Receivable/Accounts - Information for Credit and Collection Issues

Monday, August 15, 2011

Compound Interest on Accounts Owed

So this week, let’s talk about calculating interest on a debt, why it’s a good idea, and how you can do it internally before you send the file to collections.

So many creditors, from small businesses right up to national financial institutions don’t follow interest charges through the whole credit cycle, because it’s too complicated, they don’t have the capability to coordinate balances with a collection agency or the credit bureau, or they are worried about losing good will from a customer. However, this tool for encouraging timely payment is sorely underutilized.

Should You Charge Interest?

Yes, yes, and yes. Your company is not likely a bank, and when your accounts receivable goes over 30 days, those customers are hampering your company’s cash flow. And when a customer doesn’t pay within the terms of the invoice, it helps to have consequences for non-payment.

So the first thing you should do is print on your invoices, statements, and client contracts a reasonable interest rate to your industry. For the purposes of this article, let’s assume we are dealing with invoice terms of Net 30, 2% per month or 24% per annum.

(Note: If you have clearly imprinted on your sales agreements, contracts, and invoices your interest rate in monthly and annual terms, there is a small chance that if you go to small claims court, they will award your interest rate on funds owing after the judgment date. However, do not be surprised if the judge simply awards the current interest rate for judgments, which will be significantly lower.)

Now, I believe unless you are a credit union, bank, or lending institution, the purpose of interest is an incentive for customers to pay on time, not a dedicated income stream. Now, if customers balk at interest, or are a few days late in their payments, I believe discretion is in order, and you should forgive interest whenever possible. After all, if you have your payment in hand, and you have not waited over-long, demanding interest for its’ own sake is not good business.

Simple Interest

The amount of simple interest is calculated according to the following formula, where the balance is (Interest / 12 * the initial balance) * the number of months, or more formally:
Simple interest calculations are used in pre- and post-judgment interest in Ontario Small Claims Court, but we are going to focus on compound interest.

Compound Interest

When I was in Grade 10, I vaguely recalled a math equation taught to me in Business/Math for calculating compound interest. When I developed my first collections database, I fortunately still had the textbook on my shelf. So, this would be the Future Value (FV) based on the Present Value (PV) after interest (i) is calculated for a number (n) periods.
Specifically for compound interest as an annual amount, the formula for calculated the Final Amount (A) from the Principal Amount (P), based on the annual interest rate (r), the number of times the interest is calculated per year (n), and the number of years (t).
To do this in a database environment, the formula would more likely look like:


An Excel Spreadsheet

If you would like a program to figure your interest simply, without factoring payments, I have available two different sample excel spreadsheets – one that calculates interest based on monthly periods, another that calculates the balance to the day. If you would like a copy of this simple Excel spreadsheet sent to you, email me.

The formulas and examples I’ve given only show simple calculations. Once a history of payments is entered into the account records, calculating interest and balance due becomes a fairly serious undertaking.

Collections and Interest

Now, if you have done everything properly, and have the right to charge your clients interest, if the time comes to send final demands, you can reflect an increasing balance, which may encourage your customers to contact you and resolve the account before it is sent to collections.

When you inevitably assign your files to collections, you can hand the collection agency a powerful tool to assist them in recovering your funds. Make sure the agency knows what your annual interest rate is for overdue accounts, that you have the legal right to collect these funds, and ensure the collection agency has the ability to calculate and recover these funds.

The collection agency can use interest in a number of ways to increase liquidation of your accounts, speed payment recovery, and negotiate more arrangements.

• Interest allows a collector to create a sense of urgency, by advising them that as time goes by, the balance increases, and the problem becomes worse. This is a consequence that applies gentle pressure, and illustrates that the responsibility for the debt is as money borrowed from the client.

• While interest can be calculated and collected, forgiving part of the interest is a powerful negotiation tool to show good faith. If the debtor can pay in full, forgiving interest is a tool for settlement. Furthermore, if the debtor is only able to make nominal payments, forgiving or suspending interest while payment schedules are adhered to insures this matter remains a priority for the debtor

• Interest collected above the principal offsets a portion of collection agency fees, legal fees, or client expenses from their credit cycle, therefore reducing the overall bad debt writeoff, which should please many credit managers.

If you have a strong relationship with your collection agency, you can coordinate balances should a long-lost debtor come through your doors to resolve their account, or a debtor that absolutely refused payment can be told their balance-incurred balance when they call because they were denied credit they are in need of.

With the right collection partner and the right tools set up at the client and agency side, calculated interest can result in thousands of dollars in recoveries for your company. Doesn’t that seem like a worthwhile effort?

If you are seeking advice regarding setting up interest charges internally, or working with a collection agency that can employ compound interest as a collection tool, feel free to contact my office at 226-444-5695.