Accounts Receivable Turnover: Why It Matters

Accounts Receivable Turnover Paid Invoices

As a business owner, you probably have numbers running through your head all the time as it is. But, it’s important to add another calculation to your list — accounts receivable turnover — to help complete your cash flow picture.

At PayPie, we know how difficult it can be to stay on top of every sum, ratio and forecast of your accounts, no matter how diligent of a business owner you are. That’s why we try and make it simpler with insightful tools that delve deeper into your finances, rather than showing you your account balance and nothing else.

Together, we can add this calculation to the list.

What’s accounts receivable turnover?

When you invoice a customer and set the terms of payment, you’re essentially creating a form of credit.

Customer credit is a vital payment method for any business — it lets your customers buy goods or services from you now and fully pay for them later. Therefore, it can drive sales, but it can also be a detriment to your cash flow if some of your customers fail to pay in full, even with time to do so.

Accounts receivable turnover analyzes just how well you’re dealing with outstanding customer credit. The simple ratio, also known as the accounts receivable turnover ratio or debtor’s turnover ratio, gives you an insight into how customer credit affects your business.

Mainly, it points out how well you’re managing your customer credit relationships and collecting the proper payments on any outstanding debts your customers are carrying.

Read More: 7 Ways to Boost Cash Flow

How accounts receivable turnover is calculated

Jot down this ratio — or bookmark this page — so you remember it from now on:

Accounts receivable turnover = net credit sales ÷ average accounts receivable during the tracking period

Be sure you’re only incorporating your credit sales since cash payments have nothing to do with the effectiveness of your crediting scheme.

This ratio is often calculated on an annual basis. However, it can also be measured on a quarterly or monthly basis.

accounts receivable turnover ratio calculation

An example of how to calculate accounts receivable turnover

The following is an example of how to calculate accounts receivable turnover on an annual basis.

Let’s say Widgets Incorporated had $1,000,000 in accounts receivables as of January 1, the start of their fiscal year. On December 31, at the end of the year, they had $2,000,000 in accounts receivables.

Throughout the year, they had a total of $5,000,000 in net credit sales.

Step 1: To get the average accounts receivable, you follow the same formula that you would for any average. You add both numbers together and divide by two.

Average accounts receivable = ($1,000,000 + $2,000,000) ÷ 2 = $1,500,000

Step 2: Take the net credit sales and divide it by the average accounts receivable.

$5,000,000 ÷ $1,500,000 = 3.33

Step 3: Divide 365 (number of days in a year) by the accounts receivable turnover to see how long it takes an average customer to pay their bill.

365 ÷ 3.33 = 109.6

This means that the average Widgets Incorporated customer takes nearly 110 days to pay their bill. Clearly, this needs to be fixed. The company makes great widgets, but they’re a bit too generous with their payment periods and need to ramp up on collections.

Accounts Receivable Turnover Ratio

How accounts receivable turnover is used

You can’t predict future sales or cash flow with 100% accuracy, but the accounts receivable turnover ratio gives you deeper insight into your business prospects. The ratio shows you how long it takes customers to pay their debts, which can help you plan your future expenses.

By pinpointing any collections problems your company faces, you can boost cash flow back into the business. This will help you foster future growth for your company and focus your efforts to cultivate a client base that’s financially robust and responsible.

Read More: Cash Flow Basics — Key Concepts and Terms 

Why accounts receivable turnover matters

Your ratio can reveal whether or not your company has a good credit policy. It also shows how well you’re managing any outstanding debts. A low accounts receivable turnover ratio might deter lenders from working with you. Without available cash flow at the right points in time, how will you repay your debts?

If you’re unhappy with the ratio you find, you can implement new policies to boost your figures. For example, a low ratio might require you to impart more stringent penalties on late payments. Or, you could come up with a rewards program for those clients who always — or begin to — pay on time.

Read More: Cash Flow Problems: 6 Top Causes

Evaluating your accounts receivable turnover

What’s a good turnover ratio and what represents opportunities for improvement? When it comes to the account receivable turnover ratio, the higher the number, the better. A sizeable figure can highlight plenty of good qualities about your business, including:

  • You’re regularly receiving debt payments, thus boosting cash flow.
  • Customers pay you back fast, which means they don’t have an outstanding line of credit and can buy more from you.
  • You have a good customer base that adheres to invoice due dates rather than taking on debts
  • Your collection system works well.

On the other hand, you might calculate your account receivable turnover to find a very small number after the equal sign. If so, your low ratio could indicate that:

  • Your cash flow is low since your customers have lingering debts.
  • Customers can’t make payments, which means they likely won’t buy again in the future.
  • You have an overly lenient credit scheme.
  • Your collection system is ineffective.

Fortunately, once you see where you fall on this spectrum, you can start making some of the improvements mentioned above to your crediting scheme. Or, you can keep moving forward if you’ve already got a system that’s proven to work.

If you experience a cash flow shortage while you’re working on improving your accounts receivables processes, invoice factoring is one way to turn an unpaid invoice into cash. Basically, it lets you sell the invoice to a buyer/lender so that you can get a set percentage cash out of the invoice as quickly as possible. (Learn more about invoice factoring here.) 

