Credit Sales and Cash Flow: The Delicate Dance of Accounts Receivable

Extending credit to customers is a powerful tool to increase sales and build loyalty, but it comes with a price: delayed cash inflows. When you sell on credit, you create accounts receivable—amounts owed by customers that have yet to be collected in cash. The size of your accounts receivable balance depends largely on your average sales credit period.

For example, if your business has annual sales of $52 million and offers an average credit period of five weeks, your accounts receivable balance will approximate five weeks’ worth of sales, around $5 million. This means $5 million of your resources are tied up in credit extended to customers, unavailable for immediate use.

This delay impacts your cash flow and working capital requirements. The longer your customers take to pay, the more capital you must find elsewhere to finance operations, whether through borrowing or equity. This financing has a cost.

To manage this, businesses use the accounts receivable turnover ratio, calculated by dividing annual sales by average accounts receivable. A turnover of 10.4 means you collect receivables roughly every five weeks, consistent with the credit terms offered.

Improving collection efficiency by shortening the credit period or accelerating collections can free up significant cash. For instance, reducing the average credit period from five to four weeks could release about $1 million in cash, lowering borrowing costs and enhancing liquidity.

However, tightening credit policies must be balanced against potential sales losses and customer satisfaction. Effective credit management involves setting appropriate terms, monitoring receivables aging, and proactive collection efforts.

In the next installment, we will examine how inventory levels and cost of goods sold relate to cash flow and working capital management.