At Tom Vignali CPA, Inc., we deal with all aspects of business financial accounting and reporting. One critical aspect that we deal with is A/R (Accounts Receivable). In accrual accounting, A/R is the uncollected funds from revenues that have been posted to the Income Statement. This means that you have posted sales/revenues for products and/or services that you have posted to the expense line items of your Income Statement, but have not yet collected the funds from these sales/revenues. On the Balance Sheet, A/R amounts are considered to be an asset to the company, but not always. We will address some critical factors to be considered regarding A/R, and how this asset can actually be detrimental to the financial position of your business.
Now, there are a variety of financial calculations which are used in assessing the status of A/R. They include: DSO (Days Service Out), Trend Analysis, A/R vs Sales, Ratio Analysis, A/R vs A/P (Accounts Payable), and various others. These are calculations for another discussion.
So, let’s set some basic parameters:
A/R is for sales/revenues posted that you have yet to collect the funds for
Sales terms are Net 30
The costs for products/services related to A/R might have already been paid for or might be still outstanding expenses which are listed in A/P
If the products/services have already been paid for, you have used existing cash flow to fund these expenses
If the products/services have not been paid for, you will need payment to fund the payment for products/services, or you will need to pay for them from existing cash flow
A/R is usually listed as a total amount, but the aging of A/R provides a more critical analysis of the A/R balance
The age of A/R accounts can result in some detrimental assessments of financial performance
A comparison of aged A/R vs aged A/P provides some critical insights
This type of comparison could result in some detrimental assessments of financial performance
Things Balance Out – Or Do They?
For the purpose of examples, let’s assume that A/R = $100,000 and A/P = $100,000. In this instance, one can assume that you are owed as much as you owe (excluding other debts like short- and long-term liabilities, etc.). One can also assume that everything balances out. But, let’s age out both of these accounts and see what happens.
A/R Total: 100,000 A/P Total: 100,000
Current: 35,000 Current: 42,000
30+ 20,000 30+ 16,000
60+ 12,000 60+ 32,000
90+ 22,000 90+ 7,000
120+ 11,000 120+ 3,000
Now, despite the fact that one might assume that the total balances for A/R and A/P equalize themselves out, in fact, when we age both accounts, we can see some rather distressing realities.
In the Current line, we can see that we are owed far less than what we owe, which means that we might have to tap existing cash to maintain current payments against A/P. We can use the same type of comparison/calculation for all of the other aged line items.
If we combine the Current and 30+ line items and compare them, we will still owe more than what we are owed if both accounts are settled: A/R = $55,000 vs A/P = $58,000.
If we combine the Current, 30+ and 60+ line items, we significantly owe more than what we are owed if both accounts are settled: A/R = $67,000 vs A/P = $90,000.
When Is A/R Not an Asset?
Now, let’s just state that these figures are being used as an example to illustrate some problematic issues. Hopefully, your figures don’t look like this. If they do, please contact us at Tom Vignali CPA, Inc. for immediate assistance!
The above example is used to illustrate some problems when comparing the aging of A/R and A/P. It identifies how slow collections might impact your use of available cash. If you have limited available cash, this problem becomes even more critical. If the total A/R were significantly lower than the total A/P, other problems would be evident as well.
But, let’s get back to the initial premise that A/R is an asset and A/P is a liability. That’s possibly not true with the example provided. It is true that the A/P balance is a liability and always will be until paid for. But as for the A/R balance, well, some rather nasty things could happen when dealing with “old” receivables!
From A/R to Potential Bad Debt
First off, your existing lender, or potential lender, will most likely not consider A/R balances beyond 90+ as collateral assets, and they will discount them from your assets. In the above example, this will mean that $33,000 is removed as an asset from your Balance Sheet and listed as doubtful accounts or potential bad debt. This would mean that there is no longer an equal balance between A/R and A/P since the A/R balance will be reduced by $33,000, setting up a comparison of:
A/R = $67,000 vs. A/P = $100,000 (which means you owe more than you are owed!)
If you have a current loan or line of credit that has covenants regarding A/R balances, this could be devastating!
If you are applying for a loan and intend to use your A/R balance as collateral, this type of reduction could seriously impair your ability to obtain the loan.
Also, if these amounts actually do become bad debt, although they can be “written off,” you will still have to pay for all related expenses (products and services), and you will not glean any of the anticipated profits.
Another impact of such a reduction or re-classification is that these A/R amounts will not be able to be used in any cash flow projections. The result of reduced available cash in your projections for an existing or potential lender could easily put your available cash flow position into the negative, which is never looked upon favorably.
Protect the Financial Position of Your Company
These are just a few calculations every company should make regarding A/R. We hope they illustrate how an asset can easily become a liability and negatively impact the financial position of your company. We highly recommend that you use the above example and insert your own numbers into the calculation, and then perform a similar analysis. Does it generate a positive or negative set of insights?
As referenced earlier, there are many other calculations and ratios which can be used to analyze A/R. This is just one set of calculations we wanted to alert you to. It is easy to perform at any time and provides some warning signs that might merit immediate attention.
If you would like to further discuss this process, don’t hesitate to contact us at: Tom Vignali CPA, Inc.
Contact Us:
Thomas W. Vignali CPA Inc.
118 Point Judith Road
Narragansett, RI 02882
T: (401) 415-0798
tom@tomvignalicpa.com
www.tomvignalicpa.com
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