Improving Your Collection Cycle

Collecting overdue accounts is, for many small business owners, the most unpleasant task of all. Learn what you'll need to track delinquent payments and, if need, use an attorney or collection agency.

Most business owners have a lot more fun making money than collecting it. Unless you were born to be a repo man, making collections is unpleasant for two main reasons:

keeping track of which accounts are overdue can be so difficult
most people don't enjoy pressing others for money

But, alas, it's a must. While we may not be able to make debt collection pleasurable, we can make it a whole lot less painful for you.

Keeping Collections Records Organized

That whole process of identifying overdue accounts and taking steps to collect your money is called your collection cycle. The best place to start improving your collection cycle (or, if you're just starting out, to build an effective collection cycle) is to get organized.

Probably the most common reason why collections get out of hand is poor organization. If you have a lot of customers buying on credit and they buy from you throughout the month, each with different terms, keeping track can be extraordinarily difficult. However, there are a number of software programs on the market that can greatly simplify this task, or you can even create a spreadsheet if you only have a few accounts to keep tabs on.

No matter what software you choose, you'll want to take these considerations into account:

Tracking Overdue Accounts: The key is to develop an effective means of knowing when accounts come due and being able to keep track of who pays their bill and who doesn't. This is half the battle.
When to Call Your Lawyer: Once you can keep track of your accounts, the next step is to set up a system for determining which accounts to handle yourself, which accounts to turn over to a collection agency, and which accounts to send to your attorney (you don't have to use all three—you can handle everything yourself, if you want to). Lawyers, though often effective, also can be expensive. You'll have to determine which is the most effective way for you to get the money owed to you.
Paying Lawyers and Debt Collectors: Generally, either of these collection experts will require a percentage of any debt they collect.
Streamlining Your Tactics: Many collections experts will tell you that you need to start your collections process with a series of letters that grow ever more threatening. They'll tell you that if your customer fails to respond to, say, the seventh letter, you turn the account over to your lawyer. But as a small business owner you may not have the time (not to mention the patience) to send so many letters to so many people. Also, keeping track of which letters have gone to which customers just adds another layer of complexity to the process.
Avoiding the Legal Pitfalls: If you collect your own debts, you'll have to tiptoe around several laws that protect consumers from certain debt-collecting practices that are considered overly burdensome or unreasonable. If you collect primarily from other businesses, you won't have as many concerns.
Dealing with Uncollectable Debts: When should you throw up your hands and declare a debt uncollectable? If a debtor seems to have left town, there are ways of tracing him or her. But if the debtor declares bankruptcy, you may be out of luck.

Follow these basic rules, and you'll soon be behind the wheel of a well-oiled, fine-tuned collection machine.

Keeping Track of Past-Due Accounts

In accounting-speak, a debt someone owes you for goods or services you provided to them is an account receivable. Accounts receivable are part of your assets. They represent the amount of money owed to you by your customers, and they have value to you.

Of course, in reality they are valuable only if you're able to collect them. And if you're going to be able to collect them, you'll have to develop a system for keeping track. Your system must include a way of keeping track of accounts and of producing what is called an accounts receivable aging report.

Developing Your Tracking Efforts

Once you've figure out how you're going to keep track of accounts, your next step will be to decide when you want to begin collection efforts. Will it be the day after the bill is due? A week after? A month after?

The answer will depend upon a couple of factors:

First, it will depend upon who the customer is. You're probably not going to crack down on your brother-in-law if the payment is one day late (then again, maybe you will). Nor are you going to crack down on an otherwise reliable customer who happens to be one day late, one time. If, however, the customer is chronically late with payments, you may want to treat it as overdue right away (as well as reconsider whether you should be extending credit to that customer).
Second, it will depend upon the size of the balance. If the balance is especially large, and you're dependent upon the payment to meet your own obligations, you may want to treat it as overdue one day after the bill is due. If, however, the balance is especially small, you may not want to treat it as overdue for several weeks. You'll just have to ask yourself whether your time is well-spent chasing after small accounts.