How accounts receivable turnover affects cash flow

It’s clear how a positive accounts receivable turnover would boost cash flow. If customers are diligent about repaying their debts — and if you incentivize their behavior or penalize lateness — you’ll have more cash pumping into your company.

On top of that, your regular customers will keep coming back, since they’re regularly repaying and re-opening their lines of credit. The more good payments you’re receiving, the better your cash flow will be.

Cash flow is vital to your business— when money comes in on a reliable and regular basis, you can expand your reach and seize opportunities in countless ways. And, while the accounts receivable turnover ratio is one way to figure out how you can boost the amount of cash on hand, you will also benefit from a cash flow forecast from PayPie.

This report takes a deep dive into your accounts receivables to show you just how healthy your business is right now and how much it’s set to grow in the future. It helps you visualize your strongest suits, as well as the areas in which you can improve.

If you’re a business owner, then there’s no better time than now to start forecasting and planning for the future.

Log in — and crunch some numbers of your own — to get on the right track.

PayPie currently integrates with QuickBooks Online. Additional integrations are coming soon.

This article is informational only and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional. 

Images via Shutterstock and Pexels.

Cash Flow Basics: Key Concepts and Terms

Chalk board stock image for Cash Flow Basics Explained

A majority of the businesses around the world are small businesses. According to OECD data, the figure is 99%. Another thing they have in common is cash flow problems. Regardless of whether a business is in an advanced economy, emerging area or somewhere in between, cash flow and cash flow basics are a universal lifeblood and stumbling block.

In the United States alone, most small to medium-sized businesses (SMEs) only have enough cash on hand to cover 27 days of normal costs of doing business. Even the superstars, the top 25% of SMEs only have two months of cash reserves to fund their businesses.

At PayPie, we don’t believe that any SME ever intentionally overlooks its cash flow basics. It’s just matter of finding the right resources to explain the concepts and the best tools to manage financial health.

That’s why we’re providing an overview of some of the basic cash flow concepts and terms. It’s not a glossary so the words won’t be in alphabetical order. Instead, they’ll be grouped by concept in order to add context to each explanation.

Cash flow is the amount of money that moves in or out of a company.

Cash flow basics 101 — A definition of cash flow 

In its simplest form, cash flow is the amount of money the comes in or out of a company. A primary indicator of financial health, cash flow shows how efficiently a business is running and if that business is able to pay its bills and keep the lights on.

A business that’s cash flow positive has enough money available to meet its current and most-pressing financial obligations. A business that’s cash flow negative has more debt than income and might struggle to meet its financial responsibilities.

There are instances where a company is cash flow negative and is doing so intentionally, such as going through a launch or investment phase. However, in most cases, unless it’s planned or managed, most businesses would prefer to be cash flow positive.

Inflows, outflows and everywhere your cash goes

Income earned through sales, assets that can easily be converted into cash and funding, are called inflows. Cash used to pay for expenses and investments are referred to as outflows.

Some more cash flow basics every business should know are the difference between recurring cash flows and one-time cash flows.

A recurring positive cash flow is a predictable, reliable income source, like retainer or subscription fees billed to customers, while recurring negative cash flow is a consistent expense, like payroll.

A one-time positive cash flow (sit down for this) is a singular influx of cash. One example would be cash from the sale of equipment, land or facilities. A one-time negative cash flow would be a large purchase or expense, such as an insurance deductible for flood damage.

In the same vein, a fixed cost is something like leasing costs for office or retail space. No matter how many widgets you sell, you’re still paying a set rate for your kiosk. This is another shocker: A variable cost changes. These are things like fuel, utilities and raw materials.

Long story short, in most cases, you want your recurring positive cash flows to be greater than you recurring negative cash flows. You also want to be aware of your fixed costs and do as much as you can to control or plan for changes in variable costs.

Get more tips: How to read a cash flow statement.

A cash flow statement explained

There are three fundamental financial statements for tracking and measuring a business’ financial health:

  • Cash flow statement (statement of cash flows)
  • Profit and loss statement (P&L or income statement)
  • Balance sheet (statement of financial worth or net worth)

As per its name, a profit and loss statement compares revenues against costs and expenses to determine if a company is profitable. A balance sheet compares what a business owns to what it owes in order to indicate the amount of working capital, cash reserves available to cover near-term commitments and recurring expenses.

A cash flow statement brings information from the profit and loss statement and balance sheet together by analyzing the flow of cash through the company in terms of day-to-day operations, capital investments and financing activities. (This is one of those cash flow basics to remember.)

  • Operational cash flow literally includes all the nitty gritty expenses (labor, inventory, etc.) that go into making and offering the goods and services a business provides.
    • It also includes accounts receivable and payable (ingoing and outgoing invoices).
    • Current assets and liabilities are two key terms related to this concept.
      • Current assets (counted as part of your inflows) include your cash on hand and any assets that can be quickly sold to generate cash within 12 months.
      • On the flip side, current liabilities (tracked as outflows) are your expenses that must be paid within 12 months.
    • Investment cash flow represents the purchase of long-term assets, like buildings and equipment.
    • Cash flow from financing activities is the money that comes from loans or lines of credit. Depending on your business model, this can also include investors.

