The American journalist Robert Quillen once said, “Good times are when people make debts to pay in bad times.” While he was joking, the concept of taking on more debt than you can pay off is a harsh reality for many businesses. The recent news of bankruptcies caused by high debt and limited cash flow for major companies like Express has been an industry-wide point of discussion. Debt is part of doing business, but not all debts are created equal – and not all companies are able to handle debt effectively.
To make matters worse, debt and DSO appears to be on the rise. In our new study, Perils of Rising Debt and DSO, we surveyed 200 finance, accounting and auditing professionals in the United States to understand how they manage debt, the most common causes of cash flow problems and the impact of rising debt and poor financial management practices on their bottom line.
Our findings all pointed to increases in long-term debt and DSOs. 58% of businesses reported their long-term debt has increased in the last 12 months and 57% said DSO had risen too. Bad debt reserves are also increasing: 26% of respondents had increased their reserves by up to 10%, while 42% had increased them by 11-30%.
So, I decided to chat with Steve Carpenter, Country Director of North America for Creditsafe, to get his thoughts on mistakes businesses make with debt and how your business can learn from our study’s findings.
Despite the growing debt burden, a considerable portion of businesses report an improvement in their ability to repay debt. What factors contribute to this apparent contradiction and how sustainable is this trend in the long term?
Steve Carpenter: I don’t see it as a contradiction. The more their debt has grown over time and the more inflation rises, companies just don’t want to be taken by surprise anymore. That explains why 81% of businesses said they maintain an estimated allowance for doubtful accounts as part of their cash flow management process. This is a smart strategy and is tremendously valuable in growing and scaling your business.
Companies have become almost de-sensitized to the state of the economy and are realistic about their long-term debt. The last thing they want to happen is for their long-term debt to become the straw that broke the camel’s back and push them closer to bankruptcy.
The report emphasizes the significance of monitoring fluctuations in Days Beyond Terms (DBT) as an indicator of potential financial stress for businesses. How can companies effectively utilize this metric to manage credit risk?
Steve Carpenter: Days Beyond Terms (DBT) is such an important metric when it comes to protecting your cash flow and monitoring the risk within your portfolio. I think the first step to getting companies to use DBT in the most effective way is education. It’s not just your finance team that needs to get familiar with DBT – what it is, how it works, why it matters and how it can signal cash flow problems. Your sales team also needs to understand DBT so they can speed up sales deals being approved by the finance team and generating more revenue for the business.
The next step is to use DBT data in the larger context to identify key trends and patterns in how your customers and suppliers are paying their bills. Let’s say your business has agreed to Net 90 payment terms with a customer and that customer has a DBT ranging between 61-90 days. That means it could be upwards of six months before you receive your first payment from that customer. Is your cash flow strong enough to handle such a long delay in collecting payments? Now imagine how much worse things could be if several customers have a DBT ranging from 61-90. It’s not going to be good for your own cash flow.
A significant fluctuation in DBT is often the first sign that a company is having financial difficulty. A DBT of 10 means that, on average, a company pays its bills 10 days late. A DBT of 45 means that, on average, a company pays its bills 45 days late. Paying 10 days late is better than paying 45 days late. But in some industries like construction, companies are notoriously late payers. So, a consistent DBT of 45 days month-over-month may just be the norm for that industry. But if the DBT jumps from 10 to 45, this means a company is now paying their bills slower than usual, which could be an indication of financial stress. This is why it’s so important to monitor fluctuations in DBT.
The report highlights invoicing mistakes as a common reason for late payments. What steps can businesses take to minimize these errors and streamline their accounts receivable processes?
Steve Carpenter: What’s interesting is that 37% of businesses said missing PO numbers and incorrect billing information on invoices caused them to pay late. These seem like simple things, but it’s not that uncommon to see these types of invoicing issues arise. This is something that comes back to your own Accounts Receivable processes. Are these types of clerical errors happening a lot? Have a high percentage of your customers’ missed payments been caused by these issues?
