Cash flow is the most important short term factor in business survival. The days in accounts receivable ratio is a key barometer of the funding situation of a company.
A company that provides customers credit, or that allows payments over time needs to have a good understanding of when they can be expect to be paid. Looking at historical ratios can provide insight, as well as offering an opportunity against other companies.
The days in accounts receivable ratio is, as the name implies, is the calculation of how many days of cash are locked up in receivables. Receivables are the money is that is owed the company.
Calculating Days in Accounts Receivable (A/R)
There are two factors involved in the calculation:
The accounts receivable at a point in time.
The revenue generated by the company over a specific period.
An example with the following variables:
Revenue over the first three months of the year equals $90,000.
Accounts receivable on the books at 3/31 equals $30,000.
Days in A/R are calculated by dividing revenue by the number of days in the period to get the average daily revenue and then dividing that number into the accounts receivable.
Average daily revenue ($90,000 divided by 90 days) = $1,000 per day
A/R ($60,000) divided by average daily revenue ($1,000) = 60 days in accounts receivable.
The Importance of Days in Accounts Receivable
What this calculation is saying is that on average it will take 60 days to collect what it is owed. If the company pays its bills today, it will take 60 days to replace that money. The company must have a reserve of $60,000 in order to remain solvent.
The ratio is best used as an indicator to compare time periods or against like companies. If the number is increasing from a prior year, it may indicate a problem. The company can positively impact the ratio by becoming more aggressive in collecting debts.
Since industries differ in customers and payment terms, it may not helpful measure against non-similar companies. Comparing against a competitor or an industry benchmark can inform the company on the success of its credit and collection efforts.
Limitations of the Days in A/R Calculation
This calculation is only valid if the company has a solid history of generating revenue and collecting bills. A new company is likely to have a lower ratio, but keeping the ratio at 60 days (for instance) means that as new revenue is generated, the older accounts have to be collected.
Many companies use the 90 days measurement of revenue, but other time periods may be more appropriate. Too short a time frame may give inconsistent and less useful results, and too long may be useful in spotting trends.
Days in Accounts Receivable is an important business ratio, but to get the full picture of a company, it should be combined with other measurements, including return on investment and net income.