Back to Basics: Accounts Receivable

Accounts receivable is the amount of uncollected revenue for which the company is expecting to receive payment from its customers.  It represents the largest and most accessible source of non-financing cash that the company has available.  It is the last stage in the cash cycle before an item becomes cash once again.

Given that A/R is the closest to cash of all other items on the Balance Sheet, it is the most important item to manage next to cash.  There must be a concerted effort to manage A/R each and every day.  Unfortunately, experience has proven that most managers do not attempt to manage A/R with more than a passing thought until there is a problem with cash or a question arises regarding the validity of the recorded balances.  Usually, by the time a problem is recognized, the possibility of a full recovery of the cash collection potential is remote.  You must understand that the vast majority of all adjustments to A/R will have a direct impact on your bottom line and therefore your future cash flow.  An adjustment to the A/R balances will, in almost every case, result in an adjustment to revenue in one way or another.  An account that has been determined to be uncollectible will be recorded as bad debt expense and will directly reduce the company’s profit.

Mismanagement (or truly non-management) of accounts receivable has been the death of many otherwise viable companies.  Without a thorough understanding of the dynamics present in the A/R of your company you cannot be confident of any performance information produced.  With a large adjustment resulting from the fallout of an unforeseen A/R problem, any recorded profits can be completely eliminated in an instant.  Without warning, very large chunks of what was thought to be future cash flow can evaporate unexpectedly leaving the company extremely vulnerable.

Using a Collections Model to Understand Cash Inflows

It is a fact that some customers pay quickly, some delay as long as possible and most are somewhere in the middle.  An effective way to determine the period of time over which the total revenue for a given month will be collected is to look at the accounts receivable profile.  Basically, the accounts receivable profile is the standard amount of revenue that is left in the A/R aging at different points in time compared to the amount of revenue originally billed.  Because amounts from several months may become blended over time, you need to make certain judgments about how much revenue is remaining in later aging buckets (60, 90, 120 days) from those prior months. 

Although the average number of days required to collect $1 of revenue can be determined by calculating the DSO (Days of Sales Outstanding—a common accounting ratio), this does not give the whole picture.  DSO is essentially an average, which means that 50% of the cash is collected more quickly and 50% will take more time to collect.  Although this is a good way to see the point in time at which the first half of a specific month’s revenue will be collected, it will not help much to answer the question about the collection rate on either side of that point.  The reality is that revenue is collected over time – there remains less and less of a particular month’s revenue to be collected as time passes, which obviously means there has been more and more of that revenue collected during the specific timeframe.  It can be assumed that all of the revenue is expected to be collected at some point or that a specified percentage will be lost to bad debt or some other adjustment.  It is the rate of collection (by month) between the initial billing date and the day on which the final $1 has been collected that you are looking to identify. 

Once the collection rates are determined, they can be very neatly applied to the revenue for each month and layered onto the collection streams for all other monthly revenues to determine the blended cash receipt estimate for any future month.  This approach has proven very effective for accurately estimating the monthly collection amounts over extended periods.

Revenue Mix and Staff Utilization: Do You Know the Relationship?

In many cases companies (managers) believe that because revenue has not changed significantly or the overall production levels are comparable from period to period that the staffing requirements are the same.  When, in fact, the time required to produce or support one type of revenue can be radically different from that required for another.  It is the mix of these underlying activities that determines the staffing needs of the organization.  If you are only looking at the combined values you could be seriously mismanaging what is arguably the largest controllable expense you have.  Given the expense profile in many companies, this would mean that even if you are focused on managing EVERY other aspect perfectly, your management approach could very well be doing more harm than good.

Never, Ever Pay Early?

Normally, your vendors will have terms established for the payment of their invoices presented for the delivery of their respective products or services.  In order to maximize cash flow, you should attempt to extend the payment a minimum of a week or two beyond those established terms.  In most cases it should be possible to delay payments due within 30 days to 45 or even 60 days before any difficulty would develop with the vendor.  Manage the account relationship by managing the expectation for the timing of your payments.  Communication is the key.

Apart from the fact that you are a nice person and may feel a need to make people happy, why would you pay early?  What benefits are being derived?  The harsh reality is that unless there is a clear, compelling reason for making early payments to anyone (cash discounts, pricing discounts, special delivery arrangements), DO NOT do it.  Hold on to your cash as long as you possible can by closely managing accounts payable.  Take as long as you possibly can to pay your company’s bills without incurring late fees or impacting your ability to operate.  Because your vendors provide the items that are crucial to the operation of the business, these relationships should be managed carefully.


Certainly, if sufficient cash is available to meet the other obligations of the organization, take full advantage of all cash discount opportunities.  The relative returns from cash discounts are usually quite significant and are well worth the extra effort required to manage shorter payment timeframes.  For example, assume a vendor offers a 2% cash discount for payments received within 10 days as opposed to the normal 30-day terms (2 10, net 30) and your company’s standard payment cycle would dictate that payment be made in 40 to 45 days.  By making the payment within the discount terms you are losing the use of the funds at least 30 days sooner than would otherwise be the case.  However, the company realizes a 2% return for the use of those funds over the one-month period, the equivalent of a 24% annual return (2% x 12 months).  There are very few investment opportunities that offer such attractive returns with the certainty of a cash discount.  This is obviously one of the clear and compelling reasons for paying early.

For help evaluating the impact of this and other financial decisions on your future profitability, visit The Profit Experts.

The Trap of “Latest and Greatest”

Be careful that you do not get drawn into the “latest and greatest” technology myth.  There is absolutely no need to consume company resources for the sole purpose of having the most current technology unless there is a clear benefit to the operation.  Be diligent in matching purchases to both the current and the anticipated needs based only on the company’s operating plan.  Do not spend one dime that you do not have to – you will need it someday. Ask yourself: What type of technology or level of capacity is required by the specific application for which you are making the purchase?  Not only is it not necessary to purchase a $20,000 server when a $2,000 desktop PC will do the job, it is irresponsible.