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Analyzing the Factors that Affect Your Cash Flow

Filed under Cash Flow. Fact checked on May 24, 2012.

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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 daily sales:

Current Accounts Receivable Balance
Average Daily Sales
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.

Using the Average Collection Period

The average collection period can be used to determine the effect of different collection periods on your business's cash flow. This is best illustrated by the following chart.

Sales Per Day
Average
Collection
Period
$200 $300 $400 $500 $600
Investment in Accounts Receivable
30 $ 6,000 $ 9,000 $12,000 $15,000 $18,000
40 8,000 12,000 16,000 20,000 24,000
50 10,000 15,000 20,000 25,000 30,000
60 12,000 18,000 24,000 30,000 36,000

The above chart illustrates the effect that a change in the average collection might have on the investment in accounts receivable for your business. Remember, accounts receivable represent money that cannot be used for other cash outflow purposes. For example, assume that your average sales amount per day is $300, and that your average collection period is 40 days. Now assume that you were able to reduce your average collection period from 40 days to 30 days. From the illustration above, you can see that the reduction in the average collection period reduces the investment in accounts receivable from $12,000 to $9,000. This reduction generated an additional $3,000 in your cash flow.

Understanding Accounts Receivable to Sales Ratio and Receivable Aging Schedule

This ratio looks at your investment in accounts receivable in relation to your monthly sales amount. The accounts receivable to sales ratio helps you identify recent increases in accounts receivable. In contrast, the average collection period may only report accounts receivable information from the previous year, if that was the only information available to calculate it.

Using monthly sales information, the accounts receivable to sales ratio can serve as a quick and easy way to look at recent changes in accounts receivable. The more recent information of the accounts receivable to sales ratio will quickly point out cash flow problems related to your business's accounts receivable.

The accounts receivable to sales ratio is calculated by dividing your accounts receivable balance at the end of any given month by your total sales for the month.

Accounts receivable to sales ratio = Accounts Receivable
Sales for the Month

Example

Dick's accounts receivable balance at the end of the previous month was $15,000, and the total sales amount from that same month was $10,000. Dick's accounts receivable to sales ratio of 1.5 is calculated as:

$15,000
$10,000

Using The Accounts Receivable to Sales Ratio

At first glance, the accounts receivable to sales ratio might not seem like useful information. But, when you compute it each month and then look at the changes that occur as the months pass, the accounts receivable to sales ratio can signal potential problems in your cash flow. 

For example, an increase in your accounts receivable to sales ratio from one month to the next indicates that your investment in accounts receivable is growing more rapidly than sales. This is often one of the first signs of a cash flow problem.

Using The Accounts Receivable to Sales Ratio for Seasonal Businesses

A seasonal business experiences a large part of its annual sales in a particular part of the year. Comparing your accounts receivable to sales ratio to seasonal and nonseasonal months for the same year may provide you with misleading information because your business normally experiences a seasonal increase or decrease in the ratio. 

You can adjust your analysis by comparing your accounts receivable to sales ratio to the same month for the previous year or years.

Understanding the Accounts Receivable Aging Schedule

The accounts receivable aging schedule is a listing of the customers making up your total accounts receivable balance. Most businesses prepare an accounts receivable aging schedule at the end of each month. Analyzing your accounts receivable aging schedule may help you identify potential cash flow problems.

The typical accounts receivable aging schedule consists of 6 columns:

  1. Column 1 lists the name of each customer with an accounts receivable balance.
  2. Column 2 lists the total amount due from the customers listed in Column 1.
  3. Column 3 is the "current column." Listed in this column are the amounts due from customers for sales made during the current month.
  4. Column 4 shows the unpaid amount due from customers for sales made in the previous month. These are the customers with accounts 1 to 30 days past due.
  5. Column 5 lists the amounts due from customers for sales made two months prior. These are customers with accounts 31 to 60 days past due.
  6. Column 6 lists the amount due from customers with accounts over 60 days past due.

Accounts Receivable Aging Schedule Illustrated

The following is a sample accounts receivable aging schedule from Roth Office Supply:
Accounts Receivable Aging Report
Roth Office Supply
October 31, 2011
Customer Name Total
Accounts
Receivable
Current 1-30 Days
Past Due
31-60 Days
Past Due
Over 60 Days
Past Due
Quick Computer Supply $1,600 $ 300 $ 500 $ 500 $ 300
Kitchens by Voels 2,800 2,800 ---- ---- ----
Jansa's Sport Stores 1,000 1,000 ---- ---- ----
Bradley Farms, Inc. 1,600 ---- 1,600 ---- ----
TrueBrew Unlimited 2,000 1,100 500 400 ----
Enneking Enterprises 400 ---- 400 ---- ----
Hove and Sanborn LLC 600 600 ---- ---- ----
J. Siegel, CPA 1,200 1,200 ---- ---- ----
Total $11,200 $ 7,000 $ 3,000 $ 900 $ 300

Tip

If you're using one of the many available accounting software packages for billing and accounts receivable processing, check it first to see if it prepares the aging schedule automatically. Most accounting software packages will prepare an accounts receivable aging schedule at the touch of a button, but always check, and don't forget to solicit your accountant's advice.


Using the Receivables Aging Schedule

The accounts receivable aging schedule is a useful tool for analyzing the makeup of your accounts receivable balance. Analyzing the schedule allows you to spot problems in accounts receivable early enough to protect your business from major cash flow problems.

The aging schedule can be used to identify the customers that are extending the time it takes to collect your accounts receivable. If the bulk of the overdue amount in receivables is attributable to one customer, then steps can be taken to see that this customer's account is collected promptly. Overdue amounts attributable to a number of customers may signal that your business needs to tighten its credit policy toward new and existing customers.

The aging schedule also identifies any recent changes in the accounts making up your total accounts receivable balance. Almost every business has to deal with customers that are slow to pay; you should expect the same for your business.

However, if the makeup of your accounts receivable changes, when compared to the previous month, you should be able to spot the change instantly. Is the change the result of a change in your credit policy? Was the change in accounts receivable caused by some sort of billing problem? What effect will this change in accounts receivable have on next month's cash inflows? The accounts receivable aging schedule can help you spot these problems in accounts receivable, and provide the necessary answers early enough to protect your business from cash flow problems.

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