Running an Accounts Receivable Aging Report

An accounts receivable aging report is really just a fancy name for a report that tells you which accounts are past due, and by how much.

We recommend using software built specifically for accounts receivable that will generate reports automatically based on your sales records. Most basic bookkeeping software for small businesses will be able to generate such a report.

If you story all your relevant data in spreadsheets or (we hope not) by hand, you can follow these steps:

Create some record of the account, such as an invoice, which includes the customer's name, the date of purchase, the amount of purchase, etc. Organize these in a meaningful way on your computer. It doesn't much matter how you do it, just that it's well organized. For paper-based systems, generally duplicate records are kept, and they are organized both by customer, and by date.
Create some method for reviewing the accounts periodically. For example, you might want to see your 30-day accounts 35 days after the sale, your 60-day accounts 65 days after the sale, and so on. Make a note to check these on your calendar, or delegate the task to an employee. You should be careful to spread out your account reviews. If you don't pay close attention to what you're doing, you'll end up with 20 files to review on one day and none the next. You can avoid that problem by being flexible on your reviews: some 30-day accounts get reviewed after 33 days, others after, say, 37 days, and so on.
Coordinate your account files with your ledgers or with whatever system you're using for keeping track of sales and recording payments. If you're going to review an account, you certainly want to know whether it's been paid. To save a little time, you can ask an employee to pull both the account and the ledger on the review date. Of course, it won't take that much time to pull it yourself.

Using Lawyers and Collection Agencies to Pursue Bad Debts

At this point in the process, you've set up your system for keeping track of your accounts and you know pretty much when you're going to begin making efforts to collect past due accounts. The next question is, who is going to collect the accounts? In other words, are you going to do it yourself? Will you use a collection agency? Will you use a lawyer?

(If you're not familiar with using collection agencies or lawyers, you may want to see our section on how lawyers and debt collectors get paid before continuing with the discussion.)

Devising a Collections Strategy

Generally speaking, doing the collecting yourself is the least expensive of your three choices. Using a lawyer is often the most expensive. But when figuring out the cost, don't forget to consider the value of your time to the business.

If you collect debts yourself, and it demands so much of your time that your business suffers as a result, then doing it yourself will actually be the most expensive approach. Also, while doing it yourself is usually the least expensive approach, it's also usually the least effective approach. Hiring a lawyer to do it is usually both the most expensive and the most effective approach.

A good way to tackle the problem is to decide ahead of time how past-due accounts will be handled. One approach is to base your decision on the amount of the past-due account.

Your system could be set up as follows:

All past-due accounts under $25 get written off (for more on how that works, see accounting for bad debts).
All past-due accounts between $25 and $500 are collected by you.
All past-due accounts between $500 and $1,000 are turned over to a collection agency.
All past-due accounts over $1,000 are turned over to your lawyer.

The levels you choose may vary, depending upon the type of business you're in and the size of your typical transaction. This approach, however, creates at least two potential problems:

First, what do you do with smaller accounts that you can't collect? If you're unable to collect one of the $50-$500 past-due accounts, do you at some point turn over the account to your attorney?
Second, assume your lawyer's fee is a third of what he or she collects. Suppose you turn over a $3,000 past-due account that your lawyer is able to collect with one phone call because your customer misplaced the bill. If you automatically turn over all accounts above $1,000 to your lawyer, are you possibly throwing money away? Also, are you alienating your larger customers by having a lawyer contact them right after the bill is due?

One possible alternative is to set up a system based on time rather than on amount.

After considering the time needed for collects, you could revamp your system as follows:

Past-due accounts no more than 90 days old are collected by you.
Past-due accounts more than 90 days old but no more than one year old are turned over to a collection agency.
Past-due accounts more than one year old are turned over to an attorney.

While this approach solves some of the problems created by the first approach, it also raises new problems:

First, it commits you to spending at least some of your time on all of your accounts, which could be enormously time-consuming if you typically have a lot of past-due accounts.
Second, the transition of the accounts from the collection agency to the attorney after one year can be troublesome. If the attorney is able to collect the debt, is the collection agency entitled to anything for its nine months of work?

