Accounts Payable and Accounts Receivable

Posted by PITHOCRATES - November 26th, 2012

Economics 101

Someone’s Account Payable is Someone’s Account Receivable

Cash is king in small business.  Because without it you can’t make payroll or pay your payroll taxes.  As important as cash is, though, many business will never grow until they start offering credit.  Trade credit.  Selling things on account.  Because for those doing repeat business it is just too much of a pain to write a check for every purchase.  And it’s just dangerous carrying around that kind of cash.  So businesses offer credit to established customers.  Those with good credit.  And good reputations.

Customers open an account.  When they make a purchase they get an invoice generally payable in 30 days.  Or some number of days around that.  At the end of the month they will receive a statement from their vendor showing all of their open invoices.  Which they will compare with their accounting records.  By running their accounts payable report.  And they will compare the invoices they show outstanding with those on their vendor’s statement.   They will resolve any differences.  And then write a check for their outstanding invoices.

On the other end of the sale there is an account receivable.  For someone’s account payable is someone’s account receivable.  A sale that doesn’t bring cash into the business.  But a promise to pay cash within a short amount of time.  So a business can greatly increase sales by offering trade credit.  By being a mini-banker.  Their sales revenue will grow.  As will their net profit.  But not necessarily their cash in the bank.  For it will look good on paper.  But until they convert those accounts receivable into cash it will only be on paper.  And money on paper is just not as good as money in the bank.

When Invoices are Unpaid for 90 Days or More there’s a Good Chance they will Never be Paid

There is a certain euphoria small business owners feel when they see their sales grow.  Things are moving in the right direction.  All their hard work is paying off.  Finally.  Some even fantasize about spending some of that money.  Such as going out to lunch on Friday instead of brown-bagging it every day of the week.  Then some anxiety starts growing.  And it comes from their accounts receivables report.  When they see that 30 days after those sales come and go.  And a lot of those open invoices remain on the report.

The accounts receivable report small business owners review is called an aging report.  Because it shows what invoices are current, which are 30 days old, which are 60 days old and which are 90 days or more old.  And when invoices are unpaid for 90 days or more there’s a good chance they will never be paid.  In fact, once they pass 30 days the chances that their customers won’t pay them grow greater.  And this is the source of a small business owner’s anxiety.  When he or she sees those invoices move from 30 days to 60 days to 90 days.

Why do some customers pay slower than others?  Because they, too, have accounts receivable moving from 30 days to 60 days to 90 days.  And if they’re not collecting their money in a timely manner then can’t pay their bills in a timely manner.  When the economy slows down you will see a lot of businesses start to pay their bills slower.  And as they pay their bills slower businesses collect their money slower.  Which forces them to pay their bills slower.  Or, worse, borrow money to pay their bills until their customers pay theirs.

To encourage their Customers to Pay their Bills Timely many Businesses will offer Early Payment Discounts

Sales are great.  Everything that’s good follows from sales.  Sales are the first step in creating cash.  And cash is king.  But between cash and sales are accounts receivable.  Which can make or break any small business.  For you can’t often grow sales without extending credit.  But if you extend too much credit and/or your customers don’t pay their bills a business owner can lose everything he or she worked for.  Because when it comes down to it, sales are great but cash is king.

To encourage their customers to pay their bills timely many businesses will offer early payment discounts.  If the customer pays their invoice within 10 days, say, they will get a 2% discount on that invoice.  So if they have a $1000 invoice they only have to pay $980.  As an owner will trade $20 in profits to speed up their cash collections.  And if you look at some numbers you can see why.  If they have $150,000 in new sales in one month that 2% discount will cost them $3,000 in profits.  Now compare that to the cost of borrowing cash from an 11% credit line to replace the cash they can’t collect from their customers.  If they have receivables of $150,000 at 30 days, $300,000 at 60 days and $49,950 at 90+ days the interest cost to borrow money to replace these funds can add up to $3,322.46.

