Accounts receivable and cash flow are intimately intertwined. For many businesses, accounts receivable are the primary source of cash flow, so it is critically important that they are managed rigorously and proactively. An unexpected cash crunch can put a real strain on your business. It can damage your relationships with your suppliers, it can hurt your creditworthiness, and in the worst-case scenario it could even put you out of business.
In June, we wrote about best practices for accounts receivable management, which offered key suggestions like:
Remind customers about payment dates, both before and after the due date
Make it as easy – and desirable – as possible for customers to pay
Once you have put processes like these in place, though, you will need to consistently ask yourself “are my accounts receivable practices working?” Even the best A/R practices require monitoring and optimization if you want to ensure that your cash flow is predictable and reliable.
If there is a problem in your accounts receivable process, it will affect your cash flow, period. So it is critical to regularly evaluate your A/R using accounts receivable analysis to anticipate and/or zero in on problems so you can take steps to correct them before they lead to a cash crunch. By using A/R analysis tools, you can take a deep look inside your accounts receivable to answer many important questions about the current health of your business and any future risks it may face.
Let’s discuss just a few of the important questions that regular, rigorous A/R analysis can help answer and address:
“WILL I HAVE ENOUGH CASH ON HAND TO MEET SHORT-TERM NEEDS?”
This is a key question for cash flow management and forecasting, and A/R analysis can help answer it. One commonly used analytic is the average collection period (often called DSO – Days Sales Outstanding), which measures how quickly your customers are paying. The formula is:
ACP = (average accounts receivable in period/total value of sales in period) x (days in period)
Interpretations of the result will vary, but a fairly standard one is that DSO should be less than a company’s standard collection terms plus 33%. So, if you usually require payment within thirty days, the period for the formula would be 30 x 1.3, or around forty days.
A number less than the DSO can indicate that payments are coming in quickly and you should have enough cash on hand to meet short-term needs. A number higher than the DSO, however, could indicate problems and alert you that a cash crunch could be on the horizon, and you need to take action.
“AM I COLLECTING RECEIVABLES IN A WAY THAT SMOOTHS OUT CASH FLOW?”
The fancy way of saying this is “how efficiently am I collecting my receivables?” The more efficient your collections, the less likely you are to face a sudden shortfall at just the wrong moment, so regularly assessing your process efficiency can be very valuable. A common metric for assessment is accounts receivable turnover (ART) ratio. The formula is:
ART in days = 365/(net credit sales/average accounts receivable)
Just like with ACP, it is common to compare the average turnover in days to your standard payment terms in days. So, the lower your ART is versus your standard payment terms, the more efficient your receivables process is, while if your ART is higher than your standard payment terms, your process is inefficient (your customers tend to pay late) and your cash flow will tend to be choppy.
“WHICH INVOICES ARE CAUSING MY COLLECTION PROBLEMS?”
If you find that your accounts receivable are in fact causing cash flow problems, or at least putting you at risk, you’ll want to see if there are specific invoices or customers that are at the root of the problem rather than systemic process issues you need to address. A common analytical tool to determine this is the aging report. This report simply breaks your past due invoices down by age or payment period. Invoices that go unpaid for long periods are detrimental to efficient cash flow, and therefore the specific customers that are slow to pay them may be a detriment to your business. These are the customers that – as part of your cash management process – should be flagged and potentially handled differently than your more reliable customers. Consider requiring payment up front from them in order to smooth out your overall cash flow, or even simply stop serving them if it becomes too much of an issue.
“ARE MY CREDIT TERMS TOO LOOSE, OR TOO TIGHT?”
Extending credit is a means of increasing your sales by giving your customers flexibility around their own cash flow, but you can’t just give everybody credit or you’ll almost certainly end up awash in write offs and eventually out of business. Finding the right balance to maximize profits and minimize losses can be tricky, but accounts receivable analysis can provide helpful insights.
One useful resource is the aging report we just discussed. If you have a lot of customers with past due invoices, you may need to tighten up your credit terms. Another more data-driven method is a trend analysis of bad debt percentage. There is more than one way of calculating bad debt percentage, but the key here is to choose one and then look at over time – twelve months, for example. Is it increasing? That’s a good indicator that your credit terms are too loose. But if it’s decreasing, it indicates that you might actually be able to safely increase sales by loosening your terms a bit.
For any business that extends significant credit to its customers, rigorous accounts receivable management is a must. But even when you have a quality collections process in place, you still need to regularly apply accounts receivable analysis to see if improvements can be made, and if there are any potential looming risks that you might not have otherwise noticed. We’ve discussed just a few of the possible questions that A/R analysis can help you answer – don’t hesitate to ask your accountant or bookkeeper for more.