Why do Businesses Need Third-Party Collection Agencies to Maximize Cash Flow and their Bottom Line

by Sam Fensterstock, AGA
“Cash is King,” and if you are not maximizing your cash flow, it can have serious repercussions on your operations and bottom line. Most companies, in particular SMBs, wait too long to aggressively go after their slow-paying accounts. It costs four times as much to bring on a new customer as it does to keep an existing one, so no one wants to lose a customer over collection tactics. However, once a customer on credit goes 90 to 120 days past due and is no longer ordering and paying down the old balance, it is going to become more and more difficult to collect these accounts with only internal resources. The effect of your customers owing your company money for too long can be significant.

HOW IMPORTANT IS CASH FLOW?

The difference between the beginning cash position and the ending cash position of a given period is called cash flow. If you take in more than you spend you have a positive cash flow, the reverse is a negative cash flow. Cash flow is one of the major indicators financial institutions use to evaluate financial health. Banks and financial institutions are not going to loan you money if they don’t think you can pay it back. Remember, when you borrow money for any purpose, you are going to pay it back with future cash flow. You can’t pay it back if you have a negative cash flow.

HOW CAN YOU DETERMINE IF YOUR CASH FLOW CAN BE IMPROVED?

Collecting your accounts receivable as quickly as possible is a major factor in having enough money to cover current operating needs and pay off your debt commitments. There are several credit and collection performance measures that can tell you whether you are collecting your accounts efficiently, or if you need some outside help to improve your cash flow. We will discuss two of the most popular ones:

Days Sales Outstanding (DSO)

DSO is a measure of the average time in days that receivables are outstanding. It can be used to compare your company to other organizations for identifying whether your company is converting receivables to cash efficiently. In most instances a DSO under 40 days is good assuming you are giving 30 day terms. A DSO from 34 to 38 indicates very good operating performance and a DSO over 45 indicates that you are not converting your receivables efficiently and that some outside help may be necessary. The formula for computing DSO is:

(Ending Total Receivables x Number of Days in Period)/(Credit Sales for Period Analyzed)

A sample calculation is:
Ending Receivables = 1,000,000
Credit Sales for Period = 750,000
Number of Days in Period = 31

DSO =(1,000,000 x 31)/(750,000) = 41.3 days

Collection Effectiveness Index (CEI)

This measure was developed by the Credit Research Foundation (CRF) and is thought to be a far better measure of collection effectiveness than DSO. It produces a percentage that measures the effectiveness of collection efforts over time. The maximum value is 100% and the closer you are to 100% the more effective you are. A CEI under 75% needs to be improved or your cash flow will eventually be negatively affected. The formula for computing CEI is:

(Beginning Receivables+(Credit Sales/N ) -Ending Total Receivables)/(Beginning Receivables+(Credit Sales/N )- Ending Current Receivables) x 100

N = Number of Months
A sample calculation is:
Beginning Receivables = 800,000
Credit Sales = 750,000
Ending Total Receivables = 1,000,000
Ending Current Receivables (all invoices not yet due) = 700,000
N = 1

CEI =(800,000+(750,000/1)-1,000,000)/(800,000+(750,000/1)-700,000) x 100 = 64.7%

Notice the difference in the results of the two calculations. The DSO is acceptable, but the CEI is not.
Realistically, whichever measure you use, it should be computed frequently (monthly if possible) and reviewed over time. If it’s trending downward, even if it is not yet unacceptable, you should consider bringing in outside help to stop the downward trend before your cash flow is seriously affected.

WHY USE A THIRD-PARTY COLLECTION AGENCY?

Any receivable not collected represents a loss and affects your bottom line. You have laid out money for goods produced or services rendered and not collected the money due your company. Your cost of sales has gone up, but your revenues haven’t. That’s a net loss and your bottom line has been reduced accordingly. For example, suppose your profit margin is 10%. In other words, on a $5,000 sale you make $500, or your cost of sales is $4,500. If you have to write off $50,000 of receivables in a year, you need an additional $450,000 in sales to make up for it. Sometimes not such an easy task.

There are at least three good reasons to use a collection agency to help collect past due accounts:

A collection agency will collect from accounts that you could not. Your past due accounts won’t talk to you but they will talk to an agency or the collection agency’s attorney. The agency knows that to collect they must make contact with the account and they won’t stop trying until they do. A good collection agency will make 10-15 attempts to reach your former customer in the first 30-45 days they have the file, typically about three times the number of attempts your internal staff will make. As their fee is based on what they collect and agency will be more persistent and assertive than your internal collectors are at this stage of the customer lifecycle. Just remember this, collection agencies don’t get paid unless they collect your money and collection agencies do not want to work for free.

Using an agency frees up the time and resources needed to manage your current active business. Collecting money is very time consuming. You need to send letters, emails, possibly make customer visits and make phone calls, lots of phone calls. This takes time away from the things you and your employees need to do to manage and run your business on a day to day basis.

A collection agency utilizes technology that you do not have. This makes them far more proficient at collecting money than their clients. They possess advanced tools that help them find and make contact with debtors. This technology is costly and unless you are in the collection business you won’t have it. Additionally, their personnel are professional debt collectors. That is what they do and they do it well.

CONCLUSION

According to Commercial Law League of America, the amount of money you are likely to collect from a past due account is directly correlated to the age of the account. Once the account is 90 days past due you will most likely collect only about 70% of the amount due, and after 6 months only about 50%, and the amount likely to be collected continues to go down rapidly from there.

If your customer has not paid you and they are more than 90 days past due, there are no new orders coming in the door and they are not responding to your request for payment you are probably not going to get paid on your own. For these types of accounts, it makes business sense to place them with a 3rd party collection agency now and at least get 30-40% of your money back. This will allow you to maximize your cash flow and minimize the negative effect on your bottom line.
About AGA

For over 40 years, AGA has been the most respected commercial collection agency in the nation. We assist corporations with improving cash flow, while preserving a positive image with customers. We accomplish this by employing the best and brightest talent in the industry, with low turnover and unparalleled tenure.

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