Accounts Receivable Management: How Manufacturers Can Bridge the Cash Gap

JOEL A. HERMAN, CPA

Accounts receivable is often one of the biggest assets on a manufacturer’s balance sheet. However, the faster a company is able to convert its receivables into cash, the sooner it is able to pay suppliers, employees and lenders — and the less likely it will be to draw on its line of credit to make up for working capital shortfalls.

Unfortunately, many of a manufacturer’s customers may have fallen into the habit of extending payment terms during the recession. Now that the market has picked up, it is time to retrain your customers to pay on time. The simple concept of the “cash gap” shows you the importance of minimizing accounts receivable.

Cash In vs. Cash Out

Calculating your company’s cash gap is simple: Add the average days in inventory to the average collection period for accounts receivable and subtract the average payment period for accounts payable.

For example, suppose ABC Co. stocks about 50 days’ worth of inventory in its warehouse, collects its receivables in about 60 days and pays off its suppliers within 20 days. ABC’s cash gap would be 90 days (50 days in inventory + 60 days in receivables – 20 days in payables = 90 days).

Incremental Interest Costs

The cash gap reflects the timing difference between when companies order materials and pay suppliers and when they receive payment from their customers. This difference is frequently financed by a company’s line of credit. When funded by bank financing, the cash gap incurs incremental interest costs that can be easily quantified.

Getting back to our fictitious manufacturer, suppose ABC achieves a 60% gross margin on its $10 million in annual revenues, which equates to a $4 million annual cost of sales. ABC’s 90-day cash gap means that the company must front — and presumably finance — 90 days’ worth of its annual cost of sales, or roughly $986,000 [($4 million cost of sales ÷ 365 days) × 90 days].

If we assume a 5% interest rate on its line of credit (and ignore taxes) ABC’s cash gap costs the company about $49,000 each year in interest expense. For every day it shaves off its cash gap, ABC will improve its pre-tax profits by nearly $550 ($49,000 of interest divided by its 90-day cash gap). At higher interest rates, the incremental interest costs related to the cash gap are even more pronounced.

Eyes on Collections

There are few options to reduce the cash gap. You can cut back on inventory in your warehouse. However, doing so may lead to shortages and eliminate bulk discounts. You can delay paying suppliers at the risk of losing early-bird discounts and receiving less favorable credit terms.

So, speeding up collections is often the most effective and simplest way to lower the cash gap. Five ways to encourage customers to pay invoices include:

1. Performing credit checks on prospective customers;
2. Flagging new customers to ensure initial invoices are paid on time;
3. Sending out past-due reminder letters or e-mail messages and following up with phone calls;
4. Offering “early-bird” discounts to customers that pay within 10 or 20 days; and
5. Hiring dedicated, experienced collection personnel.

Manufacturers also should evaluate invoicing procedures to minimize the days in receivables. Poor communication among billing, sales and production staff can cause invoicing delays.

A Low-Risk Approach

There is no good reason to allow receivables to build up on your balance sheet and no risk to expediting collections. So, if you are looking for a quick and simple way to shrink the cash gap, always start with receivables.

S Corporation vs. C Corporation: Is it Time for You to Make the Switch?

The Protecting Americans from Tax Hikes (PATH) Act of 2015 accomplished more than just extending certain tax breaks. It also made some taxpayer-friendly provisions permanent, including the shortened recognition period for companies that convert from C corporation to S corporation status. This change is causing many manufacturers and distributors to reevaluate their corporate status.

After weighing the pros and cons, many companies are electing Subchapter S status to gain enhanced flexibility in business decisions and to lower taxes. The following are some important issues to consider before you convert.

Tax Considerations

C corporations pay taxes twice. First, they are charged corporate-level income taxes. Shareholders then pay tax personally on C corporation distributions and dividends. However, S corporations are flow-through entities for tax purposes. This means that income, gains and losses flow through to the owners’ personal tax returns. S corporations generally are not taxed at the corporate level.

However, double taxation of C corporations may become a major issue when the owners decide to sell assets or transfer equity. Historically, if a company elected Subchapter S status and sold assets or transferred equity any time within a 10-year “recognition period,” it was charged corporate-level tax on any built-in gains that occurred while the company was a C corporation. Any gains that occurred after making the S election passed through the owners’ personal tax returns.

Under the PATH Act, the recognition period has been permanently shortened to five years. If a business sells assets or stock within the recognition period, only the appreciation in value from the date of the S corporation election will be exempt from corporate-level tax.

So it is important to establish the company’s fair market value at the conversion date and to allocate it to the company’s assets. This enables taxpayers to quantify which portion of the gain should be taxed as C corporation gain and which portion should be taxed as a flow-through gain to shareholders.

Subchapter S Qualifications

For businesses contemplating a Subchapter S election, there is no time like the present to start the clock on the five-year recognition period. However, not every business qualifies for this election. It is available to only domestic corporations that use a calendar fiscal year and offer just one class of stock (though differences in voting rights are permitted). Qualifying businesses also must have no more than 100 shareholders, including individuals; certain trusts and estates (excluding partnerships); corporations; foreign individuals and entities; and ineligible corporations.

Beware, too, that Subchapter S status restricts how the company distributes cash and liquidates assets. All payouts must be made to shareholders on a pro rata basis. If these rules are not followed, or if the company merges with another entity that does not qualify, the company will lose its Subchapter S status.

Potential Pitfall

Although S corporations are required to make pro rata distributions to shareholders, they are not required to distribute income to shareholders. Therefore, shareholders who lack control over making distributions may find themselves required to pay personal-level taxes on S corporation income, regardless of whether the company distributed any cash to cover those tax liabilities.

The annual tax burden can be substantial for highly profitable S corporations and even more substantial for high-income taxpayers. As a courtesy, most S corporations pay enough distributions to cover shareholders’ tax obligations. However, there is no guarantee of distributions for shareholders who lack control over the business.

A Tough Choice

Before electing to S status, your business must obtain the approval of all shareholders. Although there are many benefits to making the switch — especially now that the recognition period to avoid corporate-level capital gains tax has been permanently shortened — it is not a prudent option for every business. Your legal and tax advisors can help determine the right choice for your circumstances.

For more information, contact Joel Herman at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.