I sometimes hear from business owners that they are making a profit, but they don’t seem to have positive cash flow at the end of the year. What happened?
Your business may generate a positive net income, but if you aren’t monitoring other key cash flow drivers, then you can find yourself strapped for cash to meet the obligations of the business.
One of those drivers that can cause a lack of cash is your Accounts Receivable (A/R) collection cycle. It’s one of the four pillars that drive cash flow (along with Accounts Payable, EBITDA, and Inventory Days-on-Hand)
Your Accounts Receivable Cycle
Many businesses offer customers the ability to “Buy Now, Pay Later” for their purchases. In other words, they are providing customers a short-term interest free loan to pay for the product or service! If your customer doesn’t pay on time or takes longer than you expect, it can create a cash flow problem in your business.
Monitoring how long it takes for you to collect your accounts receivable is important. The quicker you can collect it, the quicker you get the cash you need to pay your bills and reinvest for your company’s growth.
But how do you measure it? Below is a formula to determine your collection cycle. Keep in mind your cycle will shift weekly, monthly, quarterly, etc… The calculation is merely a “snapshot in time,” but it’s important to know.
Formula:
Annual sales / 365 days= daily sales
Accounts receivable balance / daily sales= days to collect accounts receivable
Example:
$1,000,000 / 365 days= $2,740 daily sales
Accounts receivable $80,000 / $2,740= 29 days
In the above example, it takes on average about 30 days to collect the amounts owed by the company’s customers. If this metric increases from 29 days to 39 days, then the extra 10 days has left the company with $27,400 less cash in their bank account than if they had collected it in 30 days. This is where the business owner could see a positive net profit in the profit and loss statement, but also see that their cash balance has decreased by $27,400.
Know your accounts receivable collection cycle. Calculate it on a regular basis, such as monthly. Identify customers who are consistently not paying on time and determine a strategy to encourage them to pay within the terms you have offered. It can be the difference between positive or negative cash flow!
For more resources to help you measure this important metric, check out our Numbers Coach tools and templates.