Now, here’s the important part. Don’t immediately go into a blame game with your finance team. There could be several reasons invoices have been submitted without PO numbers and with incorrect billing information. First, dig into what’s causing these specific invoicing issues. And then investigate the root cause. For example, are these clerical errors happening because your team is having to manually create and submit hundreds of invoices to customers each week? Are there any QA systems in place to prevent this from happening? If not, then that’s a good place to start.
The reality is that none of these invoice issues will be resolved in a day or even two days. It could take weeks to resolve them – depending on the issue, your relationship with your customers, your Accounts Receivable processes and other factors. You know what means, don’t you? It’ll take longer to collect your payments. So, that money won’t be coming into the business when you originally forecasted it would and your cash flow will have to suffice to pay for your operating expenses.
Could you provide insights into the inefficiencies and shortcomings of the traditional trade credit application process, particularly regarding manual processing and reliance on outdated methods?
Steve Carpenter: Selling on trade credit means companies can bring in more customers and potentially generate more revenue in the long term. But on the flip side, the risk of trade credit is that companies are giving up part of their cash flow until their customers make payment. This is clearly an issue for many businesses, as 26% of the respondents in our study said their cash flow issues were caused primarily by having a higher ratio of customers using trade credit to pay for goods and services.
The trade credit application itself tends to be outdated, long and reliant on manual processes and paperwork. That’s not ideal if your company is reviewing hundreds of trade credit applications a week. And as our recent research has found, 97% of finance managers process up to 100 credit application a day. That’s about 500 credit applications to get through in a single week. Instead of using manual processes, sending PDFs back and forth via email and trying to cross-check data from multiple sources, you can simplify the whole process by using an online trade credit application tool.
If finance teams are using physical PDFs and emailing them back and forth to prospective customers, the chances of data input errors will increase significantly. And if the wrong data is used to make a credit decision, it could have serious consequences for businesses. It could mean a company approves a customer for trade credit when, in fact, they were too risky, had too much long-term debt and had a poor track record of paying their bills on time.
Given the prevalence of cash flow issues stemming from trade credit practices, what advice would you offer to businesses to mitigate the associated risks effectively while still leveraging trade credit as a growth strategy?
Steve Carpenter: Just because there are risks associated with trade credit doesn’t mean businesses should stop extending it to customers. The key is to be strategic and proactive in doing due diligence and running business credit checks on every potential customer – no matter how big and famous they might be. And it’s about knowing how to make sense of the right credit risk data (i.e. total number of late payments, dollar value of late payments, DBT, etc.) and looking at the data to spot trends and patterns over the last 12 months, at minimum. Pay attention to sudden and drastic changes in DBT and the total number of late payments over a 12-month period. Has a potential customer’s DBT spiked from 10 to 45 in a single month and then showed a similar pattern of spiking multiple times throughout the year. This would indicate something isn’t stable with their cash flow and is affecting their ability to pay their bills on time regularly.
I’d also recommend that companies steer away from using manual credit application processes and instead, use a digital credit application tool. The benefits of doing this are tremendous. First, it will take much less time to review credit applications – and that will help finance teams be more productive and successful in their roles. And using a digital credit application tool also means the quality of data used in credit applications is much more reliable, as it can and should use their credit policy to reach all credit decisions. And because there will likely be fewer clerical errors made (compared to sending PDFs back and forth) and the credit decisions will be more reliable, that means the company will generate more revenue and the finance and sales teams can improve their working relationship.
Below are additional benefits that can be derived from using a digital credit application tool.
- Better customer onboarding: There’s nothing worse than when a new customer signs a contract with a vendor and then the onboarding process is either non-existent or poorly constructed. The smoother and faster the process is, the stronger your relationship will be with your customers.
- 360-degree view of your credit applications: Stop trying to find your information and records in a pile of papers or in multiple folders on your computer. Have everything available in a single dashboard and easily reference the data for what your team needs in real-time.
- Faster and more reliable decisions: Embed your credit policy into the backend so you can reach the right credit decision for your business and rely on that decision.
- Digital audit trail: It’s important to maintain a full audit trail of every credit application that has been submitted and reviewed by your team. Not only can your team keep these records and identify patterns in your credit decisions for future planning, but you can also share these records with the necessary authorities should the need arise.