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.