Debt Management and Recovery

Cost of a loan Although interest rates are currently low they can still build up to become a substantial cost to a business. Business loans can be obtained with an interest rate charge of 5% or 6%, but overdrafts are often incurring rates of 10% or more as well as arrangement fees of 1% to 2% of the overdraft amount. This would cost £5,000 in interest and an arrangement fee of £500 to £1,000 for a £50,000 overdraft that was fully utilised for a year. That money could be used elsewhere in the business. For example, a person on the minimum wage could be employed for 2 days a week for the year instead of paying this interest and arrangement fee.

It is also a good time to consider reducing debt. Although interest rates are currently low, it is expected that the UK will start to feel the effects of inflation with the corresponding increase in interest rates. Rates in the 1970s, 1980s and 1990s were frequently more than double or triple the current interest rate levels. There is little reason to expect that the low interest rates of the past decade will continue in the long-term. Could your business manage to keep repaying loans or even survive if the interest costs doubled?

Cashflow management Just because a business is profitable it does not mean that it will not have debts, and these debts can be enough to force it out of business. If cash from sales is not collected, the business will soon accrue debts and may run out of the cash needed to pay its suppliers. There are two elements to consider to ensure the business does not get into cash difficulties, cashflow management and credit management.

An important aspect to managing debt is working out when your cash is due to go out and when you can expect to get cash into the business. Fortunately, with spreadsheets this has become an easier task.

To complete a cashflow forecast, a business needs to list out when receipts from customers (and any other receipts such as credits from suppliers, loans from banks, etc.). It is important to include when the receipt is due to be received and not the date an invoice is raised. The business should also look at its expected level of bad debts. If the experience of the business is that 5% of invoices are not paid then expected receipts need to be reduced by this amount.

It is easier to work out when payments will be due. Many payments will be regular such as wages, rent or rates. Payments to suppliers can be calculated as it should be known when supplies will be purchased and when they will be paid. VAT and tax payments also should not be forgotten to be included.

On the spreadsheet the business can then detail these receipts and payments. A monthly total should be kept (a weekly one would be even better) so that any shortfall in a period can be calculated and appropriate financing obtained. The business may be cash positive during the year, but may have periods when it will have a deficit, such as in periods when it is stocking up, or where seasonal factors mean a downturn in sales.

Creditor Management Each business should have a credit management plan. This is to ensure that invoices that are issued are paid and customers do not build up a large debt. There is no point working for customers that do not pay you.

Where a business extends credit to a customer, it is important that the correct identity of that customer is known and also that the customer’s legal status is established. It is important to know who you are dealing with; make sure you have the exact name, trading style, legal status of the business and its address. This can be important when invoicing and chasing payments, especially when legal action is being taken.

The credit worthiness of a customer can be ascertained by performing a credit check. This can be undertaken in variety of ways:

• obtaining a status report from a credit agency;

• bank references;

• trade references;

• account experience; and

• customer visits.

The terms of trade with a customer should set out clearly how and when payment should be made, and the time limit for raising any dispute. The payment terms should detail when payment is due (for example, 14 days after invoice), plus what will be done if payments are late. It is common for interest to be charged on late payments and a charge made for reimbursement of costs of debt collection. Where a customer is late paying, raising a separate invoice for interest and costs can focus the mind of the customer. The value of the customer to the business needs to be considered, but a customer that does not pay has no value.

Where a business is selling high-value goods it should also consider a retention of title clause (a Romalpa clause). This allows the seller to recover possession of the goods where the buyer has not paid for them.

Once a decision has been made to extend credit to a customer, it is necessary to decide how much credit to allow. Where a business decides to set its own credit limit for a customer, this can be done in one of two ways.

1. The limit can be set to support sales. For example, if the customer has a good credit rating, the credit limit can be set at two months sales. This method needs constant review, however, as sales change and this should provide a trigger for keeping the customer’s ongoing creditworthiness under review.

2. The credit limit can be set by reference to the amount that the business is prepared to be owed. A popular method is 10% of net worth or 20% of working capital. This method requires less frequent revision. It also is easier to operate as sales staff can be given the authority to sell up to the credit limit.

Staff should be made aware of a customer’s credit limit, and a procedure put in place to deal with situations where a customer exceeds or asks to extend the limit. Credit limits should be part of ongoing reviews of customers and part of the business’s risk management strategy.

Late payment is a major problem for SMEs. Debts should be collected promptly in accordance with agreed terms. The aim is to get paid as soon as possible and, in any event, within the agreed terms. It is not enough to be paid eventually as this is costly for the business. Where terms are, for example, 30 days, payment should be achieved within 30 days not at, say, 45 or 60 days. Discounts can also be offered for prompt payment (such as a 2.5% discount for payment within 15 days.

