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Demystifying your Accounts - How quickly am I getting paid?

 

How quickly am I getting paid?

 

A set of financial accounts can provide far more than a simple report on the profit or loss your business has made. Digging a little deeper and running some relatively simple equations can provide a fantastic insight into the strength and health of your business.   There are many tools and measures to assist you in ‘Demystifying your accounts’ to convert the information contained in those financial statements into some useful insights into your business.

In this second article of our series we will focus on a measure of how quickly your business is being paid by your customers

 

Accounts receivable turnover ratio
 

A number of businesses are able to operate on a ‘no payment, no goods’ basis, such as your fish and chip shop or local dairy.  On the other hand for many businesses it is necessary to offer credit terms; this can be anything from 20 days through to 50 plus days depending on when during the month the sale was made and how good customers are at keeping up with their payments.

The phrase ‘cash is king’ should remind us all that although we are in business for various reasons being paid is the life blood of any business.  If sales are made on credit terms to customers it is only once the cash is collected from that sale that you will have the ability to pay your own expenses.  Whether this is your staff’s wages, your own wages or even the supplier who has provided credit terms on the inventory you have sold.

The accounts receivable turnover ratio is a measure of how quickly, on average, it is taking for your credit customers to pay you.  The formula to work out this ratio is:

               Credit sales ÷ average accounts receivable

The ratio can be worked out on a monthly or yearly basis; the period over which the credit sales and average accounts receivable are measured needs to be the same.  If you are using opening and closing accounts receivable from the annual accounts then you need to use the total credit sales for the year as well.  Likewise if you are measuring the ratio for a particular month it would be the average accounts receivable for that month and the total credit sales for that month only.

To work out the average accounts receivable add the opening and closing balance for the period and divide by two.

Dividing your credit sales by your average accounts receivable will give you a ratio.  Dividing 365 by the result of the formula will give you the average number of days it takes to collect your accounts receivable. An example of this is as follows:

 

Example 1
 

Credit sales for the year (1 April 2016 to 31 March 2017)                 $1,163,000

Opening accounts receivable (1 April 2016)                                      $120,000

Closing accounts receivable (31 March 2017)                                   $110,000

Average accounts receivable = (120,000+110,000) ÷ 2 = 115,000

Accounts receivable turnover = 1,163,000 ÷ 115,000 = 10.11

Average duration of accounts receivable = 365 ÷ 10.11 = 36.10 days

If our customers are not quite as good at paying on time and the average accounts receivable total is only moderately higher, this can have a significant impact on the ratio, as outlined in the next example:

 

Example 2
 

Credit sales for the year (1 April 2016 to 31 March 2017)                 $1,163,000

Opening accounts receivable (1 April 2016)                                      $180,000

Closing accounts receivable (31 March 2017)                                   $170,000

Average accounts receivable = (180,000+170,000) ÷ 2 = 175,000

Accounts receivable turn = 1,163,000 ÷ 175,000 = 6.65

Average duration of accounts receivable = 365 ÷ 6.65 = 54.89 days

 

Importance of collecting  

The reason for measuring how long it takes to collect credit sales is because making a sale on credit represents an interest free loan to your customers. The longer it takes for them to pay, the longer you have to fund your own business from other sources: this might have a real cost to you.  For example if you are operating in overdraft this could be a cost of anything from 10% to 20% per annum depending on the interest rate charged. It could ultimately mean that you cannot pay your own creditors or yourself for the hard work and effort that goes into running your business. 

It is also possible to calculate the ratio for particular customers, or group of customers, to work out which ones are utilising your business as a free credit facility.  Work can then be put into collecting from the slow paying customers to improve your overall ratio and health of your business. 

 

Strategies to improve payment time

If you feel that you have some concerns in this area we recommend that you speak to us about some strategies that can be implemented to improve payment times. These strategies could include all or some or all of the following:

  • Payment terms
  • Terms of trade
  • Prompt payment discounts
  • Penalty / collection fees or interest
  • Stop work / account holds
  • Enforcement action

For more information please contact Rory Noorland on 07 889 8850

 

 

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