Last week I wrote an article reviewing the balance sheet included in the first 10-Q issued by Pfizer (NYSE: PFE) after its merger with Warner-Lambert. The discussion board messages after that column ran made me realize some misconceptions about the reasons why some companies take so long to collect accounts receivable from their customers.

We can calculate days sales outstanding (DSO) to determine how long a company takes to collect the money it's owed by customers for products or services. On a quarterly basis, the formula used to calculate DSO is Accounts Receivable / (Sales/90).

Often, the first thought that comes to mind when slow collection of receivables is mentioned is that a company must harass its customers to get them to pay more quickly. If that were the case, it's believed that could lead to a decline in the relationship between the company and its customers, which would hurt the business over the long haul.

In truth, while some customers are slow payers (possibly because they are looking to manage their way through a liquidity crunch or cash-flow shortage), the majority of companies are more than willing to pay their debts on time.

So, what makes companies take so long to collect outstanding bills? The major cause is the inefficiency of the receivables management process. This process is both paper- and labor-intensive. Here's a list of some of the steps involved:

  • Seller receives a purchase order (PO) from the buyer.

  • Depending on the agreement between the parties, an order confirmation may be generated.

  • Seller notifies buyer once the product is ready to ship.

  • Seller generates an invoice for buyer.

  • The shipper of the goods is notified when the goods are ready to be shipped.

  • The shipper of the goods takes possession of the goods and delivers them to the buyer.

  • The buyer receives the goods. Typically, the shipper generates a document substantiating delivery of the goods.

  • The buyer inspects the goods and confirms that they are in good condition and whether the right quantity has been shipped.

  • If the shipment is in conformity with the order, the buyer prepares its payment for the seller at the agreed-to terms.

  • If the buyer finds a discrepancy, or there is a quality issue, either the goods are returned or there is a quality control adjustment, which leads to the issue of a credit memo.

  • Finally, once all outstanding issues are resolved, the seller receives payment for the goods.
Believe it or not, the process can be much more complicated than it looks above. You see, there can be multiple shipments to either the same or multiple destinations, multiple payments, multiple billing arrangements, etc. Even worse, much of the transaction flow is manual rather than electronic. A company could have to track anywhere from 20 to 36 documents (or more) to account for just one sale. Handling these transactions on paper is time-consuming and likely to result in errors. This leads to a high cost of managing receivables. It also has a negative impact on the seller's cash flow.

As discussed in this article, the problem is that the majority of chief financial officers and treasurers are technophobes who are unwilling to move their finance functions online. As a result, receivables often take much longer to collect than they should. According to a University of Tennessee study from 1998, more than 61% of accounts receivable are more than 50 days old.

Typically, a company may not be alerted to problems until an invoice is 45 to 60 days past due. When receivables go past 40 days, it's usually because customers are unable to figure out such important details as what they are supposed to pay for and how much it costs. There are often big discrepancies between the buyer's and seller's figures.

By improving the receivables collection process, a seller can realize the following benefits:
  • Administrative cost reduction;
  • A reduction in DSO;
  • Fewer disputed shipments;
  • Improved and more dependable cash flow; and
  • Reduced interest charges.
If companies can better manage the receivables collection process (primarily through automation), funds are freed up that enable greater focus on core business development. This means more profits over the long haul.

Now for the $500 question. While I thought Matt's column on Monday was a reasonable effort to quantify our selection approach, I don't support the use of all of his metrics. The one I like the least is relative position in portfolio, as that strategy puts some weight on adding more to our losers. I also don't favor the idea of making our approach almost entirely mechanical.

I favor the idea of using our $500 this month to add more shares of Nokia (NYSE: NOK). I own shares of each of our Rule Makers, but the only one I've added to over the last month is Nokia. I've purchased more shares primarily because I think that the decline in the stock after the second quarter earnings announcement was overblown.

At this point, I have no reason not to trust our company's management team. They've said that the current quarter will be difficult. After that, the company is expected to be back on track. It seems to me like a perfect time to add more shares of this Rule Maker.

Phil Weiss, TMF Grape on the Discussion Boards

Related Link:
  • Pfizer vs. Warner-Lambert, Rule Maker Portfolio, 11/2/99