The cash collection cycle is the number of days it takes to collect accounts receivable. The measure is important for tracking the ability of a business to grant a reasonable amount of credit to worthy customers, as well as to collect receivables in a timely manner. The concept is not the same as the cash conversion cycle, which is a longer period beginning with the outflow of cash to pay for goods and ending with the subsequent receipt of cash from the sale of those goods. The calculation for the collection cycle is to divide annual credit sales by 365, and divide the result into average accounts receivable. The formula is:
Average accounts receivable ÷ (Annual credit sales ÷ 365)
You should attempt to keep the cash collection cycle as short as possible for the following reasons:
- Rapid collection means more cash on hand, which reduces a company's borrowing requirements
- An older invoice may not be acceptable as collateral for a loan
- An older invoice may not be acceptable for invoice discounting
- An invoice is generally more difficult to collect the longer it remains outstanding
Conversely, it may be acceptable to have a longer cash collection cycle if management uses a relaxed credit policy to extend credit to more marginal customers for which the probability of collection is lower than usual.
You should always attempt to collect unpaid accounts receivable sooner, in order to accelerate cash flow. Several techniques for doing so are:
- Invoice promptly. Always issue an invoice to the customer as soon as delivery of the merchandise or provision of the services have been completed. Otherwise, you are delaying collection by never giving the customer any document from which to pay.
- Contact customer before due date. It may be cost effective to contact those customers with larger outstanding receivable balances prior to the invoice due dates. The reason is that you may uncover a payment problem that you can start working on immediately, rather than several weeks later, when you would normally notice the problem.
- Dunning letters. Send an automated notice to the customer, reminding them that a payment is about to be due, or is now past due. There are a variety of ways to send a dunning letter to attract the attention of the recipient, such as by overnight delivery.
- Obtain payment of undisputed amounts. If a customer is complaining about a particular line item on an invoice, then insist that the customer pay for all of the other line items - while you continue to investigate the one item that is in dispute.
- Personal visit. It is much more difficult for a customer to delay a payment when you are sitting in front of them. Clearly, this is only cost-effective for very large overdue balances.
- Salesperson collects. If your company uses a hands-on sales staff to make sales, these people have the best contacts at a customer, and so are in the best position to collect payment.
- Take back merchandise. If the customer simply cannot pay, and you sold it merchandise, then attempt to recover and re-sell the merchandise.
- Issue attorney letters. Also known as a "nastygram," this is a threat of legal action without actually taking legal action. It is a relatively inexpensive way to involve an attorney, and is usually issued on the attorney's letterhead.
- Turn over to collection agency. If no other method works, turn over the account to a collection agency, which may be more aggressive with its collection activities than you are willing to be.