Are You Getting Paid Fast Enough?

A hand holding a stopwatch over moneySmall business bookkeeping serves many purposes, but one of the more important functions of good financial practices is to monitor and manage cash flow. As we’ve pointed out before in the Padgett blog, adequate cash flow is critical to a business’s very survival, and it’s especially important for a small or newly established company. 

With finances so tight for most small businesses, and the economic and political environment still so treacherous and uncertain, small business owners must monitor cash flow and look for ways to improve it. Good financial planning for small businesses can’t be done without measuring current cash flow and making accurate projections of it for the future. You should also realize that if you plan to apply for a business loan, business lenders’ credit decisions will be influenced by your company’s cash flow numbers.

A large part of the task of assessing and improving a company’s cash flow lies in analyzing accounts receivable (AR) data. How long on average are your customers taking to pay you for goods and services provided earlier? One method to determine how well you are handling accounts receivable is a number called Accounts Receivable Turnover, or ART. Calculating ART for your company is relatively simple: Take your net credit sales, and divide them by your average accounts receivable. (We’ll get back to that formula in a second.)

Just to define terms first – net credit sales obviously do not include cash transactions. Somewhat paradoxically, they also do not include credit card transactions; when a customer uses a credit card, it’s the institution that issued their card, not your business, that is extending credit. It’s only when you provide goods or services with the understanding that the buyer will pay at a later date that you providing credit. Thus, the total dollar value of transactions that were conducted on payment terms such as net-30 or net-15 make up your net credit sales.

Adding up unpaid invoices and unpaid portions of invoices gives you your total accounts receivable at any time. Finding your average accounts receivable is open to a little interpretation. Let’s say you opt to base this on quarterly numbers. You would then determine your accounts receivable total at the end of each of the four foregoing business quarters, add those figures up and divide that total by 4. (You could also total monthly figures and divide by 12. In general, analyzing your AR by smaller periods will generate a more accurate average, especially if your business experiences large seasonal sales fluctuations.)

Now, to get back to the ART formula. Let’s say that you had $250,000 in net credit sales for the past year. You calculated that your average accounts receivable figure each quarter was $50,000. Your ART is $250,000/$50,000 = 5. Remember, the ART is a ratio, not a dollar figure. ART’s value lies in showing the relationship between the volume of your sales and how much of those sales usually remain unpaid-for at any given time. The rule of thumb is, the higher your ART, the healthier your cash flow is. Put another way, a higher ART indicates that you’re getting paid more quickly and are exposed to less risk of non-payment at any given time.

So, let’s say that you experience healthy growth over the next year at the same time that you implement measures to get paid faster. You find that your net credit sales have grown to $300,000 and your average quarterly accounts receivable has dropped significantly to $30,000. Your ART is now $300,000/$30,000 = 10. That’s double what is was the previous year – and remember, a higher ART is better! Knowing your ART gives you, lenders and potential investors a more rounded picture of the health of your business than just your sales figures or growth figures alone.

Next time, we’ll briefly discuss why and how to get your business’s average accounts receivable down and your cash flow and ART up.

PADGETT BUSINESS SERVICES® provides financial services and tax services that help small business owners to thrive in the present and to plan for growth in the future. With Padgett on your side, you’ll be able to focus on important elements of your enterprise while we handle the details. 

Do you have the support you need to manage your small business bookkeeping? Contact us to schedule an appointment to speak with a local small business advisor.