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Sometimes, building profitability means looking at two sides of an issue—controls and growth—especially when it comes to growing the business. In this case, we look at the fundamentals of cash flow control coupled with the potential of expanding accounts receivable with cautious, but less conservative extension of credit.

Why Accounts Receivable Get Out of Control

In a tight cash flow world, it’s difficult to find the funds to invest in additional accounts receivable, regardless of the potential profit payoff. In that sense, it’s imperative that business owners focus on the reasons why accounts receivable get out of control in the first place.

Most research in the area suggests that both the customer and the business owner are partially to blame. From the owner’s perspective, three key causal factors lead to longer collections:

In too many instances these three items slip out of control, almost unnoticed. If they can be cleaned up, then the funds for an increased use of credit should be readily available.

Increase Credit for Profitability

Credit extension is often viewed not as a service, but as a necessary evil. But you just might be giving up profit dollars by being more conservative than you have to be. That doesn’t mean you should avoid monitoring the credit worthiness of customers and that you need to lower your standards, but that the economics of credit can favor a somewhat more aggressive credit policy rather than a tighter one.

Regarding the economics of credit, let’s take “Firm A” as an example. This firm generates $450,000 in sales volume, operates on a gross margin of 25% and produces a pre-tax profit of $22,500 or 5% of sales. From a credit perspective, the $450,000 in sales required an investment of $69,187 in accounts receivable. The firm also experienced bad debt losses of 0.1% of sales or $4,500. The major expense items, other than bad debts, can be broken down into variable expenses and fixed, or overhead, expenses. The variable expenses were estimated to be 0.3% of sales or $1,350. Of much greater significance, fixed expenses were $88,200.

With less stringent credit policies, it might be possible to add 5% to overall sales. Any number could have been chosen—5%, 1% or 10%—it makes no difference. What is critical is the impact that such incremental business has on expenses and investment. The figure of 5% was chosen as simply a round number that allows for ease of calculation.

With the additional sales, four key factors change:

Overall, Firm A’s 5% increase in sales caused profit to increase by 12.6%. Again, these positive results don’t mean that you should extend credit to everyone, but that the true costs of servicing additional accounts must be weighed against the additional sales and gross margin they will generate. The economics of credit, from a profit perspective, actually favor greater rather than lesser use of credit. If this reality can be married with proper control of accounts receivable balances, you should be able to increase profits without incurring dramatic increases in investment levels.

Special thanks to Dr. Albert Bates, CEO of Profit Planning Associates, for his help in preparing this article. Note: Speak with your accountant or financial advisor before making any changes in your credit program.