Cash collection cycle definition
/What is the Cash Collection Cycle?
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.
How to Calculate the Cash Collection Cycle
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)
Understanding the Cash Collection Cycle
The cash collection cycle should be kept as short as possible, because rapid collection means more cash on hand, which reduces a company's borrowing requirements. In addition, an older invoice may not be acceptable as collateral for a loan. Further, an older invoice may not be acceptable for invoice discounting. And finally, 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.
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How to Shorten the Cash Collection Cycle
You should always attempt to collect unpaid accounts receivable sooner, in order to accelerate cash flow. Several techniques for doing so are noted below.
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. This will require a highly organized billing process, to ensure that accurate invoices are issued at once.
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. This can cut several weeks from the time required to collect cash.
Issue 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. It may also be worthwhile to send it to different people within the customer’s organization, which may trigger a response.
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. This may require you to cancel the original invoice and issue a replacement that does not contain the offending item.
Make a 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. This is an excellent activity for your salespeople, who may have a number of contacts within the customer’s organization.
Take Back Merchandise
If the customer simply cannot pay, and you sold it merchandise, then attempt to recover and re-sell the merchandise. However, the merchandise must then be classified as used, and so will likely need to be re-sold at a significantly lower price. Consequently, even accepting a smaller payment from the customer might yield a larger profit than if you were to take back 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. As was the case with a dunning letter, it can make sense to send this letter to different people within the customer’s organization, to see if anyone takes action.
Turn Over to a 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. However, collection agencies usually charge a substantial fee, so try all other alternatives first.
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