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Managing receivables
Managing your accounts receivable helps you to improve cash flow for your small business. Accounts receivable are assets that are owed to you by your customers.
Managing your receivables is a bit of a balancing act: you want to convert them into cash as soon as possible without alienating your customers in the process. An overly aggressive collection effort might backfire. Not offering trade credit to your customers deprives you of additional sales opportunities.
You can monitor the performance of your accounts receivable by doing a periodic ratio analysis. The two main ratios for evaluating how well you manage your receivables are the receivables turnover ratio and average number of days of receivables outstanding (days receivable):
- Receivables turnover ratio. The receivables turnover ratio measures the number of times your business "turns over" its receivables in a year. It is a measure of the operating efficiency of your small business. Since the more frequently you turn over your receivables the better, a higher ratio is preferable.
To calculate receivables turnover, divide sales by average accounts receivable. You should include only receivables that result from the sale of your product or service. The following table shows how Alpha Beta Co., a maker of widgets, improves its receivables turnover ratio to 7.5 from 4.1 over the five-year period ended in 2003:
| Alpha Beta Co. |
2003 |
2002 |
2001 |
2000 |
1999 |
| Sales ($000) |
$1,500 |
$1,300 |
$1,200 |
$1,100 |
$1,000 |
| Avg. receivables ($000) |
$200 |
$220 |
$210 |
$255 |
$245 |
| Receivables turnover (times) |
7.5 |
5.9 |
5.7 |
4.3 |
4.1 |
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- Average number of days of receivables outstanding. Average number of days of receivables outstanding (days receivable) measures the number of days it takes, on average, to collect your accounts receivable. This ratio is simply the inverse of the receivables turnover ratio.
To calculate days receivable, divide the number of days in a year (365) by the receivables turnover ratio. Since the fewer the number of days to collect the better, a lower figure is preferable. The following table shows how Alpha Beta improves its days receivable over the same five-year period:
| Alpha Beta Co. |
2003 |
2002 |
2001 |
2000 |
1999 |
| Receivables turnover (times) |
7.5 |
5.9 |
5.7 |
4.3 |
4.1 |
| Days receivable (days) |
48.7 |
61.9 |
64.0 |
84.9 |
89.0 |
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As these two tables show, looking at trends over several years helps in forecasting cash flows and identifying ways to further improve cash flow.
An aging schedule is a useful way to evaluate your receivables that are past due. The schedule helps you identify and monitor receivables that are the most problematic. If you decide to write off those receivables, the schedule helps to quantify the amount of a potential write-off. The following aging schedule is for Alpha Beta's accounts receivable at the end of 2003:
Alpha
Beta Co. |
30-45
days |
46-60
days |
61-90
days |
Over 90
days |
Total |
| $ (000) |
$120 |
$40 |
$30 |
$30 |
$220 |
| Share (%) |
54.6 |
18.2 |
13.6 |
13.6 |
100.0 |
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The table shows that 13.6% of Alpha Beta's receivables are more than 90 days past due. If Alpha Beta has a collection policy of writing off receivables that are past due 120 days, it may lower its forecast for cash flows 30 days from now based on the chance that some of these receivables will be written off.
Rather than tie up limited resources, Alpha Beta can hire a collection agency to collect on accounts that are delinquent. To manage its accounts receivable in the future, Alpha Beta might consider using a factor. Factors are companies that specialize in buying accounts receivable. In exchange, factors pay a discounted value of the receivables to the company selling the receivables.
Next Topic: Managing inventory
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