Statements should be sent out promptly. Where the statement shows an amount that is overdue, a letter should be sent with the statement making it clear that payment needs to be made. Normally, a supplier would not send more than two reminder letters asking for payment to be made before threatening action to recover the debt.

Telephoning the customer can be a powerful aid to collecting payment. Where debts are chased by telephone, the person chasing the debt should have the skill, knowledge and authority to deal with the request

Debt management A business that is in debt needs to have an action plan to deal with the debt. The first step is to work out what debts the business has, the total amount of the debt and when repayments are due. Until this is done there can be no action plan to deal with the debt. The business then needs to compare what it owes to the income it is generating. Can the debt be sustained? If the payments that are due exceed the income it will be necessary to approach the banks and other lenders to reschedule the loans. A smaller repayment amount may be possible if all loans are consolidated into one loan for a longer period. This may also provide the opportunity to seek a better deal.

A key to debt management is to ensure that amounts due are paid on time. This avoids penalties and extra interest charges. It also allows the business to avoid getting a bad credit rating. If possible, the business should look to increase its payments to reduce the amount owing. This will save interest costs. It is necessary, however, to check on the conditions on the loan to ensure there is no charge for repaying early.

If debts become unsustainable the business should consider entering into an insolvency procedure. It may, for example be possible to enter into a voluntary arrangement with creditors to rearrange amounts that are owing.

Financial stability A business can use accounting ratios to assist in determining their own creditworthiness and also the creditworthiness of customers. The following are the most commonly used ratios.

Current ratio: This indicates the businesses’ ability to meet its short-term debt. The ratio is the current assets divided by the current liabilities. The rule of thumb for an acceptable current ratio is 2:1. This means there is £2 available to pay each £1 of debt. A lower figure (say 1:1) means that there may be difficulty in meeting short-term liabilities. A higher figure is better than a lower figure.

Liquidity ratio: Also called the quick asset ratio. This indicates the ability to meet immediate debt (within one month). This is calculated as (current assets less inventory and prepayments) divided by (current liabilities less the bank overdraft). The rule of thumb for an acceptable liquidity ratio is 1:1. This means there is £1 available to pay each £1 of debt. A higher figure is better than a lower figure.

Debt to total assets: This measures long-term financial stability and is sometimes referred to as gearing. It measures the funds provided by creditors and the protection provided by the owners/shareholders. Lenders wish to see the owners/shareholders to accept some risk if they are accepting risk in lending money to the business. This is calculated by dividing total liabilities by the total assets. A usually acceptable figure is 0.4:1. That is 40p of liability (debt) is covered by a £1 of assets. A higher figure (say 0.8:1) means that the business relies heavily on external funding (is highly geared). A lower figure is better than a higher figure as this shows there is less risk to creditors.

Debt to equity: This ratio shows how assets are financed by outside or external parties. It is calculated by dividing total liabilities by equity. A business norm would be 0.6:1, that is 60p of liabilities has been funded by £1 of equity. A higher figure (say 1.5:1) would indicate a risk to creditors. A lower figure is better than a higher figure as this shows there is less risk to creditors.

Times interest earned: This ratio shows the ability to meet interest payments. It is calculated by dividing profit (earnings before interest and tax (EBIT)) by interest charges. It would normally be expected that EBIT would be four times higher than the interest charges. Lenders may believe there is a risk of interest not being paid if the interest cover is less than this. A higher figure is better than a lower figure.

Accounts receivable turnover: This ratio describes how long it takes to collect debts from credit customers. It is calculated by dividing the credit sales by the average accounts receivable. The average accounts receivable is calculated by adding together the opening and closing credits and dividing by two. But, if the number of days in the year is divided by this figure it will tell you the number of days it takes to receive payment. For example, if the credit sales are £800,000 and the average accounts receivable is £256,000, the accounts receivable turnover figure is 3.1. This means that the average accounts payable are paid 3.1 times per year. Dividing the number of days in the year, 365, by 3.1 means that it takes 118 days to receive payment from credit customers. For most businesses this would be an unacceptable delay, but the business may be in an industry where slow paying customers is normal. For most businesses, however, credit customers should be paying in 30–45 days. A customer that does not pay in 183 days (6 months) they often will not pay at all. Also, the longer the payment period the greater the cost to the supplier as it will incur more interest charges (if borrowing) or it could use the funds to invest or grow its business. A lower figure is better than a higher figure as this shows a good credit control policy is in place.

Conclusion Managing debt and creditors may not be a glamourous part of the business. It is, however, essential for the health of the business, Debt and creditor management is something that good business play close attention to.

Contact Ashored for help and support with Debt Management and Recovery.