So an early payment discount can equal a business’ borrowing costs.  Making it a wash.  While offering a huge benefit.  Allowing a business to pay their bills.  Like payroll.  Payroll taxes.  And their vendors.  For in difficult economic times all businesses have cash problems.  And will do almost anything to improve their cash position.  And when it comes to paying their bills and they can’t pay them all guess which ones they’re going to pay first?  Those that help their cash position.  That is, those invoices that offer an early payment discount.  Because sales are great.  But cash is king.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , ,

FUNDAMENTAL TRUTH #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 17th, 2010

DURING UNCERTAIN ECONOMIC times, people act differently.  If business is down where you work, your company may start laying off people.  Your friends and co-workers.  Even you.  If there is a round of layoffs and you survive, you should feel good but don’t.  Because it could have been you.  And very well can be you.  Next time.  Within a year.  In the next few months.  Any time.  You just don’t know.  And it isn’t a good feeling.

So, should this be you, what do you do?  Run up those credit cards?  By a new car?  Go on a vacation?  Take out a home equity loan to pay for new windows?  To remodel the kitchen?  Buy a hot tub?  Or do you cut back on your spending and start hoarding cash?  Just in case.  Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc.  And another loan payment won’t help.  So, no.  You don’t run up those credit cards.  Buy that car.  You don’t go on vacation.  And you don’t take that home equity loan.  Instead, you hunker down.  Sacrifice.  Ride it out.  Prepare for the worse.  Hoard your cash.  Enough to carry you through a few months of unemployment.  And shred those pre-approved credit card offers.  Even at those ridiculously low, introductory interest rates.

To help hammer home this point, you think of your friends who lost their jobs.  Who are behind on their mortgages.  Who are in foreclosure.  Whose financial hardships are stressing them out to no ends.  Suffering depression.  Harassed by collection agencies.  Feeling helpless.  Not knowing what to do because their financial problems are just so great.  About to lose everything they’ve worked for.  No.  You will not be in their position.  If you can help it.  If it’s not already too late.

AND SO IT is with businesses.  People who run businesses are, after all, people.  Just like you.  During uncertain economic times, they, too, hunker down.  When sales go down, they have less cash to pay for the cost of those sales.  As well as the overhead.  And their customers are having the same problems.  So they pay their bills slower.  Trying to hoard cash.  Receivables grow from 30 to 45 to 90 days.  So you delay paying as many of your bills as possible.  Trying to hoard cash.  But try as you might, your working capital is rapidly disappearing.  Manufacturers see their inventories swell.  And storing and protecting these inventories costs money.  Soon they must cut back on production.  Lay off people.  Idle machinery.  Most of which was financed by debt.  Which you still have to service.  Or you sell some of those now nonproductive assets.  So you can retire some of that debt.  But cost cutting can only take you so far.  And if you cut too much, what are you going to do when the economy turns around?  If it turns around?

You can borrow money.  But what good is that going to do?  Add debt, for one.  Which won’t help much.  You might be able to pay some bills, but you still have to pay back that borrowed money.  And you need sales revenue for that.  If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan.  But you don’t have the sales now.  And the future doesn’t look bright.  Your customers are all going through what you’re going through.  Not a confidence builder.  So you’re reluctant to borrow.  Unless you really, really have to.  And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble.  Just what a banker wants to see in a prospective borrower.

Well, not really.  In fact, it’s the exact opposite.  A banker will want to avoid you as if you had the plague.  Besides, the banks are in the same economy as you are.  They have their finger on the pulse of the economy.  They know how bad things really are.  Some of their customers are paying slowly.  A bad omen of things to come.  Which is making them really, really nervous.  And really, really reluctant to make new loans.  They, too, want to hoard cash.  Because in bad economic times, people default on loans.  Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors.  And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail.  And all the money they created via fractional reserve banking will disappear.  Making money even scarcer and harder to borrow.  You see, banking people are, after all, just people.  And like you, and the business people they serve, they, too, hunker down during bad economic times.  Hoping to ride out the bad times.  And to survive.  With a minimum of carnage. 

