Redwood Analytics

In addition to considering what the market may bear, efficient billing practices, reduced write downs, and other pre-invoice processes, you should consider the time it takes your clients to pay for your services after the invoice is billed.

 

For example, if two firms bill their client in the same month $5,000 for services rendered, one pays at 45 days and the other pays at 120 days, the first firm retains a higher rate and is thus more profitable. How?

 

Based on data from the Department of Commerce, the value of a dollar decreases by 10% at 60 days and 20% by the time the debt is 120 days old. Studies also show that there is a 90% chance to collect a debt under 60 days, but that you only have a 20% chance of collecting the debt after 120 days. Finance companies use formulas based on percentages more restrictive than the above when providing loans secured by a firm's receivables.

 

 

Taking the above into consideration, the value of services for the firm which was paid at 45 days comes to $4,500 and the services for the firm which was paid at 120 days was only $4,000. The amount paid is still $5,000, but there is a $500 difference in the "time value" of the cash received for the first firm and a $1,000 difference for the second.

 

Now consider what this does to rate. Suppose the $5,000 represented 20 hours of work at $250 per hour. For the firm which was paid in full at 45 days, the collected rate would be $225, a full $25 less per hour. For the firm which was paid in 120 days, the rate is reduced to $200, or a $50 credit to the client per hour.

 

The above looks at the value of the debt owed. It does not take into consideration the chance to collect on the debt (not to mention pre-bill adjustments). If you want to forecast earnings, projections of revenue need to include the probability that the invoices will be paid. These percentages may differ from company to company. In the below graph (click on graph to download spreadsheet), I use a 95% chance to collect on AR up to 60 days. It decreases to 85% between 61 and 90, 60% from 91 to 120, and 20% after 120.

 

 

Calculating the aged receivables and multiplying the value by the percentage representing the chance to collect, your AR doesn't look nearly as nice as it does if you only consider the billed value. This combined with the decreased value of the service dollar makes for a dire forecast for those who don't take collections seriously.

 

The above takes a firm-wide look at receivables. You can replace the aging values with a specific client and determine whether your client is providing better or worse value for the rate charged. In this way you can determine the time value of existing client receivables. 

 

Some may think that if you eventually receive the money, then you ultimately receive 100% of the money and the analysis above merely complicates a simple process. This line of thinking neglects to consider the time value of money. Financial institutions, insurance companies, and law firms consider the time value of money when calculating probabilities. In fact, when determining rate, firms often start with increasing their billable rates by the average percentage of inflation that may or may not be reflective of the cost of doing business in their region. It is a probability factored into the rate. Why would you not also take into consideration the negative impact of inflation on aged receivables, which is what the chart above (at least in part) represents?

 

Firms who don’t consider the time it takes to collect their receivables leave an important variable on the table when negotiating rates. Further, they decrease the value of their services since the debt that is collected after 120 days is likely induced by a discount if it is ever paid at all. Why spend time worrying what your billed rate is relative to others if you are ultimately going to devalue it by not seeing that the value for the work performed is retained?

 

Firms need to focus more attention on collections. In fact, a commitment to collecting debt within 60 days should be considered crucial to maintaining the value of the services you provide. With a monitored collections strategy, you will end up spending less in resources for future collections which will give you an effective rate increase without the client paying a penny more per hour.

 

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