Receiving a payment when you expect it is key to cash flow management. Yet, 59% of small businesses experience late payments. This, in turn, makes it more difficult to manage accounts payable.
Accounts payable (AP) and accounts receivable (AR) are the two processes that most directly impact cash flow. To maintain financial health and adequate liquidity, your business must master AP and AR operations.
To synchronize your cash outflows and cash inflows, monitor these three payment metrics.
1) Accounts receivable turnover ratio
The accounts receivable (AR) ratio measures how efficiently your business manages collections.
To calculate your AR turnover ratio, divide net credit sales by average accounts receivables. The result is the number of times your business collects accounts receivables throughout the period analyzed.
First, you need to find your net credit sales and average accounts receivable values. You can find the information you need on your balance sheet or income statement.
Net credit sales
Subtract sales returns and sales allowances from sales on credit to find net sales on credit.
Average accounts receivable
To calculate average accounts receivable, add starting accounts receivable and ending accounts receivable for the period to be analyzed, and divide by two.
Now you are ready to calculate your accounts receivable turnover ratio using the following formula:
Your AR turnover ratio should align with the payment terms you offer customers. For example, let’s say you offer net 30 payment terms and are analyzing a 365 day period.
(365÷ 30 = 12.16)
Your AR turnover ratio should be close to 12 collections per year.
Your AR turnover ratio should also mirror your inventory turnover ratio (the number of times stock on hand is sold and replenished over a certain period). If you have a high inventory turnover ratio but a low AR turnover ratio, it means you are moving products out but not getting paid for them promptly.
2) Days sales outstanding
Days sales outstanding (DSO) is the inverse of the AR turnover ratio. DSO is the average number of days it takes a company to collect payment for a completed sale. While a higher AR turnover ratio is ideal (more collections), a lower DSO is best (lower time to collection).
To calculate your days sales outstanding, divide your average accounts receivable by net credit sales, and multiply by the number of days in the period analyzed.
The result should be close to the net terms you have agreed on with customers.
Use DSO and the AR turnover ratio to inform your credit and collections policies and to identify customers that regularly miss payment deadlines. Check industry DSO benchmarks to see how your collections operations compare to competitors.
3) Accounts payable outstanding
Days payable outstanding (DPO) is the average number of days it takes your business to pay its bills and invoices. A higher DPO is generally preferred as it means more cash available for short-term investments and expenses.
To calculate your days payable outstanding, divide your average accounts payable (AP) by the cost of goods sold (COGS). Then multiply by the number of days in the period you are analyzing.
First, let’s define the components of the formula:
Cost of goods sold
The cost of goods sold (COGS) is the direct expense of producing goods. This includes the cost of purchasing inventory, the cost of labor, and associated purchases of supplies and services.
To calculate the COGS, refer to the inventory values under the current assets section of your company’s balance sheet. Add the starting cost of inventory to the cost of labor, supplies, and associated services. Then subtract the ending cost inventory from this sum (you may need to refer to the balance sheet of the next accounting period to find the ending cost of inventory).
Average accounts payable
Average accounts payable is calculated in the same manner as average accounts receivable. From your company’s balance sheet, add the AP value from the start of the period to the AP at the end of the period, then divide the sum by 2.
Now, calculate your DPO with the following formula:
Contrast your days payable outstanding (DPO) with days sales outstanding (DSO). A high DSO with a low DPO indicates that cash inflows will not be sufficient to keep up cash outflows. This is likely due to payment terms. For example, if you offer clients net 60 payment terms, but your suppliers hold you to net 30, you’ll need 30 days of working capital available to avoid late payments to suppliers.
Partner with Inxeption to take back cash flow
By tracking AR and AP performance with the metrics we’ve presented, you can identify sticking points that are disrupting healthy cash flow and take corrective action.
One way to improve cash flow is by digitizing payment operations—and Inxeption has the tools to help.
For example, with Inxeption’s Shopping Cart, buyers can use digital payment methods like ACH, credit card, or purchase orders. This reduces manual invoicing and the errors and longer collection cycles that come with it.
Inxeption’s Easy Order Portal also allows sellers to prioritize their best buyers with dedicated online sales channels, custom pricing, and integrated shipping. With customers able to re-purchase with ease, you get paid faster.
Recognize that your customers have cash flow concerns, too. They may struggle to make full payments with shorter terms.
With Inxeption’s In-cart Financing, you can offer buyers financing to purchase your goods and repay over time. This is a win-win, improving liquidity for both parties and helping to build stronger buyer-seller relationships.
Do you want access to tools that can improve cash flow while offering an improved experience to customers? Visit us online to get a free demo of Inxeption Cart or give us a call at 888.852.4783 to speak with a digital commerce expert.