Every business financial statement has a specific function. What a cash flow statement does differently is that it helps identify patterns in terms of how and when money is coming into or leaving a business.

Publicly traded corporations have to share their cash flow statements. The average small business doesn’t. Instead, for SMEs, its cash flow basics and measurements are vital financial management tools.

While business models and structures vary, most SMEs will pay the most attention to operational cash flow as part of their cash flow analysis and forecasting.

A cash flow statement combines info from the P&L statement and balance sheet

The direct versus the indirect method of reporting cash flow 

The difference between cash and accrual accounting and how each one calculates net income lies at the heart of the direct and indirect methods for reporting operational cash flow.

Operational cash flow is singled out because it’s the main areas affected by differences in how inflows and outflows are tracked. Warning: It’s a little dry for the next few paragraphs, get ready to skim…

  • Net income is the total amount of money a company has left once all other expenses are taken out.
  • The cash method of accounting tracks income and expenses as they take place.
  • The accrual method includes future income and expenses before they’ve actually hit the company’s books.

Businesses that use cash-based accounting are able to easily use the direct method. This is because they’ve already tracked the actual cash movements in and out of the business as part of the net income.

As most small businesses use the accrual system, the indirect method requires that flow of cash be added back in when net income is entered into the cash flow statement.

When you use the indirect method, you have to account for the actual amounts that come in and out, like accounts receivable (money coming in from customers) and accounts payable (the money you owe to others).

And that’s more detail than you probably ever wanted to know about the direct and indirect method. (So much for just cash flow basics.) Big picture: Whether you scramble or poach your eggs, in the end, you’re still eating eggs.

If you’re curious, when you request a free cash flow forecast from PayPie, we use the indirect method in our calculations.

cash flow basics cash flow management

Cash flow management and monitoring — the basics

One of the cash flow basics that every overview should cover is all the terms that relate to management and monitoring. Cash flow management refers to the entire process of monitoring your cash flow from the creation of cash flow statement to analyzing the results.

The process starts by creating a weekly or monthly cash flow statement. Once the statement is complete, you can perform a cash flow analysis or deep dive on the numbers.

Cash flow forecasting (cash flow projections) are the inferences and predictions drawn from the regular creation and analysis of cash flow statements. A cash flow forecast is a report that contains these interpretations.

Then there’s a cash flow budget that compares the projections in a cash flow forecast with the actual numbers reported in your cash flow statements.

When you bring all these details together to determine how much cash moves in and out of your business and when it happens, you have a cash flow cycle (cash conversion cycle).

It’s sort of like a Russian nesting doll with the cash flow statement as the smallest doll and forecasting and budging being the next sizes up. Each level of detail and analysis builds up to create a larger whole.

Learn more about cash flow and financial health. 

Cash flow versus profitability — what you really need to know

The more you read about cash flow and cash flow basics, the more you’ll see discussions on the difference between cash flow and profitability.

What you need to know is that profitability just means that there’s money coming in. On the other hand, cash flow shows the money coming in and going out. Cash flow helps you determine your break-even point when the amounts coming in equal the amounts going out.

Profitability is only one side of the coin. A business can be making money, but money can also be leaving a company at a rapid or unexpected rate. It happens — more often than anyone would like.

Here’s an example: Jane’s bakery, Cake-and-Bake, is extremely popular. She’s got so many orders, she can barely keep up. Since business is booming, she bought a few more industrial mixers and hired more staff.

What she didn’t do was project was how much cash was coming in from the current and future orders — before buying new equipment and hiring more people. The result: She went too far beyond her break-even point. She found herself low on dough (pun alert) because the cost of the mixers and the new staff members was more than amounts coming in from existing orders.

Short-term liquidity versus long-term solvency  

Liquidity and solvency are often mentioned together, especially in discussions on business financial health. The key takeaway is that liquidity is a short-term measure of your ability to pay your bills.

Solvency is the long-term measure of your ability to keep your company running over time. It’s often used as an indicator of the overall viability of your business model.

Most areas within a cash flow statement and forecast focus on liquidity. This is especially true for operational cash flow, where most of the current assets and liabilities are tracked.

Solvency is often evaluated in terms of debt levels and equity (primarily recorded in cash flow from financing activities). It measures how much ownership the company and its founders have retained in comparison to outstanding loans and/or investor and shareholder agreements.

Take a bow… you’ve just covered some of the basics of cash flow.

It wasn’t that bad, was it? One more concept that’ll change how you see your cash flow basics is automation. You don’t have to build spreadsheets or toil away endlessly to create cash flow forecasts. With PayPie, you can use the information you already have in your accounting software to create easy-to-read cash flow forecasts.* Learn more and get started today.

*PayPie currently integrates with QuickBooks Online. Additional integrations are coming soon.

This article is for informational purposes only and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.

 

Image via Pexels.