What it means
Receivables appear the moment a business sells on credit rather than for immediate payment. Revenue is recorded when the work is done or the goods shipped, so the accounts show a profit while the bank balance has not moved at all.
That gap between recorded sales and cash in hand is exactly what the receivables balance measures. The business consequence is that a growing, profitable company can still run out of money.
If sales double and customers take 60 days to pay, the receivables balance roughly doubles too, and every extra dollar tied up there has to be funded from somewhere, usually an overdraft or the owner's patience. Fast-growing firms fail for this reason far more often than for lack of demand.
Finance teams manage receivables with two headline measures. Receivables turnover shows how many times the balance is collected and rebuilt over a year, and days sales outstanding (DSO) translates that into the average number of days customers take to pay.
Both are read against the credit terms actually offered, because a 45 day DSO on 30 day terms means something quite different from the same figure on 60 day terms. The ledger is not worth its face value.
Some customers will pay late, some will pay short, and some will not pay at all, so accountants deduct an allowance for expected credit losses to arrive at the net figure reported. An ageing report, which buckets balances by how long they have been outstanding, is the practical tool for spotting where that allowance needs to grow.
Businesses can also turn receivables into cash early rather than waiting. Factoring sells the invoices to a finance company at a discount, invoice discounting borrows against them while keeping collections in house, and simple early settlement discounts pay customers a small reward to pay sooner.
Each costs money, so the sensible comparison is against the cost of the overdraft the receivables would otherwise require.
In practice
Real-world examples.
Example
A commercial printing firm wins a national retailer as a customer, which triples its monthly sales but insists on 90 day payment terms. The receivables balance climbs by $480,000 within a quarter, and the firm arranges an invoice discounting facility to bridge the gap rather than delay paying its own paper suppliers.
Example
An IT consultancy reviews its ageing report and finds $138,000 sitting in the "over 90 days" bucket, almost all of it owed by two clients who dispute portions of the work. The finance director realises the problem is not collections effort but unclear scope sign-off, and changes the contract template so milestones are signed before invoicing.
Example
A wholesale food distributor offers a 2% discount for payment within 10 days on 30 day invoices. About 40% of customers take it up, which shortens average collection by a week and reduces the peak overdraft requirement enough to cover the cost of the discount.
Formula
Calculation
Receivables turnover = credit sales / average receivables, and Days sales outstanding = 365 / receivables turnover.
Calder Packaging sells $7,200,000 a year entirely on credit. It opened the year with receivables of $850,000 and closed with $950,000, so average receivables were ($850,000 + $950,000) / 2 = $900,000. Receivables turnover is $7,200,000 / $900,000 = 8.0 times, and days sales outstanding is 365 / 8.0 = 45.6 days.
Since Calder offers 30 day terms, customers are running about 15 days late on average. If a tightened collections process brought DSO down to 35 days, the receivables balance would fall to $7,200,000 x 35 / 365 = $690,411. That releases roughly $210,000 of cash into the bank, a one-off gain worth about $16,800 a year in avoided interest if the overdraft costs 8%.Case study
Seen in the real world.
Perrin Fabrications is an illustrative company invented for this entry. It made industrial shelving, grew sales from $4,000,000 to $6,500,000 in two years, and reported healthy profits throughout. Yet the managing director spent every month worrying about payroll, because receivables had grown from $600,000 to $1,300,000 and the overdraft was permanently near its limit.
A review found the causes were mundane rather than dramatic. Invoices were raised in a weekly batch rather than on despatch, adding an average of three days; nobody chased anything until an invoice was 45 days old; and three large customers had quietly moved from 30 day to 60 day payment without anyone approving it.
Perrin invoiced on despatch, started a polite reminder call on day 25, and reinstated 30 day terms for two of the three customers while pricing the third's longer terms into its quotes. DSO fell from 73 days to 51 over six months, releasing about $390,000 of cash. In this fictional example nothing about the product or the sales team changed; only the plumbing did.
Watch out
Common mistakes.
- Reading a rising receivables balance as good news because it reflects higher sales, without checking whether it has risen faster than sales themselves.
- Counting the full ledger as available cash when part of it is disputed, uncollectable or owed by a customer already in difficulty.
- Chasing every small overdue balance equally instead of concentrating effort on the handful of large accounts that make up most of the exposure.
Questions
People also ask.
Are receivables an asset or income?
An asset; the sale was already recorded as income when the goods or services were delivered, and the receivable is simply the right to collect the cash for it.
What counts as a good days sales outstanding figure?
One close to the credit terms you actually grant, so about 35 days on 30 day terms is healthy while 60 days on the same terms points to a collections problem.
Should a small business use factoring?
It can make sense when growth is outpacing available funding, but compare the total fee against your overdraft rate and check whether the arrangement is with recourse, which leaves you liable if the customer never pays.
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