Accounts receivable refers to unpaid bills for goods and services incurred by customers for which the business expects to receive payment at some future point in time. In an ideal scenario, the business will receive all of its payments at the time of the transaction, or in as little time as possible when it does not receive cash payments.
This allows the business to make more accurate calculations about its cash flow. However, in the real world, not all payments are made according to the same schedule. There are many advantages to a business that extends credit to its customers, and some outstanding balances will take longer to collect than others.
For this reason, business accountants have a metric which allows them to evaluate how long it takes for the business to collect payment on outstanding accounts.
Accounts receivable days (A/R days) refer to the average time a customer takes to pay back a business for products or services purchased. With this metric, the business can make important evaluations which reflect on its overall health.
Accounts receivable days allows a business to evaluate its credit and collections policies and procedures to determine if these are effective. It also helps the business make estimates and projections about future cash flow into the business, which can inform other important financial decisions.
Accounts receivable days represents the average number of days within a defined period of time that it takes for the business to collect outstanding payment from customers.
This average provides a general, representative figure for a past reporting period, rather than an actual, real-time number that reflects on any specific customer account or accounts. It is calculated in two basic steps, with some smaller steps along the way.
The first step is to calculate the average accounts receivable as a proportion of total sales for the period in question. The second step is to apply this proportion to, or multiply it by, the number of days in the period. The outcome will result in an average number of days in the period that it takes to collect outstanding payment from customers.
The formula looks like this:
Accounts receivable days = [Average AR ÷ Net Revenue] x Days
Step 1: To calculate the average accounts receivable, accountants will take the AR balance at the beginning of the time period, add it to the ending balance, then divide by two.
Net revenue represents total gross revenue for the business minus refunds, discounts and other adjustments.
A more detailed representation of Step 1 looks like this:
[Average AR = Beginning AR + Ending AR ÷ 2] ÷ [Net Revenue = Gross Revenue – Refunds, Credits and other Allowances]
Step 2: Accounts receivable days is typically calculated for a period of one year, so the number of days is usually 365.
The formula often looks like this:
[Average AR ÷ Net Revenue] x 365 = accounts receivable days
Let's look at an example:
A clothing business had $100,000 in sales for one year. It began the year with $10,000 in accounts receivable and ended the year with $20,000 in accounts receivable.
The average accounts receivable for the year equals $15,000:
[$10,000 + $20,000 = $30,000] ÷ 2 = $15,000.
The average AR as a proportion of net revenue equals 15 percent:
$15,000 ÷ $100,000 = .15
With this figure, we can now calculate the accounts receivable days:
.15 X 365 = 54.75
The result of this calculation tells us that it takes about 55 days on average for the business to collect outstanding payment from its customers.
The calculation will change depending on the number of days in the period. For example, for one month, the number of days will be 30. For a quarter (three months), the number of days will be 90 (3 x 30 days = 90 days).
Accounts receivable days is an important metric for a business. It measures the effectiveness of a business's credit policies and procedures. If a business has lower accounts receivable days, it is doing a good job of collecting payment from customers.
This indicates that the business has adopted sound policies for extending credit to its customers, it has extended credit to reliable customers who pay on time, and its procedures for collecting unpaid bills are working efficiently.
Accounts receivable days also helps businesses make good projections about cash flows. Cash flow is an important indicator of the business's ability to generate cash currency. Cash is important for the business to meet its daily obligations like payroll, taxes, and purchasing.
If the accounts receivable days are relatively low, this is an indicator that the business is effectively receiving payment for the goods and services it provides, which will have a positive impact on its cash flow and all of the other obligations that depend on it.
There is no universal standard for an accounts receivable days that applies equally to all businesses as industry and type of business all have an impact. Acceptable figures range from as low as 30 days to as high as 70.
Some industries typically experience higher accounts receivable days, like in the 50 to 70-day range. Others are accustomed to a lower figure, such as 30 days. Depending on which industry a business identifies with, they will want to reference the appropriate benchmark.
Accounts receivable days can also vary depending on the credit policies and collection procedures adopted by the business.
Markets and customer demographics can also come into play.
When accounts receivable days begin to exceed the range for a particular industry, the business may want to take a closer look at its internal policies and procedures and consider steps that could lead to improvements.
A common method for analyzing accounts receivable days is to do a historical comparison. A side-by-side comparison of accounts receivable days from one accounting period to another will reveal patterns and trends about the business.
If for example, accounts receivable days for a business have declined from one year to the next and this isn’t due to a wide change in credit policy across the customer base, this may be an indication that the business is improving its collections process.
If the accounts receivable days are increasing from one period to the next (again, without any wide reaching changes to credit policy etc), this may be a sign that processes need refinement.
It may also be helpful to compare more than two reporting periods to better identify patterns, historical trends and potential seasonality impacts.
If after calculating and comparing accounts receivable days, the business discerns a number that is relatively high for its industry, or increasing over time, it may be time to revisit credit policies and procedures and make some changes.
More well-defined credit policies, better evaluation of potential credit customers, and a more conservative practice for issuing credit, may help improve collections and lower the number of accounts receivable days.
Improved invoicing, better communications with customers, and a more effective collections process can also make an impact.
Days Sales Outstanding (DSO) is a very similar metric to accounts receivable days. Both are indicative of a similar function within the business, which is to collect payments from customers.
However, DSO is calculated somewhat differently. DSO is calculated through the formula:
(Accounts Receivable ÷ Credit Sales) X Number of Days = DSO
The main difference between the two calculations is represented by the denominator in the fraction.
In accounts receivable days, the average AR is calculated as a proportion of (divided by) the total net sales for the business.
In DSO, the AR is taken as a proportion only of total credit sales. In this way, DSO is more of a precise measurement of the effectiveness only of credit sales. In contrast, accounts receivable days measures the effectiveness of AR in relation to the overall sales of the business.
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