While managing cash flow is always important, the recent economic turbulence has renewed interest in this topic. Businesses have begun to focus (to an even greater extent) on ensuring that clients and customers pay what they owe when it is owed. Reason being, bad debts directly affect the bottom line of the business: for instance, a bad debt of $50,000 for a 10% margin business requires replacement revenue of $500,000.
This article will outline some techniques that a business can utilize in developing a proactive system to decrease bad debts. (Please note: specialized tools such as in the case of contractors and the Construction Lien Act are beyond the scope of this article.)
Obviously, the starting point in analyzing a business’ bad debts is the sales that led to the extension of credit. It could be said that there are a number of related stages of a sale: (1) pre-sale; (2) sale; (3) post-sale; and (4) a salvaging phase.
- Pre-sale Stage: “Early and often”
Having Proper Systems
Businesses too often treat cash flow management as an “as needed” item or on an ad hoc basis, which is only slightly better than doing nothing. It is extremely important to have proper and proactive systems and processes in place. These include implementing invoicing software, an accounting system, and a billing process to optimize efficiency. Invoicing software will help track receivables and retain an account of what has been sent, viewed and paid; there are many program options with different functionality so consider options and choose the one that best suits your business. To optimize the billing process, for instance, it is helpful to establish set days for email, phone call, then letter reminders.
That’s not to say your system is devoid of people. To the contrary, in addition to current staff, it may be necessary to acquire expertise in order to run these systems. Consider retaining a bookkeeper, an accountant, an accounts receivable clerk, a collection agency, a law firm and a Chief Financial Officer, if even only on a part-time basis.
Another precaution is to consider obtaining trade credit insurance. As its name suggests, trade credit insurance protects against trade credit default. The insurance is typically paid out if the customer goes bankrupt or has not paid within 90 days of the due date. In a typical situation 90% of the loss is paid out 60 days after the claim has been filed. Specific insurance companies specialize in this area. They may also help with due diligence as they may be familiar with a risky client.
Qualifying the Debtor
Be selective in choosing with whom you do business. Taking time to pay you means your customer is receiving financing, and guess what, you’re the bank! Giving proper consideration and researching potential customers, especially those who are making larger purchases, before granting credit will save time (and money) down the road.
There are many sources of valuable information available. For instance, ask potential customers for trade references, including references from banks and professionals, and actually contact these references; join industry and trade group associations; and conduct credit checks. In addition, depending on the industry, blogs may have complaints from suppliers about their customers.
When researching a potential customer’s business consider, amongst other things: how long the business has been established, how and from where the business is being run, what the business’ customers think of it, and whether its suppliers are reliable.
If the risk in granting credit appears acceptable, the next step is to establish work and payment terms and expectations with the customer (as discussed more fully in Section 2 below).
- Sale Stage: “There’s no time like the present…”
It is important to be open and transparent at the outset of a relationship, so as to avoid misunderstandings in the future. It is advisable to document the understandings in an engagement letter or a formal contract, or even by posting payment terms on a website.
Structure Payment Terms
The options for payment terms are limited only by your creativity.
As a starting point, always ask for a deposit as this helps cash flow and, as a screening tool, eliminates clients who are unlikely to pay in the end.
Do not wait until the end of the assignment to bill customers. Billing upon achieving certain milestones (e.g. when the job is 50% completed) is a good strategy to retain leverage and get “as much cash in the door” as possible. Billing on a timely basis will help with cash flow and to establish expectations.
Incentives and Disincentives
Use “carrots” and “sticks”; that is, discounts can be offered for prompt payment and interest and collection expenses can be imposed for overdue payments.
Discounts have many benefits as they enable you to entice clients to pay early but also provide insight into which clients have healthy cash flows and, on the contrary, about which clients you should be concerned.
As per the Interest Act, the right to charge greater than 5% interest on late payments must be specified in the invoice or contract. Further, penalties must be expressed on a per annum basis. Reserving the right to recover collection expenses (such as legal fees) should also be considered.
Security and Guarantee
When entering into an agreement, you should consider obtaining security. Depending on the business, security may be taken in personal or real property; however, you will typically have to register a financing statement or mortgage to perfect the security interest.
Different industries have different options for obtaining security. For instance, in the business of inventory sales, you can obtain a Purchase Money Security Interest (PMSI). This gives the seller special rights in the goods sold and in the proceeds from the resale or lease until payment is received. You must be aware of special rules for PMSIs, such as: the financing statement filing before delivery or, in some cases, within 10 days of delivery or that it may be necessary to notify existing security holders of your security interest.
