Isn’t it a great feeling to see that you’ve just made a new sale?
But as you’ve perhaps noticed it takes time to see those money being deposited into your bank account. This delay has something to do with how most product businesses operate. In particular – the accounts receivable process.
Here’s a quick example to illustrate this. When you order an item online, through big sellers like Amazon, or even through a smaller company, you pay for that item (and any shipping costs) in advance of its delivery. If you use a debit card, then the seller immediately receives a money transfer from you.
If you use a credit card, then you are under the rules of the bank, which means you make payment when they bill you. As a result we have this situation:
- To the company who sold you the product, you are listed as revenue
- To the credit card company, you still owe, you are counted in the accounts receivable column on their balance sheet.
As a business owner, you may find yourself engaging in the same types of transactions as you sell products or services. And you certainly keep track of how much you sell, your inventory turnover, the costs of goods sold, etc. Most likely you are already recording and documenting all of these things on your many financial reporting forms, so that you can see the state of your company’s financial health.
Keeping track of your accounts receivable and the health of collecting on those receivables is directly related to how much free cash flow you have to keep and grow your business.
What is Accounts Receivable: A Definition
As a business, you can choose two options to get paid.
First, you can invoice clients upfront (that is before any goods or services are delivered to them). That’s what Amazon and other e-commerce companies do. First, you place an order and send the money. Then you receive your box of goods.
Service businesses typically do not charge the full amount upfront. Asking a 50% deposit from the client is okay, but most set their invoice payment terms to “due on receipt”. That is the client has to pay up just after they received the service. Got a haircut? Now go on and pay at the cash desk.
The second option is extending credit to customers. When you do that, you are counting on your customers to pay at some future date, usually determined by you as a payment term. You deliver the product or service and then you invoice the customer and state the due date for the payment, for instance within 30 days.
Until you actually receive payment, the amount a customer owes you is placed in your balance sheet under the term “accounts receivable.” It is actually an asset on the balance sheet, because you do anticipate that the money will be coming in. Once it comes in, it is transferred over to actual revenue.
So the proper accounts receivable definition is the sum of money owed to your business for goods/services delivered or used, but not yet paid for by the customer.
The Difference Between Accounts Receivable and Accounts Receivable Turnover
Now that you know what accounts receivable are, you also should be looking at your accounts receivable turnover. In short, this is a term that defines how often, on average during a reporting period, you collect on those receivables.
You might be asking why this is even important to know. Well, this figure can tell you how often, on average, you are sending out invoices and actually getting paid.
The important consideration in accounts receivable turnover is something known as the accounts receivable turnover ratio.
What Accounts Receivable Turnover Ratio
So the turnover ratio will evaluate your ability to issue credit to your customers and then to collect funds within a reasonable time frame. Usually, this ratio is calculated on an annual basis. Although it can also be done on a quarterly basis, in order to compare the efficiency of your collection efforts with previous quarters.
If you have a high accounts receivable turnover ratio, in general, your collections methods are efficient, and your invoices are being paid on time.
If your turnover ratio is low, however, it means that you are not collecting what is owed in a timely manner, and you may need to fix that. Start with sending out regular payment reminders and perhaps consider more aggressive methods of debt collection if you still cannot recuperate all your dues.
How to Calculate Accounts Receivable Turnover
Like most everything else in business finances and reporting, there is an accounts receivable turnover formula. It’s relatively simple, and you can make these calculations yourself. The formula is this:
Net Annual Credit Sales ÷ Accounts Receivables = # Times
Let’s define each term.
Net Annual Credit Sales are the total of sales that you have made on a credit basis during the reporting period, usually one year. But you can shorten this to quarters, if you wish. Remember, you also need to modify net annual credit sales if you have had returns, made monetary allowances, and given discounts. Subtract all of those things from gross credit sales. Your net credit sales should be taken from your income statement. Note: this figure should never include cash sales.
The accounts receivable figure comes directly from your balance sheet. This is the amount of debt from customers that is still owed but not yet paid.
When you divide the net credit sales by the accounts receivables, you get a result. And that result is the number of times each year (or quarter) that you collect or clear out all the receivables. There is an important caveat in determining receivables, however, and that will be explained in the example below.
Accounts Receivable Turnover Example Calculation
Sally runs a business that sells fabrics to interior design companies that produce such things as draperies, pillows, furniture coverings, etc. At the end of last year, her net accounts receivables were $10,000. This year they were $15,000. Her net annual credit sales this year were $90,000. To use these figures in the formula, the process would be as follows.
$90,000 ÷ $12,500 ($25,000 ÷ 2 to get average for the 2 years) = 7.2.
Sally has thus collected on accounts receivable 7.2 times.
Now take 365 days a year and divide it by 7.2 times. This figure is 50.69 days. She is not collecting often enough – not too good. It means that Sally’s average customer is not paying for almost 51 days – ouch, that’s not great for her cash flow.
Sally has some work to do to increase that ratio. She needs to collect more often than every 51 days.
If you have ended up with a number close to Sally’s, below are some helpful tips to help you get back on track.
What Can You Do To Improve Your Accounts Receivable Turnover
A low ratio probably means that your payment collections are not quite effective. Or that your customers may find paying on time a big challenge e.g. due to their long corporate buying cycles. Also, you may be giving credit too leniently, and customers are taking advantage of this.
You need to tightened up your payment policies, and here are several things worth doing:
Look at the payment rates of your customers individually. Instead of imposing new payment terms for all customers (including those who are paying up within a reasonable period of time), focus on the late payers. This approach is known as A/R Aging Report.
Figure out what to do with them individually. You may choose to either cut off those companies who are seriously in arrears. If they are struggling to pay their invoices, it is unlikely that they will be adding new purchases to debt they can not pay. If they do, then you cannot allow the purchases until arrears are made up.
Consider pre-authorized checks or some type of automatic deductions:
- For customers who are typically late, you can begin to require payment up-front.
- Review your credit terms. Consider issuing a small discount for payment within 30 days or late fees when not paid within 30 days. But be sure to balance these behaviors against those in your industry, to ensure that they are reasonable.
Automate invoicing as much as possible. Once you send the first invoice (which should accompany the shipment of product), payment receipts should be automatically documented. You can also send auto-reminders a few days before an invoice is due. When payment does not come in, tune your email client to send out automatic payment reminders. Pester the client with them up till you receive the payment.
Knowing your accounts receivable turnover rate is important. It will give you some key information about the efficiency of your revenue collection processes and point out whether your accounts receivable are at a decent rate for the industry and for your own cash flow health.
Use the formula above to determine your turnover ratio. If it is not comparable for the industry or if it is not satisfactory for your own cash flow needs, take a look at the steps that you may want to take to improve that ratio.
Everyone likes to receive payment on time. And you should be no different. Take stock of your accounts receivable and do what will make your revenue collections as efficient and successful as possible.
Image by Michal Jarmoluk