EBITDA and Other Scary Words: Scary Word No. 4 – Accounts Receivable
"This article originally appeared on Financial Poise and is reprinted here with permission."
A guy walks into a bar and asks the bartender for a drink. The bartender gives him the drink and tells him how much he owes him and the guy says, “Put it on my tab.” And this brings us to our next scary word: “Accounts Receivable” (wait; that’s two words). Accounts Receivable or “AR” (now it’s one word and not so scary) is exactly that, “the tab.” It is the money owed to a business by its customers in exchange for goods received or services provided.
Unless you operate your business on a cash-and-carry basis (and many do), AR is a significant part of your business and an integral component of your company’s financial statements. AR is shown on your company’s balance sheet as a current asset probably right under cash as it is one of the more liquid assets. AR also plays a significant role when looking at the overall health of your business or applying for financing. That said, it is very important to do periodic analysis of your company’s AR because you know what they say: “It’s all about perspective.” So, what do we mean by that? Well let’s say that a company has very low AR. One might look at it and take it as an indicator that the business collects its AR quickly, maintaining a steady cash flow stream. But at the same time, someone else may look at it and take it as an indicator that the business is not producing enough sales and therefore is not doing well. The exact opposite can be said about very high AR. One might say high AR is an indicator that a business is not collecting its AR quickly enough, causing cash flow problems; or that the business may have uncollectible AR sitting on the books. Someone else may see the high AR and say it indicates the business has a tremendous amount of sales and is doing very well.
So what can you do as a business owner to ensure you have healthy AR? The good news is you won’t need a degree in finance or mathematics to do it; there are several simple ways you can analyze your AR.
Determine who gets credit:
We are pretty sure that the owner of the bar knew the man who told the bartender, “put it on my tab.” Don’t just give any customer credit. Determine the creditworthiness of your customers by doing background checks. Set up payment terms based on customers’ creditworthiness and make sure they follow these terms. Periodically evaluate high risk or unreliable customers and change their credit terms as needed.
Review AR aging reports:
Many software platforms will automatically produce AR aging reports. The AR aging report is a very useful tool that will help you evaluate your receivables. The report will usually display unpaid invoices in aging buckets such as “current,” “30 days past due,” “60 days past due” and “over 90 days past due.” By doing a detailed review of this report you can determine which invoices are past due and in turn send out statements or make phone calls to your customers in order to help in your collection efforts. You can also determine which customers are slower in paying and consider changing their credit terms or making more frequent contact with these customers. You may even want to identify potential bad debts and create an allowance for bad debts.
The AR-to-sales ratio is a simple and quick ratio that will tell you the percentage of sales that are in your AR. To calculate this ratio you divide your total AR at the end of a period by your total sales for that period. It’s that simple!
AR turnover ratio:
The AR turnover ratio estimates how many times a year a company’s AR is collected. The lower the turnover rate, the longer receivables are being held, and the less likely they may be collected. Therefore, a low turnover rate may indicate that an allowance for doubtful accounts may be needed or even a direct write-off. To calculate this ratio, take your net sales for a period of time and divide them by the average AR for the same period. For example let’s say you have the following:
Net sales for the year — $57,500, AR beginning of the year — $7,700, AR end of the year — $8,900
57,500 divided by (7,700+8,900)/2 = 6.92
And there you have it! Your AR turnover ratio is 6.92 for the year. So on average in this example AR is collected approximately seven times a year.
Days in AR:
We talked a little about days in AR in our previous installment when we discussed scary word number 3: cash. The days in AR ratio indicates the entity’s average collection period or the number of days sales are not collected. The higher the ratio, the longer it takes for your AR to be collected. This can be an indicator that you may need to revisit terms with your customers or increase your collection efforts. To calculate this ratio, you divide the number days in the period by the AR turnover ratio from above, like so:
365 divided by 6.92 = 52.75
As you can see, in this example it takes almost two months to collect AR. In this scenario, it would probably be a good idea to review customers’ payment terms.
Understanding your industry is crucial when reviewing your company’s ratios. And incorporating seasonality is just as important! For example, if your industry average is an AR to sales ratio of .1, then you would want your AR to turn over about 10 times a year and you collect your AR in approximately 37 days. However, ratios can be deceiving when you have a seasonal product or service. If 50 percent of your sales are in December, then even though your AR to sales ratio is .1, your AR turnover is five days.
Another thing to keep in mind is the timing of your invoices. How quickly are you sending out an invoice after the goods are sold or the services are provided? A billing lag not only affects your AR, it also affects how fast you get paid. It is a good idea to minimize the time between the sale and the invoicing in order to more accurately match your sales and AR.
So there you have it. With a few simple tools, you can evaluate and analyze your company’s AR and improve your cash flow to help pay for some operating expenses; maybe even a bonus?!