For these reasons, businesses and bankers hoard cash during uncertain economic times.  For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty.  Uncertainty about when a recession will end.  Uncertainty about the cost of healthcare.  Uncertainty about changes to the tax code.  Uncertainty about new government regulations.  Uncertainty about new government mandates.  Uncertainty about retroactive tax changes.  Uncertainty about previous tax cuts that they may repeal.  Uncertainty about monetary policy.  Uncertainty about fiscal policy.  All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future.  Or severely reduce the purchasing power of their customers.  When this uncertainty is high during bad economic times, businesses typically circle the wagons.  Hoard more cash.  Go into survival mode.  Hold the line.  And one thing they do NOT do is add additional debt.

DEBT IS A funny thing.  You can lay off people.  You can cut benefits.  You can sell assets for cash.  You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset).  You can factor your receivables (sell your receivables at a discount to a 3rd party to collect).  You can do a lot of things with your assets and costs.  But that debt is still there.  As are those interest payments.  Until you pay it off.  Or file bankruptcy.  And if you default on that debt, good luck.  Because you’ll need it.  You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.

Profitable operations.  Yes, that’s the key to success.  So how do you get it?  Profitable operations?  From sales revenue.  Sales are everything.  Have enough of them and there’s no problem you can’t solve.  Cash may be king, but sales are the life blood pumping through the king’s body.  Sales give business life.  Cash is important but it is finite.  You spend it and it’s gone.  If you don’t replenish it, you can’t spend anymore.  And that’s what sales do.  It gets you profitable operations.  Which replenishes your cash.  Which lets you pay your bills.  And service your debt.

And this is what government doesn’t understand.  When it comes to business and the economy, they think it’s all about the cash.  That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy.  The tax and spend stuff.  When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm.  Interest rates must be too high.”  Because their tax and spending sure couldn’t have crashed the economy.  That stuff is stimulative.  Because their god said so.  And that god is, of course, John Maynard Keynes.  And his demand-side Keynesian economic policies.  If it were possible, those in government would have sex with these economic policies.  Why?   Because they empower government.  It gives government control over the economy.  And us.

And that control extends to monetary policy.  Control of the money supply and interest rates.  The theory goes that you stimulate economic activity by making money easier to borrow.  So businesses borrow more.  Create more jobs.  Which creates more tax receipts.  Which the government can spend.  It’s like a magical elixir.  Interest rates.  Cheap money.  Just keep interest rates low and money cheap and plentiful and business will do what it is that they do.  They don’t understand that part.  And they don’t care.  They just know that it brings in more tax money for them to spend.  And they really like that part.  The spending.  Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’?  Especially when it gives you money and power?  And a permanent underclass who is now dependent on your spending.  Whose vote you can always count on.  And when the economy tanks a little, all you need is a little more of that magical elixir.  And it will make everything all better.  So you can spend some more.

But it doesn’t work in practice.  At least, it hasn’t yet.  Because the economy is more than monetary policy.  Yes, cash is important.  But making money cheaper to borrow doesn’t mean people will borrow money.  Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more.  Not until they feel secure in their jobs.  Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt.  But they are not going to add additional debt to expand production.  Not until they see some stability in the market and stronger sales.  A more favorable tax and regulatory environment.  That is, a favorable business climate.  And until they do, they won’t create new jobs.  No matter how cheap money is to borrow.  They’ll dig in.  Hold the line.  And try to survive until better times.

NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend.  Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans.  Instead, they’ll beef up their reserves.  Instead of lending, they’ll buy liquid financial assets.  Sit on cash.  Earn less.  Just in case.  Dig in.  Hold the line.  And try to survive until better times.

Of course, the Keynesians don’t factor these things into their little formulae and models.  They just stamp their feet and pout.  They’ve done their part.  Now it’s up to the greedy bankers and businessmen to do theirs.  To engage in lending.  To create jobs.  To build things.  That no one is buying.  Because no one is confident in keeping their job.  Because the business climate is still poor.  Despite there being cheap money to borrow.

The problem with Keynesians, of course, is that they don’t understand business.  They’re macroeconomists.  They trade in theory.  Not reality.  When their theory fails, it’s not the theory.  It’s the application of the theory.  Or a greedy businessman.  Or banker.  It’s never their own stupidity.  No matter how many times they get it wrong.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,