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Understanding accounts receivable cash flow

Accounts receivable refers to the money customers owe a company for what they've bought but haven't paid for yet. Getting those payments on time is important because it ensures your business has the cash it needs for daily operations, ongoing commitments, and long-term strategic plans. 

To convert accounts receivable into cash, you’d send an invoice to a customer. If the customer pays on time, the accounts receivable is settled, and the amount is deposited into your company's bank account. If the due date arrives and you haven’t yet been paid, you may choose to send reminders or follow-ups. In cases of delayed or unpaid invoices, you may escalate collection efforts, charge late fees, or face the risk that you’ll no longer be able to collect the cash.

Financial statement implications

Let’s discuss what happens when a client pays off an account receivable. On your financial ledgers, you’ll debit cash and credit the account receivable. This will usually have no net impact on current assets, as both cash and accounts receivable are often considered short-term assets. However, higher cash balances are preferable, as this allows greater flexibility. Also, there’s a risk of lingering accounts receivable balances ultimately being unable to be collected. 

Regarding a statement of cash flows, the activity of accounts receivable is reported within the ‘Operating Activity’ section of the financial statement. When you collect A/R, its net cash inflows on the statement of cash flows increases. Keep in mind that generating sales increases the A/R balance, though—this means that there may not always be positive cash activity from operations on the statement of cash flow.

Access Ramp's free PDF example and template of the cash flow statement in our Accounting Documents Library.

Staying on the topic of financial statements, several financial ratios are impacted when accounts receivables are received:

  1. The accounts receivable turnover ratio reflects how efficiently your company collects outstanding payments. It’s calculated by dividing net credit sales by the average balance in A/R. When receivables are extinguished for cash, the A/R balance decreases. This increases the turnover ratio, indicating that customers are paying for goods faster.
  2. The day's sales outstanding ratio measures the average number of days it takes to collect payments from customers. When A/R is converted into cash more quickly, the day's sales outstanding decreases. This means it’s taking less time to receive cash.
  3. The cash flow statement margin reflects how effectively your company generates cash from its core operations. The cash collected from A/R is included in operating cash flow, so when A/R is extinguished for cash, the margin improves. This means you’re doing a better job of generating cash specific to your day-to-day activities.

Benefits of converting accounts receivable to cash

There’s no way around it: effective working capital management is vital for your business to meet short-term cash flow needs. Accounts receivables don't pay bills; cash does. By getting rid of balances in A/R, your company can make sure it has sufficient liquidity to cover daily bills or long-term debt that has incremental short-term payments due. 

When your company holds money in accounts receivable, there’s always the risk that it won’t be able to collect those funds. The conversion of accounts receivable into cash plays a key role in reducing the risk of bad debt expenses and the need to write off uncollected receivables. If your company is holding an account receivable for a company that goes bankrupt, it may never receive cash for its sale and may need to recognize an accounting loss or expense. 

Having a clear understanding of cash on hand (which is largely driven by converting A/R to cash) also empowers your company to make better and more formulaic strategic plans. When you know how much cash you have, you can confidently invest in growth opportunities, respond to unexpected expenses, and build strategies for expansion. If your company has its current assets tied up in accounts receivables, it may not have a clear sense of how much cash it’ll have and when it'll get this cash. 

Very broadly speaking, cash on hand is the most flexible current asset (especially when compared to accounts receivable). This somewhat insulates a company from operational and market risk, especially during economic downturns. Your company will be better positioned when its account receivable cash flow is high as it has more confidence and capabilities to meet its obligations even if future sales should lag.

Last, there's a customer service angle to consider when thinking about cash flow driven by accounts receivables. Converting A/R into cash quickly and not having lingering receivables or past-due balances can help enhance your relationship with customers. It reflects professionalism and reliability, demonstrating that your company values its customers' satisfaction and wants to proactively work through problems before they escalate. Efficient A/R management can foster trust and strengthen communication channels between your company and the people it serves. 

Downsides to converting accounts receivable to cash

It’s not always ideal to have incredibly high accounts receivable cash flow. One potential downside is the concept of discounted cash flow. When companies offer incentives for early payment to expedite A/R conversion, customers can pay less money if they pay faster. While this can improve short-term liquidity, it can also impact your company's long-term liquidity as the full invoice amount isn't received in cash.

Sometimes, there's a trade-off between liquidity and flexibility. While having cash on hand provides liquidity and financial stability, some companies may prefer to hold accounts receivable that can be pledged or used to secure loans or lines of credit. In this case, your company can somewhat have its cake and eat it too by keeping its future cash flow while securing short-term needs. You might consider doing this for financial leverage if you believe you can generate returns higher than the debt service expense you’d be charged on the loan.

Lastly, it was mentioned above that a potential benefit of accounts receivable cash flow was the relationship aspect with a customer. This can also pivot to become a downside. Overly aggressive A/R collection practices or pushing for early payments can strain relationships with customers, not making them want to make future financial commitments with your business. There’s a balancing act in trying to collect cash flow from A/R, and pushing it too far may jeopardize future business.

Negative accounts receivable

You may wonder what happens if a company’s accounts receivable cash flow conversion process is so strong, it results in overcollection or a “negative” accounts receivable balance. This is also a downside, as it means your company is now holding onto a liability and owes money to its vendors. Not only is this administratively inefficient, but it can skew cash flow as now your company has cash on hand it must relinquish and can’t use for operations. In this case, you should recognize a payable with a credit balance as opposed to a negative A/R balance.

You may see a net negative on a statement of cash flows when looking at accounts receivable or operating activities. This means that your company is either spending more money than it’s taking in or isn't converting A/R to cash fast enough. It’s not unusual for companies (especially those in cyclical markets) to switch from positive cash flow to negative cash flow. 

The bottom line

Converting accounts receivable into cash can give your company more liquidity, less risk of bad debt, and a greater ability to pivot in different directions. With higher accounts receivable cash flow, you can expand your business or have greater security that current bills can be paid. Remember that emphasizing converting accounts receivable may drive clients away or result in discounted amounts of cash received. It’s a delicate practice of offering customers credit, trusting that they’ll repay their debts, and setting up efficient processes to oversee it all.

Now that you have more cash flow, use Ramp to control spend and optimize finance operations 

Ramp's accounting automation platform streamlines and optimizes the AP process with real-time data sync, automated invoice processing, and integrated payments. Ramp’s automation capabilities simplify invoice processing, ensuring timely payments and helping you build strong relationships with vendors.

Get Ramp and experience the power of automated accounts payable first-hand.

Try Ramp for free
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Director of Growth, Ramp
Luke is a growth marketer responsible for Ramp's contributor network. Prior to Ramp Luke has run growth and marketing teams at LogRocket, Tervela, and Acquia. Luke also consults on dozens of pre-seed, seed, and series A startups on their go-to-market strategies.
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