Ep 17 – Accounts Receivable

Episode 017 – Accounts Payable

Recorded: March 14, 2022

Released: March 14, 2022

Intro by Clive Castle

Sounds by ZapSplat

Accounts payable are the bills that you owe to creditors, suppliers, vendors, etc. and will pay at a later date. Scrutinizing each bill for accuracy shows that you are a good steward of your business’s financial resources. Find the transcript of this episode below.

Transcript

Hello and welcome back to The Better Bookkeeper Podcast. I am your host, Patrick Donovan, President of Cape May Counting House. Thank you for joining me today as I talk about accounts payable. If you would like to see the transcript of today’s episode please visit thebetterbookkeeper.com/017. You can also follow our Facebook page to leave a comment or question at www.facebook.com/thebetterbookkeeper.

As I mentioned, the topic of this episode is Accounts Payable which are the bills that you owe to vendors, suppliers, and contractors. It can also include money that you owe on bank loans or liabilities that you owe but haven’t paid yet like utilities or sales tax or payroll taxes. Just like with accounts receivable from our previous episode, properly managing your accounts payable can also help improve your cash flow. So, let’s get into it.

I’ll see you on the other side.

(MUSIC)

Welcome back! In the intro I explained that accounts payable is money that you owe to suppliers, vendors, bank loans, tax liabilities, utilities, among other things. When you get a bill but will pay it at a later date, you will record it in your accounting software as accounts payable so that you will be able to keep track of what you need to pay out. If you are using the cash basis for your accounting you would not use accounts payable. Hopefully, you are using the accrual basis which means you will be entering these bills into your software.

The first step in managing your accounts payable is to actually have a system in place for managing your accounts payable. If you have multiple team members in your business there should be a process for receiving and entering a bill, verifying its accuracy, storing all source documents, and a process for approving the bill for payment. Within this process is what is called a three-way match where you match the purchase order to the receiving report to the vendor invoice. Any discrepancies should be addressed and resolved immediately.

Verifying that what you need to pay is exactly what you owe is done by communicating with any individuals who were involved with these transactions. You also want to verify that the vendor is correct, the unit costs, quantities, and terms, among other things, are correct. Look to make sure that the bill hasn’t already been entered into your system. If you had a contractor provide services, speak with those team members who oversaw the contractor’s work. Was it satisfactory? Did they complete all their tasks on time, completely and correctly? If the bill is for inventory, check with your receiving department to see if they did in fact receive all of the product you’re being billed for. Was the inventory in satisfactory condition? If not, you should be requesting a credit or returning product for a refund to lower the amount you owe. If you received inventory that you can’t sell because it is of inferior quality but don’t return it, then you will be taking the loss instead of the supplier where the real responsibility lies. When it comes time for a business to be paying money out, you should be scrutinizing every bill for accuracy. Communication between departments is very important to determine if credits need to be requested from vendors.

Furthermore, the person who is entering the bill should not be the same person who is approving and remitting payment because this opens up the opportunity for fraud. Separation of duties is an internal control function that helps to eliminate bogus bills from being paid or bogus invoices to customers from being reported in an attempt to inflate revenues.

Next, you should review your accounts payable aging report. Similar to your accounts receivable aging report, accounts are broken into different buckets such as 1-30 days past due, 31-60 days past due, and so on. Identify the oldest accounts as those are the ones that should be prioritized to prevent unfavorable outcomes. If needed, create a spreadsheet to do some analysis or play out some different scenarios.

You could also review your Accounts Payable Turnover Ratio which is calculated by dividing your net credit purchases from vendors and suppliers by the average accounts payable for the same period. This tells you how many times during that period you paid your average accounts payable.

To find out how many days it takes you, on average, to pay your bills you would divide 365 by your accounts payable turnover ratio that you just calculated. Once you have calculated this, compare it to the terms you have with your vendors and suppliers. It gives you insight into how well you are meeting your terms and if improvements need to be made. Creditors may be willing to offer better terms to borrowers who pay on time which could save you money down the road.

Now that you have gone through your bills and verified that the amounts are correct and identified accounts that need immediate attention, it’s time to determine your ability to pay them. You should start asking some basic questions about your current financial situation like what is the balance in your bank account? What are your projected cash inflows over the next 30-45 days? You should also factor in how quickly people typically pay you and take into consideration slow payers, late payers, and no payers. (Expecting every invoice to result in a payment on time is unrealistic.) Ask yourself what are your projected cash outflows over the next 30-45 days to become current on your bills?

