financing solutions are secured this way. A margined operating line uses the accounts receivable (< 90 days) as a basis to determine the lending amount. A client goes ‘out of margin’ when the accounts receivable drops lower than what was factored into this calculation. 

A business needs to have a significant average amount of receivables to qualify for a margined operating line (generally at least $1 million), and so typically a smaller business will instead have an unmargined operating line that’s secured by a less volatile asset – like equipment or a building.

 

How this impacts your business banking:
“If there are issues collecting receivables it will negatively impact working capital – which is the liquid cash available to keep the business operating,” says Rust. “This can affect the banking relationship by tripping working capital-related covenants or putting the operating line out of margin. It can also result in overdrafts in the operating account and trigger the fees that come with that.”

 

Common challenges: Operating line goes out of margin 

 

Making good on how much cash you expect to receive (and when) affects the amount of cash available through your margined operating line.

 

“If a company has a margined operating line with the bank, the amount of cash they have available is usually calculated based on a percentage of the receivables they hold that are less than 90 days old,” says Rust. “Having receivables older than 90 days can compound working capital issues because it’s not just that the money hasn’t been collected for work completed. On top of that, the funds that were available on the operating line need to be repaid once the receivable is no longer in good standing and able to support the operating line limit.”

 

Being out of margin is similar to an overdraft in an operating account – if the shortfall is not covered in the short term, the bank may return recent cheques that were issued on the account to resolve it. If the shortfall is still not corrected, the bank may start collection proceedings. That said, if you know there will be a shortfall in advance it’s important to be proactive and contact your bank. “Your relationship manager may be able to work with you to find a solution,” says Rust.

 

Construction companies: Construction contractors have a unique challenge when it comes to holdbacks, which are a percentage (10%) of the receivable that is held by the developer or general contractor. Holdbacks are released at the end of the project.

 

“Banks don’t margin holdback receivables, so if a construction contractor takes on projects that have holdbacks they need to be aware that 10% of the funds will be held until the project is 100% complete – and this means they’ll need to have the working capital to fund that,” says Rust.  

 

Unique considerations for small- vs medium-sized business owners:

“Generally, a company needs an average of $1 million in receivables to qualify for a margined operating line,” says Rust. “With this in mind, in lieu of an operating line, smaller businesses will really want to focus on building relationships with customers and carefully timing purchases to not strain cashflow.”

 

Solutions that support a business’ ability to collect:

“Having strong relationships with larger customers goes a long way to collecting on time,” says Rust, explaining that 30 to 60 days is a good limit, with up to 90 days for larger public companies or government institutions. “From a banking products perspective, a margined operating line gives some relief on the receivable crunch. As long as receivables are collected before the 90-day cut off it’s a great solution to liquidity issues related to receivables.”

 

He adds that Receivable Insurance can also be a good option for some companies, especially if they have higher concentrations of customers who pay late and the average receivable days are over 90. This type of insurance covers your business against losses when you’re unable to collect payment from your customers.

 

CWB offers operating lines and can also connect clients with Receivable Insurance providers.  

 

Related tools:

Cash flow calculator