What it means
When a business sells on credit, it records revenue at the point of sale and a receivable in place of the cash it has not yet received. From then until the customer pays, the business is lending the customer money interest-free.
The total of those loans at any moment is accounts receivable, and the average time customers take to pay is days sales outstanding (DSO), the key measure of how well receivables are managed. Receivables tie up capital.
A business with $10 million of annual sales and 60-day terms has, on average, $1.6 million owed to it at any time, which it must fund from its own resources or borrowings. Reducing collection time by 10 days releases about $270,000 of cash with no change in sales or profit.
That is why credit control, the routine of invoicing accurately, chasing on schedule and escalating persistently, is one of the highest-return activities in any finance function. Not every receivable will be collected.
Businesses estimate the amounts likely to go unpaid and record an allowance for doubtful accounts, a contra-asset that reduces receivables to their expected collectable value, with the charge going to bad debt expense. The estimate is usually based on an ageing analysis: the older a debt, the less likely it is to be paid, so higher percentages are applied to older bands.
When a specific debt is confirmed as uncollectable it is written off against the allowance. Accounting standards now require an expected credit loss approach that recognises likely losses from the day the receivable arises rather than waiting for evidence of default.
Receivables can also be turned into cash before the customer pays. Invoice factoring sells them to a finance company at a discount; invoice discounting borrows against them; and supply chain finance lets customers' banks pay early.
Each has a cost, and each is a signal that a business's own collections are not keeping pace with its needs.
In practice
Real-world examples.
Example
A law firm invoices clients monthly and reports receivables of $2 million against annual billings of $9 million, a DSO of 81 days that the partners resolve to cut by chasing within seven days of the due date.
Example
A manufacturer sets a credit limit of $50,000 for a new customer after checking its credit rating, and puts the account on hold when the balance reaches the limit until payments arrive.
Example
A staffing agency that must pay its temporary workers weekly while clients pay in 45 days uses invoice discounting to bridge the gap.
Think of it
“Accounts Receivable is like lending your lawnmower to a neighbor who promises to pay you next week. You've provided something of value, and now you're waiting to collect what's owed.
Formula
Calculation
Days Sales Outstanding (DSO) = (Average Accounts Receivable / Credit Sales) x Number of days in the period
Receivables Turnover = Credit Sales / Average Accounts Receivable
Net Receivables = Gross Receivables minus Allowance for Doubtful Accounts
Worked example. A packaging supplier has annual credit sales of $7,300,000. Receivables were $1,100,000 at the start of the year and $1,300,000 at the end. Standard terms are 30 days.
- Average receivables = ($1,100,000 + $1,300,000) / 2 = $1,200,000
- DSO = ($1,200,000 / $7,300,000) x 365 = 60 days
- Receivables turnover = $7,300,000 / $1,200,000 = 6.1 times a year
Customers are paying in 60 days against 30-day terms. If the supplier could bring DSO to 40 days, average receivables would fall to $7,300,000 x 40 / 365 = $800,000, releasing $400,000 of cash.
Allowance calculation from the year-end ageing of the $1,300,000:
- Current (not yet due): $700,000 at 1% = $7,000
- 1 to 30 days overdue: $350,000 at 3% = $10,500
- 31 to 60 days overdue: $150,000 at 10% = $15,000
- Over 60 days overdue: $100,000 at 40% = $40,000
- Required allowance = $72,500
- Net receivables = $1,300,000 minus $72,500 = $1,227,500Case study
Seen in the real world.
A fast-growing marketing agency doubled revenue in two years and was consistently profitable, yet its overdraft kept rising. The founder assumed growth simply needed more cash. A review of receivables showed DSO had drifted from 38 days to 71 days as the agency won larger clients with longer payment processes, and that nobody owned collections: account managers were reluctant to chase clients they were trying to grow, and the finance assistant sent statements monthly and nothing more.
Receivables stood at $1.9 million, including $300,000 more than 90 days old. The agency hired a part-time credit controller, introduced a schedule of reminders starting three days before due date, required a purchase order number on every invoice so that clients' systems would not reject them, and offered a 1.5% discount for payment within 10 days on its two largest accounts.
DSO fell to 45 days in six months, releasing about $700,000 of cash, and the overdraft was cleared. The founder's conclusion was that the business had been lending its clients the money it was borrowing from the bank.
Watch out
Common mistakes.
- Treating receivables as sales already banked. Until the cash arrives, the sale is a loan to the customer.
- Leaving credit control to whoever has time. Collections need an owner, a schedule and escalation rules.
- Carrying old receivables at full value. Debts more than 90 days old are unlikely to be paid in full and should be provided for.
Questions
People also ask.
What is the difference between accounts receivable and accrued revenue?
Accounts receivable is invoiced and unpaid. Accrued revenue is earned but not yet invoiced.
What is a good DSO?
Close to the credit terms offered. A DSO much longer than terms means customers are paying late or terms are being extended informally.
How is a bad debt recorded?
An allowance is estimated for expected losses and charged to expense; when a specific debt is confirmed uncollectable it is written off against the allowance.
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