A business of any scale, whether large, medium, or small, runs successfully if it receives a constant flow of money. So, we all know the fact that a business provides its services and products to other businesses and customers in exchange for money.
However, there are times when many buyers take the products or services on a credit basis to pay the amount later. In such a condition, it becomes very hard for a business to operate when the amount to be received from buyers increases gradually.
In the trading world, a company facing this challenge is determined by the term “Accounts Receivable (AR).”
So, what exactly is Accounts Receivable (AR), and how does it function for a business?
Accounts Receivable, also abbreviated as AR, is the bill that is due to be paid by the buyer to the company or a business. Apart from money, the payment can also be in the form of goods or services.
Most of the companies apply a maturity period, within which the buyer needs to settle the credit transaction. Moreover, for a successful business, it is always recommended to have no pending payment process for accounts receivable.
Effect of Accounts Receivable (AR) on Cash Flow and Financial Modeling
Accounts Receivable (AR) is an assurance of an amount that a company will get from the customers. Accordingly, any fluctuation in AR, whether increase or decrease, impacts directly on the business’s cash flow.
Further, after analyzing a cash flow, a company can decide the grace time period for its customers to get the credit amount. The AR balance updates with respect to the amount mentioned in the invoice that a company issues to its customers. Unless the customer pays the invoice, the Accounts Receivable (AR) balance amount remains unchanged.
Recording Accounts Receivable (AR) as it Showcases Your Future Cash Inflow
One of the major aspects of the cash flow performance for any company is the accounts receivable. Yes. This is a fact. Recording an accounts receivable under the current asset of the balance sheet displays the future cash inflow of the company.
In a financial accounting method, the cash flow profit will be the net profit made before receiving payments for any goods or services to the customers. Hence, it does not matter how much profit a company is gaining. In the end, an increase in AR always interrupts the cash flow.
Relation Amid Accounts Receivable (AR) and Your Cash Flow
Here are how these two entities, Accounts Receivable (AR) and Cash Flow, are connected.
- Increase in Accounts Receivable (AR) – In simpler terms, when the payment format of a company’s sales is in the form of credit rather than cash, then there is an increase in Accounts Receivable (AR). In such a scenario, even if the company has a high revenue, the AR gets deducted from the net earnings.
- Decrease in Accounts Receivable (AR) – When a company receives cash payments from its customers for all the credit transactions, then Accounts Receivable (AR) is marked to be decreased. In this situation, since the credit has been settled down in the form of cash, the reduced amount of AR is added to the net profit.
In a nutshell, an increase in Accounts Receivable (AR) will always represent the low cash flow of the company and vice versa.
How Days Sales Outstanding (DSO) Helps in Projecting AR?
A DSO or Days Sales Outstanding is a metric used in financial models to project Accounts Receivable (AR). The metric determines the average number of days taken by a company to get the credits settled by its customers in the form of cash using the following formula –
DSO – Accounts Receivable ÷ Revenue × 365 days
An elevation in DSO indicates a negative impact on the cash flow and denotes improving collection efforts. Similarly, a decrease in DSO displays an improvement in collection efforts. Hence, implementing a DSO helps to project the Accounts Receivable (AR) of the company.
How to Improve and Optimize Accounts Receivable (AR) to Enhance Cash Flow?
There are scenarios when the companies encounter goofing up with the invoice generation process or not keeping track of dispatched invoices either via electronic prints or emails. Of course, when there are large processes, then the occurrence of such a situation is a normal instance.
However, a method to overcome this limitation is to establish a timely dispatch of invoices to the customers. This also quickens the process of payment collections from customers, and thus, conversion of Accounts Receivable (AR) into cash.
Another effective alternative is to automate the billing system, which again helps to cut off the delay in sending the invoices to the customers. These implementations will help to enhance cash flow, thereby reducing Accounts Receivable (AR) to a company.
Every company seeks better growth, revenue, and profits for precise business and involved operations. And to serve these purposes, having an incremental cash flow plays a significant and vital role in this regard.
Hope our discussion in this blog post on the effect of Accounts Receivable (AR) on business cash flow and financial modeling must have helped you.
So, we can conclude that keeping track of accounts receivable (AR) and implementing efforts to minimize it by receiving payments from customers to settle down the credits not only AR helps in alleviating the net profit but also improves the overall rise in involved cash flow.