Similarly, you should consider the appropriateness of obtaining a guarantee from the parent company or another shareholder. Guarantees are difficult to obtain; however, the benefit of having one warrants at least inquiring into the possibility, especially for substantial contracts.
The goal of an invoice should be to receive money quickly and efficiently.
The most effective invoices are those that are easy to read, have no marketing fluff and have the terms displayed clearly and prominently. Specifically, an invoice should have the payment due date, information on the goods and services supplied, the mailing address, the corresponding purchase order or contract reference, and the required provisions, such as interest for overdue payments. Providing all this information clearly minimizes the opportunity for dispute.
In addition, consider the most effective way(s) to send an invoice and determine the best time for sending it (e.g. when the customer is “in funds”). It is often helpful to send the invoice multiple ways (post, fax, email, etc.) so as to ensure the customer receives it and is aware of it.
Finally, be flexible in how customers may pay (e.g. VISA, AMEX, wires, EFT payments and cheques) so as to increase the likelihood of prompt payment.
Due to the difficulties associated with “verbal arrangements”, especially if the relationship or the customer’s business sours, businesses should require a written agreement for every material project. As stated above, the client should always acknowledge and confirm what they are receiving, how much it will cost, when the sum is owed and any repercussions for late or non-payment.
Make use of Boilerplates
To that end, standard legal provisions (a.k.a. boilerplate) are extremely helpful; here are a few key standard provisions to consider including in your contract:
- An entire agreement clause is important in order to forestall claims that representations and warranties were provided outside the written agreement.
- A liquidated damages provision (as a genuine pre-estimate of damages for a breach) avoids the need to prove the contract is breached and to substantiate the damages.
- An express agreement is sometimes required to waive implied conditions and warranties of fitness for purpose and merchantable quality under applicable sales-related legislation such as Ontario’s Sale of Goods Act.
- Disclaimers are important to limit the opportunity to make excuses. All warranties, conditions, covenants and representations should be disclaimed and indirect, special or consequential damages should be excluded.
- You should also expressly address the possibility of the customer claiming that the purchase price should be set off by the amount of alleged damages.
- To avoid the customer raising defences unknown to the seller and to ensure judgment can be obtained and recognized in a known manner, the parties should clearly attorn to the non-exclusive jurisdiction of the supplier’s home jurisdiction and make it the choice as to the governing law as well.
- It is important to consider if an arbitration clause would be appropriate in your particular circumstances given the timing and the associated costs.
- Post-Sale Stage: “Keep your eye on the ball!”
Once a sale is completed, unless all money is received upon or prior to completion, there is still work to be done. There are many tactics that can be utilized when dealing with customers who have not yet paid, most of which come back to basic personal relations (or negotiation 101):
- You should analyze and stay on top of numbers and trends in your customers’ business/industry so as to be alerted to potential problems early on (hence the importance of an accounting or early warning system).
- It is helpful to get to know the cheque writer and accounting staff at your customer’s business as these people can provide important information when you are waiting for a payment.
- Situations should be personalized and elevated within the customer’s organization as required. You should use leverage and stress points if available. For example, if a key step needs to be taken by you for the benefit of the customer, you should insist on being paid for the previous step before moving forward.
- If the client is employing stall tactics, be proactive, such as offering to pick up the cheque or sending a courier.
- You may have to lean on your “champions” at the customer’s business.
- It may be helpful to appoint a “bad cop” to deal with the client so as to create a separation between yourself and the issue of nonpayment.
- It is prudent to keep a journal of the correspondence between your business and customers so as to have a record in case a situation worsens.
- Salvaging Phase: “A bird in the hand…”
Time is of the essence at this stage.
It is imperative to have a clear policy for recovering bad debts. It is important to promptly and consistently show the customer and the market that debts will not be forgotten and the business will not give up on monies properly earned. Sending reminders, making calls and sending demand letters are all things that must be done. At a minimum the business should stop performing new work or taking new orders from the client. However, in the event that all else fails the debt should be assigned to a collection agency or legal counsel. Sometimes the threat of further action (and the damage it could cause to a business credit rating) is enough to lead to a payment. The above being said, you should always be open to strike a deal with the client so as to resolve the situation.
As outlined above, it is imperative for a business to focus on each aspect of a sale to decrease the odds of a debt going bad. That said, each stage is intimately related to the other stages; for example, it is important to pay close attention to a customer’s (or potential customer’s) business and industry in determining whether to grant new credit in the first place (pre-sale) and in assessing how to handle (and when) outstanding trade credit (post-sale).
Please click here for a summary chart of the steps outlined above.