The importance of understanding the difference between accounts receivable and accounts payable days
Every business owner has heard about the importance of cashflow – that cash is the lifeblood of the business. Your company might be great at making sales BUT until that sale has materialised as cash in your bank account, it is merely a figure in a sales report. The money has not been received into the business to be used to pay suppliers, or wages, or realised as profit for example. We understand that businesses will spend the amounts owed before the cash is received, but that can be a risk. In this article, we explain why and the importance of understanding the difference between accounts receivable and accounts payable days.
What are accounts receivable and accounts payable days?
Accounts receivable is the amount owed to the company from the sale of products and services on credit. Accounts receivable days are how long it takes, on average, for customers to pay their invoices.
Accounts payable is what the company owes to suppliers, and accounts payable days are an average of the credit terms offered for those purchases.
They are separate calculations but they are interlinked. Understanding the difference between accounts receivable and accounts payable days will help your business to have positive cashflow, and to adequately manage any cashflow issues should they arise.
What should my accounts receivable and accounts payable days be?
As a general rule of thumb, your accounts receivable days should be less than your accounts payable days. This means you will have the cash in your bank account ready to make payments to your suppliers on time and in full (within the specifications of your credit terms). The bigger the difference between the two, the larger the buffer your business has in case customers don’t pay their invoices on time.
If the difference is small (a day or two) then there’s an increased risk that if a customer takes longer to pay you, you won’t have the cash in your account to pay your suppliers on time. You could incur a late payment penalty as a result.
The situation your business must avoid is having accounts receivable days MORE than accounts payable days. In that scenario, your business will need to have plenty of cash reserves to pay suppliers on time, before getting paid by customers. If a customer then had an issue paying you on time, you could be left in financial difficulty.
How to calculate accounts receivable and accounts payable days.
The formula to calculate your accounts receivable days (how long it takes on average for your clients to pay you) is:
(Accounts Receivable / Total Revenue) x Number of Days
In plain English, the calculation is (Total amount on credit with customers / Total amount of sales) x 365 (as you typically look at this calculation across a year).
If your total sales in a year are £200,000 and £25,000 of those sales are on credit, the calculation would be: (25,000 / 200,000) x 365 = 46. It takes on average for your company to receive payment for a sale on credit in 46 days.
Accounts payable days are the credit terms you agreed to with your supplier which typically are 30, 60 or 90 days terms. If the average accounts payable terms are 60 days, then accounts receivable being 46 days is positive. If the average accounts payable terms are 30 days then there will be a cashflow issue, and you will want to consider ways to reduce your accounts receivable days.
Ways to reduce your accounts receivable days.
If you need customers to pay their invoices quicker and reduce your accounts receivable days, there are several options to consider:
- Incentivise paying early –reward customers who pay early with a small percentage discount.
- Make it easy to pay– consider if there are alternative payment methods you could offer which simplify paying the invoice for the customer.
- Be proactive and regularly communicate – you can easily set up automatic payment reminders in your accounting software but nothing beats picking up the phone and speaking to a customer. Contact them as the due date approaches, don’t just wait for the invoice to be late.
- Implement late fees and stricter payment terms – you may find that implementing late payment fees encourages customers to pay on time in the future. It may also be worth reviewing the amount of credit you offer future customers to help reduce accounts receivable days.
What does ‘good’ look like?
There is no one-size-fits-all description of exactly how many accounts receivable and accounts payable days are good – it depends on many factors. Each will have its own influencing factors on the standard credit terms. How much cash is already in the business and what it plans to achieve over the next few years will also have an impact. What may be good today might not work for the business in the future.
If you are finding that your accounts receivable days are increasing or you would like expert advice on how to monitor and improve your cashflow, speak to the team at Accounting Clarkes on 01252 612484.