Are you experiencing a cash crunch and need to hold off paying some bills? Do you currently have past-due bills to pay? Are you being charged interest or late fees for them? Are you at risk of being sent to collections? How many seriously delinquent bills do you have that need to be paid immediately? Are suppliers or vendors threatening adverse actions such as halting shipments, pausing services, or even switching to cash on delivery? Making notes in your vendor accounts can help provide important details regarding who may be willing to wait a little longer and those who will absolutely not.

Are you in a good cash position? Perhaps you could afford to pay some bills early to take advantage of an early payment discount. However, you should also look to see if there are other opportunities that could provide a better return for your cash than the typically 2% discount you may receive for paying a bill early.

Once you have selected your accounts to pay, prepare them for approval according to your accounts payable management process. Do you have to submit an approval request, attach source documents, and provide a summary? Providing all of the necessary information to the person responsible for approving bills for payment makes the process more efficient. By this phase, any discrepancies should have already been identified and resolved. If you are printing out physical checks, review each one for accuracy. Make sure that the checks are legible, aligned correctly, and the fields are filled out with the appropriate information. Make sure that the checks get signed by the appropriate authorized signers. As a final step, you may want to send out emails to your vendors to update them that the checks are going out. This would be wise if you are sending out payments for very old accounts where vendors have already threatened adverse actions. This would cause them to hold off on proceeding or at least delay that action for a few days to make sure they actually receive the payment before proceeding.

If you did, in fact, reach out to any vendors, make sure to add a note into the account in the event you need to refer to it later on.

So, to be clear, there is more to managing accounts payable than just writing out a check and mailing it. You should be verifying that the bill is legitimate and accurate before even recording it into your system by performing a three-way match, then resolving discrepancies. Separate duties between team members to hopefully eliminate the opportunity for fraud. Review your current financial situation, including funds you are realistically expecting to flow into and out of the business over the short term. Identify accounts to be paid, prepare them for approval, and finally verify that checks are complete and accurate before sending out.

And that, is that. I hope that you found this episode about accounts payable helpful. I also hope that you will make use of it in your business or that of your clients to provide additional value. In the end, that’s what it’s all about, the value you add to your boss or your client.

February 25, 2022

Ep 16 – Accounts Receivable

Episode 016 – Accounts Receivable

Recorded: February 25, 2022

Released: February 25, 2022

Intro by Clive Castle

Sounds by ZapSplat

Accounts receivable are the sales that you generated on account that your customers will pay at a later date. Managing your accounts receivable is crucial to the success of your business as it directly impacts your cash flow. Find the transcript of this episode below.

Transcript

Hello and welcome back to The Better Bookkeeper Podcast. I am your host, Patrick Donovan, President of Cape May Counting House. Thank you for joining me today. If you would like to see the transcript to today’s episode please visit thebetterbookkeeper.com/016.

The topic of this episode is Accounts Receivable which are the sales for which you have not yet been paid. Poorly managing accounts receivable will inevitably result in cash flow problems down the road. Since every business needs cash inflow, accounts receivable is where we will focus today. I’ll see you on the other side.

Welcome back! If you have listened to previous episodes of this podcast you will notice that I am a big proponent of financial statement analysis. This should become part of your toolbox when it comes to providing value to your boss and/or your client, depending upon your situation. We will be touching on this later in this episode.

Now, let’s start at the beginning. Your boss or client needs to have a clearly defined system for extending credit. Specific criteria should be identified to qualify a customer for credit. You could also use screening services that will pull a credit report (as long as it is for a permissible purpose) and provide you with a summary regarding the creditworthiness of a potential borrow. It may be enticing to offer credit to every customer to boost sales but you must also consider that having loose credit policies will more than likely increase your chances of not getting paid. Each sale on account that does not get paid means you are taking a loss so it may be better to err on the side of caution and don’t implement policies that are too generous. On the flip side, credit policies that are too restrictive will cause you to lose out on a lot of sales. This is more an art than a science but it helps to have a conversation with a potential customer before extending credit, in addition to, a credit application.

While qualifying criteria is important, terms also need to be clear so that a customer knows their obligations to a T. How much credit will you extend, what is the interest rate, how will the monthly payment be calculated, will you set a minimum payment, when will the payment be due each month, what payment options do you offer (such as in-person, mail, on your website, or through your bookkeeping software)? You could even consider setting up an automatic payment plan but you must get this in writing, signed and dated by the customer. Your contract or credit agreement should also spell out any collection efforts should the account default. If there will be additional charges if an account goes to collection, that must be spelled out as well. Setting aside a block of time to go over this so that the customer fully understands and agrees to the terms is crucial.

