Impact of Receivables on Cash Flow & Financial Modeling

Staying on top of what you owe and what you’re owed is vital to good financial management. Your business’s cash flow statement (CFS) summarizes this and paints a picture of how your company’s operations are running and how well it manages its cash position.

Every business must record its payables and receivables to measure its cash flow. While receivables equate to “Cash In,” payables are a part of “Cash Out.” Cash flow is affected by asset and liability changes in your business. While an increase in AR hurts cash flow, a decrease in the same helps cash flow. And cash flow statements are used to make management decisions and financial modeling.

Effect of Accounts Receivable on cash flow and financial modeling

Your business’ accounts receivable asset shows how much money your customers still owe you, and this asset is a promise of cash that your company will receive. Any increase or decrease in AR will affect your business’ cash flow.

AR is a short-term liability to your customer and cash to your business. Cash flow considerations can determine how long you can allow your customers go without paying. Once you create an invoice and issue it to your customers, the AR balance will be updated with the corresponding amount and will remain so until the invoice gets paid.

For example, if you make a sale of $15,000 with the terms of sale at 50% cash and 50% credit payable within 45 days, record $7500 as sales as it is cash inflow and the balance as an inflow when you get paid.

Recording Accounts Receivable

Per the double-entry system of bookkeeping, for every debit, there is credit. So, when credit sales happen, accounts receivable will be debited while sales as income will get credited. AR is recorded under current assets of the balance sheet as it represents your company’s future cash inflow. It is a key measure of your business’ cash flow performance and an essential component of your working capital.

In accrual accounting, AR will increase alongside net profit. The cash flow statement’s starting point will be net profit which increases even though there aren’t any cash transactions. Increases in AR will be deducted from the net profit to cash used from operations.

The relationship between accounts receivable and cash flow is as follows:

Increase in AR: This happens when a company’s sales are increasingly paid with credit as the form of payment instead of cash. When AR increases, it gets deducted from net earnings because it is not cash even though they are in revenue.

Decrease in AR: This happens when a company has successfully retrieved cash payments for all its credit purchases. When AR decreases, more cash enters your company from customers paying off their credit accounts. The amount by which AR has been reduced will be added to net earnings.

To reiterate, an increase in receivables represents a reduction in cash on the cash flow statement, and a decrease in it reflects an increase in cash.

Days Sales Outstanding (DSO)

The standard modeling convention is to tie AR to revenue to forecast accounts receivable, given how they are closely associated. DSO is the metric used in most financial models to project AR. It measures the number of days on average it takes for an organization to retrieve cash from customers that paid on credit.

DSO is calculated using the formula:

DSO – Accounts Receivable ÷ Revenue X 365 days

If your company’s DSO has been increasing over time, it implies that your collection efforts need more improvement, given how AR means more cash is tied up in operations. And a decline in a company’s DSO means that the collection efforts are improving, which can positively impact the cash flow.

Cash is king to any business, and accounts receivable can make a huge impact. Therefore, it is essential to ensure your AR is in an optimal state to increase your company’s cash flow health.

How does AR impact financial modeling?

Your company’s receivables balance means a portion of revenue hasn’t been received as cash yet. If it is going to take a long time, it can significantly impact cash flow. In financial modeling and valuation, adjusting free cash flow for changes in working capital, including AP, AR, and inventory, is crucial. Receivables are usually listed as assets on balance sheets, revenue on income statements, and wholly excluded from cash flow statements.

Compared to inventory, cash, and other assets, AR can skew the accounts on a balance sheet to favor illiquid assets. The ratio of outstanding receivables to cash received in a period can impact the cash-flow statement. AR can impact the future expected income that finance leaders use to make budgeting decisions. Analyzing receivables can also help investors better understand your company’s overall liquidity and financial stability.

How to optimize your AR to improve cash flow?

Many companies struggle with billing. Some make consistent invoice errors, while others fail to generate invoices promptly. In some cases, companies bounce back and forth between mailed and electronic invoices, resulting in a lot of confusion. The key is to establish a process that ensures accurate invoices are sent on time. Also, being diligent in collecting payments from your customers can quickly turn your AR into cash. Organizations should consider automation and electronic billing systems to reduce payment delays and generate exception reports to flag account anomalies.

Contact us now!

Reliable accounts receivable is critical to maintaining a healthy cash flow. To fuel the growth of your business, it is important to make this your most vital link. Get in touch with us right away to discuss this topic in detail.

At QX, we have offered highly effective accounts receivable management services to businesses across industries and geographies for almost two decades now. Using our unique People-Process-Platform approach, we have optimized and streamlined several financial functions to deliver the highest accuracy, the maximum reduction in manual errors, improved visibility, and tremendous cost savings.