Accounts receivable, average collection period, accounts receivable to sales ratio--while you might roll your eyes at all these terms, they're vital to your business. Learn all the important aspects of analyzing and improving your cash flow.
To properly manage your business's cash flow, you must first analyze the components that affect the timing of your cash inflows and cash outflows. A good analysis of these components will point out problem areas that lead to cash flow gaps for your business. Narrowing, or even closing, cash flow gaps is the key to cash flow management.
Some of the more important components to examine are:
- Accounts receivable. Accounts receivable represent sales that have not yet been collected in the form of cash. An account receivable is created when you sell something to a customer in return for his or her promise to pay at a later date. To properly manage your cash flow, you must know the negative cash flow affects caused by the time it takes your customers to pay on their accounts.
- Credit terms. Credit terms are the time limits you set for your customers' promise to pay for the merchandise or services purchased from your business. Credit terms affect the timing of your cash inflows. Offering trade discounts is one way you might be able to improve your cash flow.
- Credit policy. A credit policy is the blueprint you use when deciding to extend credit to a customer. The correct credit policy is necessary to ensure that your cash flow doesn't fall victim to a credit policy that is too strict or to one that is too generous.
- Inventory. Inventory describes the extra merchandise or supplies your business keeps on hand to meet the demands of customers. An excessive amount of inventory hurts your cash flow by using up money that could be used for other cash outflows.
- Accounts payable and cash flow. Accounts payable are amounts you owe to your suppliers that are payable sometime within the near future, "near" meaning 30 to 90 days. Without payables and trade credit you'd have to pay for all goods and services at the time you purchase them. For optimum cash flow management, you'll need to examine your payables schedule.
Understanding Accounts Receivable and Cash Flow
Accounts receivable represent sales that have not yet been collected as cash. You sell your merchandise or services in exchange for a customer's promise to pay you at a certain time in the future. If your business normally extends credit to its customers, then the payment of accounts receivable is likely to be the single most important source of cash inflows.
In the worst case scenario, unpaid accounts receivable will leave your business without the necessary cash to pay its own bills. More commonly, late-paying or slow-paying customers will create cash shortages, leaving your business without the cash necessary to cover its own cash outflow obligations.
Accounts receivable also represent an investment. That is, the money tied up in accounts receivable is not available for paying bills, paying back loans, or expanding your business. The payoff from an investment in accounts receivable doesn't occur until your customers pay their bills. The idea of accounts receivable as an investment is an important concept to understand if you wish to consider the impact of accounts receivable on your cash flow.
The following analysis tools can be used to help determine the effect your business's accounts receivable is having on your cash flow:
- Average collection period measurement
- Using the average collection period
- Accounts receivable to sales ratio
- Accounts receivable aging schedule
- Using the accounts receivable aging schedule
Measuring the Average Collection Period for Sales Receipts
The average collection period measures the length of time it takes to convert your average sales into cash. This measurement defines the relationship between accounts receivable and your cash flow. A longer average collection period requires a higher investment in accounts receivable. A higher investment in accounts receivable means less cash is available to cover cash outflows, such as paying bills.
The average collection period is calculated by dividing your present accounts receivable balance by your
Average Collection Period =
The average daily sales volume is computed by dividing your annual sales amount by 360:
| Average Daily Sales = | Annual Sales 360 |
Using the annual sales amount and accounts receivable balance from the prior year is usually accurate enough for analyzing and managing your cash flow. However, if more recent information is available, such as the previous quarter's sales information, then use it instead. Be sure to compute the average daily sales correctly using the number of days actually reflected in the sales figure (e.g., 90 should be used if a quarterly sales amount is used).
Example
David owns and operates an auto supply and repair shop. David's total annual sales amount from the previous year was $200,000. The total balance of his accounts receivable at the end of the same year was $20,000. David's average collection period is calculated as follows:
David's average daily sales volume is $556 per day:
| $200,000 360 | = | $556 |
The average collection period is 36 days:
| $20,000 $556 | = | 36 |
For David's previous year, each dollar of sales was invested in accounts receivable for 36 days. Assuming that David's business has not changed drastically from last year, the cash inflows from sales on account will not be available for cash outflow purposes for 36 days.
