When business is good, work flows in and revenues increase. For many business owners, this creates expectations of increased cash for their coffers as a result of all their hard work.
And yet for many people, the cash doesn’t seem to flow in despite notable increases in business activity. That leaves them wondering why they aren’t seeing more funds despite the steady workload.
The answer, in most cases, lies in how profit and loss (P&L) is accounted for, specifically the different results obtained between cash and accrual accounting. This article is going to clarify those concepts, help you figure out where your cash is going, and give you tips on how to determine your uncollected cash flow and improve your accounts receivable turnover.
Where’s my cash? (Hint: Look into Cash Basis Accounting vs. Accrual Accounting)
Understanding the difference between cash and accrual accounting is central to comprehending the dilemma of why cash can be over or underestimated in the present.
The first step is to understand how cash accounting works. This is fairly straightforward: cash accounting recognizes income and expenses when the money actually changes hands.
For example, if someone makes a sale and earns cash, the business owner records revenue straight away. Accordingly, if they pay expenses in cash, expenses are recorded immediately.
Things get tricky when bills arrive that are paid in the future, or when services are executed before the company collects payment. The sales made today get recorded, but the expenses aren’t accounted for until a future date. This results in inflated cash amounts in the present when you use cash vs accrual accounting.
Accrual Accounting is the Solution (Plus: it’s GAAP Compliant)
The use of accounts receivable and accounts payable are more accurate ways for estimating cash flow in the present. This is the basis for the accrual method of accounting. Besides providing greater accuracy, this method is more in line with Generally Accepted Accounting Principles (GAAP) that require business owners to use the accrual basis for their income statement.
Besides death and taxes, another sure thing in life (at least for small business owners) are the bills coming their way. These amounts, in most cases, are exactly what must be paid. Accounts receivable, on the other hand, can be a different story, because not all clients pay their bills.
Accounts Receivable Turnover Ratio: How to Calculate Uncollected Cash Flow
Some clients pay their bills, others don’t. That’s a fact of life for business owners, so it's important that they make the best estimate possible for the amount of cash flowing into their business bank account from their uncollected accounts.
This is where the Accounts Receivable Turnover Ratio comes into play. It’s an accounting method that takes the net value of credit sales during a given period by the average accounts receivable balance during the same period. It’s a method of calculating accounts receivable based on previous business activity, allowing small businesses to make reasonable assumptions about how much cash is coming their way.
Improving accounts receivable turnover involves many factors. These include a company’s specific collection process, policies regarding extending credit, and actions taken in the event of a high ratio of services rendered vs. payments collected. The overall success of improving accounts receivable turnover will result in better cash flows in the present that are eventually reflected in a company’s financial statements.
A/R Turnover and Financing Current Operations
Financing current operations and reinvesting into a business are factors critical to its long term success. This should involve taking profits and using those funds - rather than dipping into savings or taking out credit.
Businesses must be aware of how much cash they truly have before making financing or investment decisions. A/R turnover paints the most accurate picture of business health in terms of profitability. This is required when formulating a future strategy that guarantees business success, because it gives the best estimation of how successful business activities are in the present.
A Final Word
Many small business owners experience times when cash flows seem to be restricted. This depends a great deal on the method of accounting used, specifically P&L accrual or cash accounting.
The main difference between the two lies in the timing of when revenues or expenses are recorded. The cash basis method records revenues and expenses when cash exchanges hands while the accrual method uses accounts receivable and accounts payable.
Determining your accounts receivable turnover is critical to determining uncollected cash flow. Improving the turnover allows a company to better determine their cash position in the present in addition to providing insight into the profitability of their business activities.