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What is Accounts Receivable?
Accounts Receivable (A/R) is defined as payments owed to a company by its customers for products and/or services already delivered to them – i.e. an “IOU” from customers who paid on credit.
- What is accounts receivable (A/R)?
- Is accounts receivable an asset or liability on the balance sheet?
- Do accounts receivable get captured on the income statement?
- How does an increase (and decrease) in accounts receivable affect cash flows?
Table of Contents
Accounts Receivable (A/R) Definition
Under accrual accounting, the accounts receivable (A/R) line item refers to payments not yet received by customers that paid using credit rather than cash.
Accounts receivable represents a company’s total outstanding (unpaid) customer invoices.
On the balance sheet, accounts receivable is categorized as an asset since it represents a future economic benefit to the company.
However, the amount charged to the customer is recognized as revenue once the customer is billed, despite the cash still being in the possession of the customer.
Whether cash payment was received or not, revenue is recognized and the amount to be paid by the customer can be found on the accounts receivable line item.
Accounts Receivable – Balance Sheet Accounting
If a company’s accounts receivable balance increases, more revenue has been earned with payment in the form of credit, so more cash payments must be collected in the future.
On the other hand, if a company’s A/R balance declines, the payments billed to the customers that paid on credit were received in cash.
To reiterate, the relationship between accounts receivable and free cash flow (FCF) is as follows:
- Increase in Accounts Receivable → The company’s sales are increasingly paid with credit as the form of payment instead of cash.
- Decrease in Accounts Receivable → The company has successfully retrieved cash payments for credit purchases.
With that said, an increase in accounts receivable (A/R) represents a reduction in cash on the cash flow statement, whereas a decrease in A/R reflects an increase in cash.
On the cash flow statement, the starting line item is net income, which is then adjusted for non-cash add-backs and changes in working capital in the cash from operations (CFO) section.
Since an increase in A/R signifies that more customers paid on credit during the given period, it is shown as a cash outflow (i.e. “use” of cash) – which causes a company’s ending cash balance and free cash flow (FCF) to decline.
While the revenue has technically been earned under accrual accounting, the customers have delayed paying in cash, so the amount sits as accounts receivables on the balance sheet.
Projecting Accounts Receivable (A/R)
For purposes of forecasting accounts receivable, the standard modeling convention is to tie A/R to revenue since the two are closely linked.
The days sales outstanding (DSO) metric is used in the majority of financial models to project A/R.
DSO measures the number of days on average it takes for a company to collect cash from customers that paid on credit.
The formula for days sales outstanding (DSO) is calculated as follows.
Historical DSO = Accounts Receivable ÷ Revenue x 365 Days
To properly forecast accounts receivable, it’s recommended to follow historical patterns and how DSO has trended in the past couple of years, or to just take an average if there appear to be no significant shifts.
Then, the projected accounts receivable balance is equal to:
Projected Accounts Receivable = (DSO Assumptions Assumption ÷ 365) x Revenue
If the days sales outstanding (DSO) of a company have been increasing over time, that implies the company’s collection efforts require improvement, as more A/R means more cash is tied up in operations.
But if DSO declines, that implies the company’s collection efforts are improving, which has a positive impact on the cash flows of the company.
Accounts Receivable Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Accounts Receivable Example Calculation
In our illustrative example, we’ll assume we have a company with $250 million in revenue in Year 0.
Moreover, at the beginning of Year 0, the accounts receivable balance is $40 million but the change in A/R is assumed to be an increase of $10 million, so the ending A/R balance is $50 million in Year 0.
For Year 0, we can calculate the days sales outstanding (DSO) with the following formula:
DSO – Year 0 = $50m / $250m * 365 = 73 Days
As for the projection period from Year 1 to Year 5, the following assumptions will be used:
- Revenue – Increase by $20m per Year
- DSO – Increase by $5m per Year
Now, we’ll extend the assumptions until we reach a revenue balance of $350 million by the end of Year 5 and a DSO of 98 days.
Starting from Year 0, the accounts receivable balance expands from $50 million to $94 million in Year 5, as captured in our roll-forward.
The change in A/R is represented on the cash flow statement, where the ending balance in the accounts receivable (A/R) roll-forward schedule flows in as the ending balance on the current period balance sheet.
Since the DSO is increasing, the net cash impact is negative, and the company would likely need to consider making adjustments and identify the source of the growing collection issues.