Internally, there needs to be systems in place for collecting your accounts receivable. You will need to be assertive here, not rude, but assertive. The business has provided goods or services and expects to be paid. If your software allows it, set up email reminders to go out to customers a week or so before their payment is due, the day after the payment was due if it hasn’t been received (of course, change the verbiage you use because now the account is in default), and a few times thereafter in an attempt to cure the delinquency as quickly as possible. If a customer calls, be sure to take copious notes of what transpired, who spoke to whom, etc. This will aid you as you work through bringing the account current.

This takes care of the pre-sale activity. Now, let’s look at what happens after the sale.

So, to start, let’s do some analyzing. One of the key metrics you should be using to gauge the effectiveness of your collection strategy is to calculate your Days Sales Outstanding (or DSO) ratio. It provides you with how many days, on average, it takes you to collect from customers who have purchased on credit. Usually, you would calculate this on a monthly basis so that you can see whether you are improving from one month to the next. You don’t want to wait a year to find out you’re getting worse.

You will need to take some numbers from your financial statements to feed into this equation. The first is your average accounts receivable which you will calculate by adding your accounts receivable balance at the beginning of the period and the balance at the end of the period and dividing by 2. The next number you need will be the total credit sales you had during that same period.

So to calculate your Days Sales Outstanding, take your average accounts receivable for the period and divide it by your credit sales for the period. Then multiply that number by the number of days in that period. Then, compare this to the terms you offer. If your DSO is 38 days but your terms are 10 days, then you have a lot of work to do to remedy this. On the other hand if your terms are 30 days then you’re not too far off but could still use some improvement.

The next calculation will be the Accounts Receivable Turnover ratio. This is similar to Days Sales Outstanding but it looks at your accounts receivable from a different angle. For this, you will take your credit sales for the period and divide by your average accounts receivable for the period. This will give you a scope of your credit sales compared to your average accounts receivable. If this ratio increases from period to period it is telling you that you are making a larger portion of your sales on account compared to the average. The increase in accounts receivable should cause you to put a greater emphasis on reviewing your existing collection procedures because your cash flow can be negatively impacted if you don’t as you will be waiting for more of your sales to be converted to cash.

Now that you have done some analysis, where do you go from here?

At a bare minimum, an accounts receivable aging report should be pulled once a month, preferably, more often so that it doesn’t take a month before the next action is taken. This report will drop each sale into what is called a bucket. You will have one bucket for accounts that are current, one bucket for 0-30 days past due, one for 30-60 days past due, 60-90 days past due, and depending upon your software you may have one for over-90-days past due or 90-120, and then a final one for 120+ plus days past due.

What you need to remember is that the longer an account is past due the more difficult it will be to collect. The more time that has passed, people begin to forget details about the transaction, if there were issues with the product or service, with whom they spoke, and so on. This is why it is so important that you stay on top of your accounts receivable. It may give you a warm and fuzzy feeling that your sales are increasing because you are allowing people to take longer to pay you but if they never pay you then you have only worsened your financial situation.

So, with your accounts receivable aging report you want to focus on the accounts that are 0-30 days past due as this represents the lowest hanging fruit. Those accounts you will have the best chances of collecting but don’t forget the older accounts. Just know that you may be facing some sizable write-offs with accounts older than 90 days but that doesn’t mean you shouldn’t still work them. As you begin to start paying more attention to the accounts receivable you, ideally, want to minimize the chances of an account getting to that stage. It’s going to happen, for sure, but you want to keep that bucket as low as possible.

Any discussion about accounts receivable would not be complete if we didn’t discuss allowance for doubtful accounts and bad debts expense. Every business who sells on credit must face the possibility that some accounts will just not be collected which means there should be some sort of offset to accounts receivable. Otherwise, the accounts receivable balance will not be completely accurate in terms of what will actually be collected. Having this offset will give investors and lenders a bit more insight into the makeup of you’re A/R balance and be used to determine if that balance can really be trusted as an asset.

To use this allowance you would review your accounts receivable balance at the end of the month and make a guestimate of what you think would not be collectable. You would then make an adjusting entry to your books by debiting Bad Debt Expense by that amount and crediting Allowance for Doubtful Accounts by the same amount. In subsequent periods, you would review the accounts receivable balance, determine the amount that may not be collectable and make the adjusting entry to reflect that. Remember, the reason these adjustments are made is to reflect a more accurate amount of what will be collected and these adjustments should be made in the period in which the sales are made, hence why you are reporting an allowance for bad debt.

And that, is that. I hope that you found this episode about accounts receivable helpful and that you will make use of it to provide additional value to your clients.