Time Value of Money and the Importance of A/R
Over the past several weeks we have been discussing issues faced by "Same Way Sal". One issue he shares with many other small business owners is collecting money on account in a timely manner. Today we will be looking at how the Time Value of Money, Inflation, and the way you invoice can affect your business
To illustrate my point a year or two ago I hired a contractor who came with good references to build a room on my house. He required a down payment and then the remainder was due at completion. After the job was completed I contacted him about how I should get payment to him. Once I was finally able to connect with him to pay him he stated that I was one of the only clients who has ever proactively sought him out to pay him. He also stated if his business needed cash he would just contact one of the bigger clients he had and asked them for a check.
This epitomizes how small business owners feel about getting paid. Whether it is because they don't know how to ask or if they are afraid to ask many small business owners let invoices sit out unpaid until they absolutely need the cash.
This is a bad business practice for many reasons. Not only are your setting a president for your clients that they aren't required to pay on time but due to inflation and the time value of money you are giving money away.
Time Value of Money
The principle of time value of money states a dollar today is worth more than a dollar tomorrow. For example, if you loan someone $1000 today and asked them to pay it back in 12 months. With a current market interest rate of 4%, you would in eases be giving them $38.76.
This is because it is assumed that if you had the $1000 at the beginning of the loan term that you would invest it in a way to get the minimum market return and because you didn't have the funds available you would lose at least $38.76
The same principle applies to invoices. If you completed a job for $1000 and the client hasn't paid you within a month you have lost $3.
Let me big picture that for you. If your business has $500k in sales each year and half of your clients pay a month late that would be a loss of $822. The $822 represent a loss at a 4% market rate which is unusually low. If the rate were to increase to 8% the number doubles to $1,639
Current U.S. inflation, as of this post, is 1.6%. For those who don't know inflation, as defined by investopedia.com, is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. In lay man's terms that means every month $1 USD is worth less than the last. Or to put it another way at the end of a 12 month period at the above rate $1 USD would be worth $0.98.
To apply that to our above example not only would we be losing $822 because of the time value of money but an additional $325 due to inflation. Revenue would be more accurately portrait as $498k.
The last thing I want to talk about is client perception. If you allow the above practices to continue it will perpetuate your cash flow issues. You won't be able to move from a small mom and pop to a thriving small to mid size business. To combat this you need
- Clear and Concise Payment Terms
- You must enforce the terms across the board
- Friends and Family get the same terms
- You must track the invoices and payments with close to 100% accuracy
You can easily do the first two but the third can be hard for small businesses. Because it requires a change in process. To get high accuracy in Account Receivable you must have a reliable and consistent way of tracking invoices and client payments. Which is hard to do it you don't have a consist way of invoicing and collecting payments. The best way to fix this is implement a cloud based invoicing solution like Xero, Freshbooks, or Bill.com and use it exclusively for sending invoices and tracking payment collections
To conclude, as a small business owner your not running a charity. If you provide a valuable services you should be paid for it and paid timely. At the onset of any engagement make it clear what your payment terms are so there is no confusion when it is time to invoice. You clients will respect you more and your business will do better. Lastly, don't spend extra time trying to chase down paper copies of invoices use a cloud based solution and track all invoices and payments in it so that your have a central source of truth.
If your business is having issues with Account Receivable Let us know. We would love to discuss solutions and if your need help you implement them.
firstname.lastname@example.org or call (434) 515-1669