Overseeing your accounts payable and accounts receivable (AP & AR) is among the more tedious component of running your growing business. AP and AR management involves tracking large amounts of paperwork, reviewing contract terms, and can take significant time from your workday. Because of this, it’s among the more popular account services offered by CPA firms. It’s imperative not to overlook accounts payable and accounts receivable as a strategic tool in the financial management repertoire. Effective oversite can stretch cash flow by taking advantage of free money, reducing working capital requirements and allow managers to increase enterprise revenue.
Working capital turnover
To understand the impact that invoicing terms can have on your business, we must delve into the cash flow management process to understand the working capital turnover cycle and how it impacts to revenue. For this conversation we are using a managerial accounting understanding of working capital, defining it as the cash needed to fund inventory and operations necessary to produce and sell a product. This is opposed to the GAAP balance sheet calculation of current assets less current liabilities.
Working capital turnover:
Take a simple example of a distributor. The distributor may buy 25 units at $5 each for a total order price of $125. The $125 needed to buy the product is the working capital. Now let’s assume the units sell for $10 each, this means the total revenue capacity per order is $250.
The next component of the process is time. What a manager is looking at is how many times can they re-cycle their working capital each year to generate revenue. Assume the 25 units can sell through in two months, the distributor will be able to turn over their working capital 6 time per year, for a total revenue of $1,500.
If the inventory is purchased for cash, a company’s ability to turn over their working capital is equal to their ability to turn over their inventory. If the inventory is purchased and sold on invoicing terms, managers can use these terms to try to increase their ability to turn over working capital by requiring it to be tied up in revenue for shorter periods.
The amount of time that working capital is tied up in inventory is called the float period. When the distributor purchases inventory with cash, the float period is equal to the time it takes to sell the inventory. Two month. If the distributor were to purchase their inventory on 30 day invoicing terms, float period would reduce to 30 days and their ability to turnover working capital would increase from 6 times a year to 12, doubling their revenue capacity.
The revenue capacity formula:
A company’s revenue capacity can be simplified to a formula that is a function of three variables, the total amount of working capital available, gross margin, and the ability to turn over working capital.
Revenue capacity = (working capital available / (1 – gross margin rate)) * (working capital turnover)
How accounts payable and accounts receivable impact the revenue capacity formula
To illustrate further the impact of accounts payables and receivables on revenue let’s look at a theoretical example of a manufacturing business that is slightly more complex than our distributor example. The manufacturers supply chain might look like this.
- Order raw materials; pay upfront and hold in inventory for 30 days on average
- Manufacture finished goods; hold finished goods inventory for 15 days on average
- Deliver to customer; get paid on net 30 terms
- Gross margin (revenue minus cost of inputs) of 50%
This company has a 75 day float period, or 2.5 months, calculated by adding up the days in the supply chain components. They can repeat this cycle 4.8 times per year. The remaining revenue impacting variable is how much working capital they have and for simple math we’ll assume they have exactly $10k.
Revenue capacity = ($10,000 working capital / (1 – 50% gross margin)) * (12 / 2.5 mo. float period)
- Revenue per float period = $20,000
- Float period cycles per year = 4.8
- Revenue capacity = $96,000
How to influence revenue capacity:
We can use this formula to determine how the company can make more money. Here are the options:
- Shorten the float period. The quickest path is through invoicing terms. The company pay up-front when buying and sells on 30 day terms. If they were to start buying on 30-day terms, the float period would reduce to 1.5 mo. which would increase their annual revenue capacity to $160,000, a 67% improvement.
- The alternative is to increase working capital and get more volume out of each cycle. This is a more expensive option since capital comes with a cost. If the float period hasn’t yet been maximized, increasing working capital is a wasted expense. To reach the same revenue capacity growth of 67%, working capital would need to grow by $6,600 or 60%.
How to interpret early payment terms
One method for sellers to entice customers to pay quickly is to offer a discount. A common offer is a 2% discount on the invoice if paid within 10 days. This will appear on the invoice terms as “2% 10, net 30” (referred to as “two ten net thirty”). This means they’re offering a 2% discount if the invoice is paid in 10 days, or the full amount is due in 30 days.
Should I accept an invoice discount:
If invoicing terms are effectively a loan from the seller to the buyer, the early payment discount means the seller is defining their terms on their loan. In the case of “2% 10, net 30” the seller is stating that 20 days of cash is worth 2% of the bill. On an annual basis, 2% every 20 days adds up to 36.5%. The customer then has to decide if they’re willing to part with cash in exchange for a 36.5% return.
For the customer, if the annualize discount rate (36.5%) is greater than your cost of capital then it’s worthwhile to increase your working capital and pay invoices early.
Should I offer an invoice discount:
As a seller, the goal of offering a discount is to shorten your float period. If offering a discount decreases your float period by a greater rate measured as a percentage) than the annualized discount rate (36.5% in the above example), then it’s worth offering the discount.
Referring back to our example:
- Normal conditions: 2.5mo float period = $96k annual revenue capacity.
- 2% discount every 20 days = 36.5% annual discount
- Annual revenue after discount is reduced by $35k.
- To get the revenue capacity back to $96k, the float period needs to decrease to 1.6mo. (36.5% decrease from 2.5mo.)
Optimizing accounts payable and accounts receivable
Optimizing your accounts payable and accounts receivable is likely the cheapest and easiest way to get more out of your working capital and maximize your revenue potential.
The goals are simple.
Accounts Payable: The goal is to maximize the length of these short-term interest free loans.
- Don’t pay early, pay only when invoices are due.
- Maximize the early pay discount.
- Avoid fees for late payment. A free loan can quickly cost you money.
Accounts Receivable: The goal is minimize the length and volume of the short-term interest free loans you give out.
- Ask for up-front payment when possible.
- Encourage early payment and call customer often to collect.
- Maximize the early pay discount
- Enforce late fees as much as you can.
Accounts Payable and Accounts Receivable metrics to track:
Cash flow metrics:
- Total due
- Total past due
- Cash flow forecast
- Top ten outstanding
- Average terms offered and received
- Average days to payment (ensure your maximizing your terms)
- Average days late/early vs terms
- Total uncollectable accounts (how often to customer not pay)
Managing AP & AR with Luca:
Luca offers an easy to use report to track and manager your accounts payables and receivables. With this tool you can:
- Track total accounts payables and receivables
- Automatically flags past-due accounts
- See your cash flow forecast of what’s coming in and due to pay in the next 90 days
- See the next ten invoices due to pay and collect, in order of date and dollar size
- Track your average terms offered and received
- Track average days to payment
- Track average days late when paid
- Track unpaid receivables trends