How Sales Revenue Drives Accounts Receivable

In this business example the company made $10,400,000 total sales during the year. This is a sizable amount, equal to $200,000 average sales revenue per week. When making a sale the total amount of the sale (sales price times quantity for all products sold) is recorded in the sales revenue account. This account accumulates all sales made during the year. On the first day of the year it starts with a zero balance; at the end of the last day of the year it has a $10,400,000 balance. In short, the balance in this account at year-end is the sum of all sales for the entire year (assuming all sales are recorded, of course).

In this example the business makes all its sales on credit, which means that cash is not received until sometime after the day of sale. This company sells to other businesses that demand credit. (Some businesses, such as supermarkets, make all sales for cash.) The amount owed to the company from making a sale on credit is immediately recorded in the accounts receivable asset account for the amount of each sale. Sometime later, when cash is collected from customers, the cash account is increased and the accounts receivable account is decreased.

Extending credit to customers creates a cash inflow lag. The accounts receivable balance is the amount of this lag. At year-end the balance in this asset account is the amount of uncollected sales revenue. Most of the sales made on credit during the year have been converted into cash by the end of the year. Also, the accounts receivable balance at the start of the year from sales made last year was collected. But, many sales made during the latter part of the year have not yet been collected by year-end. The total amount of these uncollected sales is found in the ending balance of accounts receivable.

Some of the company's customers pay quickly to take advantage of prompt payment discounts offered by the company. (These discounts off list prices reduce sales prices but speed up cash receipts.) On the other hand, the average customer waits 5 weeks to pay the company and forgoes the prompt payment discount. Some customers wait 10 weeks or more to pay the company, despite the company's efforts to encourage them to pay sooner. The company puts up with these slow payers because they generate a lot of repeat sales.

In sum, the company has a mix of quick, regular, and slow-paying customers. Suppose that the average credit period for all customers is 5 weeks. This means that 5 weeks of annual sales were still uncollected at year-end. (This doesn't mean every customer takes 5 weeks to pay, but rather than the average time before paying is 5 weeks.) The relationship between annual sales revenue and the ending balance of accounts receivable, therefore, can be expressed as follows:

x Sales Revenue = Account; Receivable

Chapter 4 Exhibit on page 20 shows that the ending balance of accounts receivable is $1,000,000.

The main point is that the average sales credit period determines the size of accounts receivable. The longer the average sales credit period, the larger is accounts receivable.

Let's approach this key point from another direction. Suppose we didn't know the average credit period. Nevertheless, using information from the financial statements we can determine the average credit period. The first step is to calculate the following ratio:

SI0,400,001> Sales Revenue = ^ 4 Times $1,000,000 Accounts Receivable

This calculation gives the accounts receivable turnover ratio, which is 10.4 in this example. Dividing this ratio into 52 weeks gives the average sales credit period expressed in number of weeks:

Time is of the essence. Whlat interests the business manager, and the company's creditors and investors as well, is how long it takes on average to turn accounts receivable into cash. I think the accounts receivable turnover ratio is most meaningful when it is used to determine the number of weeks (or days) it takes a company to convert its accounts receivable into cash.

You may argue that 5 weeks is too long an average sales credit period for the company. This is precisely the point: What should it be? The manager in charge has to decide whether the average credit period is getting out of hand. The manager can shorten credit terms, shut off credit to slow payers, or step up collection efforts.

This isn't the place to discuss customer credit policies relative to marketing strategies and customer relations, which would take us far beyond the field of financial accounting. But, to make an important point here, assume that without losing any sales the company's average sales credit period had been only 4 weeks, instead of 5 weeks.

In this alternative scenario the company's ending accounts receivable balance would have been $200,000 less ($1,000,000 - 5 weeks = $200,000), which is the average sales revenue per week ($10,400,000 annual sales revenue - 52 weeks = $200,000). The company would have collected $200,000 more cash during the year. With this additional cash inflow the company could have borrowed $200,000 less. At an annual 8% interest rate this would have saved the business $16,000 interest before income tax. Or, the owners could have invested $200,000 less in the business and put their money elsewhere.

The main point, of course, is that capital has a cost. Excess accounts receivable means that excess debt or excess owners' equity capital is being used by the business. The business is not as capital-efficient as it could be.

A slow-up in collecting customers' receivables or a deliberate shift in business policy allowing longer credit terms causes accounts receivable to increase. Additional capital would have to be secured, or the company would have to attempt to get by on a smaller cash balance.

If you were the business manager in this example you'd have to decide whether the size of accounts receivable, being

5 weeks of annual sales revenue, is consistent with your company's sales credit terms and your collection policies. Perhaps 5 weeks is too long and you need to take action. If you were a creditor or an investor in the company, you should pay attention to whether the manager is allowing the average sales credit period to get out of control. A major change in the average credit period may signal a significant change in the company's policies.

CHAPTER 5 EXHIBIT—COST OF GOODS SOLD EXPENSE AND INVENTORY

CHAPTER 5 EXHIBIT—COST OF GOODS SOLD EXPENSE AND INVENTORY

Cost of Goods Sold Expense and Inventory

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