Perhaps the best approach would be to combine the two.

After weighing time and the amount of past-due accounts, you revise your system as follows:

All debts will be collected by you for 30 days after they're past due.
After 30 days, all past-due accounts greater than $1,000 will be turned over to your lawyer. You will continue to collect all other debts.
After 60 days, all past-due accounts of between $500 and $1,000 will be turned over to a collection agency or to a lawyer.
After 90 days, all past-due accounts under $500 will be turned over to a collection agency.

This approach, as you can imagine, could be difficult to keep track of. If you believe it would be too difficult to track, you should go back to one of the previous approaches. In any event, if you decide to collect any of the past-due accounts yourself in whichever approach you choose, you should check out streamlining your tactics for suggestions on how to improve your collection techniques.

Assessing the Costs of Using Lawyers and Debt Collection Agencies

Lawyers and debt collectors usually get paid by taking a percentage of what they collect. The amount is usually 33 percent, although it can range from as low as 15 percent to as high as 50 percent.

In addition, if you have your lawyer file suit on your behalf, you'll usually have to pay the court costs (about $400-$1,000) up front, although you can recover those costs from the debtor if your suit is successful. Bear in mind if a lawsuit is filed and there are expenses involved (such as the cost of witness depositions), the expenses are taken off the top. In other words, the expenses are subtracted from the amount your lawyer is able to recover, before your lawyer takes the one-third, or whatever amount you've agreed upon. However, unless the amount owed to you is especially large, there shouldn't be too many (if any) expenses. You should discuss this with your lawyer before you agree to turn over the account.

Guidelines for Hiring a Lawyer or Debt Collector

Before you put a lawyer on retainer or hire a collection firm, consider these pointers:

Don't turn over a past-due account for collection until you're sure that it's "uncollectible" by you. In other words, don't turn over any past-due accounts that haven't been paid because of some simple oversight on the part of the customer. You're throwing money away if you turn over a past-due account that you could have collected with a single phone call.
It's not cost effective to have a lawyer collect your small debts, and most lawyers won't agree to do it anyway. The idea of spending a couple of hours collecting a $30 debt for a $10 fee just doesn't light a fire under too many lawyers. What constitutes a "small debt" will depend upon the lawyer.

Be extremely wary of paying a lawyer by the hour to collect your debts. In fact, don't do it unless you have a specific task you want the lawyer to perform (for example, write two letters). Otherwise, you could end up paying out more than you collect.

Collection agencies usually will handle smaller debts, but only if you give them volume. They're probably not going to be interested in collecting two $50 debts, but they may be interested if you have a hundred of them.
There are no hard-and-fast rules for using a lawyer versus a collection agency. Lawyers are usually more expensive and more effective (because, unlike collection agencies, they can take the debtor to court for you). Your decision might be made by which past-due accounts your lawyer is willing to take, or it might be made by whether you're willing to take your customers to court, if necessary. If you're not, you might as well use a collection agency.

Suppose you turn over several large past-due accounts to your lawyer with an agreement that the lawyer will receive one-third of what is collected. Sometimes one of those customers will pay you directly, after the lawyer sends out a letter but before the customer receives it. In other words, the customer didn't know that the lawyer was involved. Does the lawyer get one-third of that account? Generally, yes, unless you spell out a different arrangement.

Set up a sliding scale, if possible. For example, suppose you agree that your lawyer will send out two letters, then will make a personal visit or telephone call, and then, if necessary, will file suit against the customer. You might agree that the lawyer will get 10 percent up until the personal visit or phone call, 20 percent up until suit is filed, and 33 percent thereafter.

If you want to use a collection agency first and then a lawyer when you reach the point of filing suit, make sure that you carefully discuss with the collection agency how the files will be transferred to the lawyer. In fact, if you don't already have a lawyer, you may want to consider getting a referral from the collection agency. If the lawyer and the collection agency have worked together in the past, the transition shouldn't be difficult.
If you turn over your accounts to a lawyer, carefully spell out your fee arrangement.