Receivables Rx: Key Metrics to Assess the Health of your Cash Flow

For many businesses, accounts receivable (AR) is one of the largest assets on the balance sheet. It represents the cash you’ve earned but haven’t yet collected. Efficient AR management is critical for maintaining healthy cash flow, reducing bad debt and fueling growth. But a key question often goes unasked: How do your company’s receivables compare to others in your industry? This is where benchmarking comes in.

Why benchmarking matters

Benchmarking is the process of comparing your company’s financial and operational metrics against those of peers in your industry. For receivables, benchmarking helps determine whether your collections practices, customer credit policies and cash management strategies align with competitors. The key is to use data from businesses that closely resemble your own in terms of size, customer base and industry segment.

Without context, an AR balance or ratio can be misleading. For example, collecting in 45 days might sound reasonable. However, if the industry average is 30 days, you’re financing your customers longer than your competitors are, potentially straining your liquidity. Benchmarking provides a reality check, highlighting areas where you may be lagging and where improvements could quickly boost cash flow.

3 diagnostic tools

There are three primary tools you can use to monitor how well your company manages receivables:

1. AR turnover ratio. This ratio is computed by dividing net credit sales by your average AR balance. The average balance equals the sum of your beginning and ending AR balances, divided by two. This ratio measures how many times, on average, receivables are collected during a period. A higher turnover suggests more efficient collections. When compared to industry data, it can reveal whether your business is converting receivables to cash as quickly as your peers.

2. DSO ratio. A more intuitive way to evaluate AR is to estimate the average days it takes to collect payment after a sale. The days’ sales outstanding (DSO) ratio equals the number of days in the period divided by the AR turnover ratio. For example, if your AR turns 10 times per year, your DSO ratio would be approximately 36.5 days (365 divided by 10). A lower DSO ratio generally means faster collections. If your DSO is higher than industry benchmarks, it could signal overly generous credit terms or collections inefficiencies.

3. AR aging report. This report categorizes receivables based on how long they’ve been outstanding. It breaks down the total balance into aging buckets, such as 0 to 30 days, 31 to 60 days, 61 to 90 days and over 90 days. Benchmarking your percentages in each bucket against industry norms helps identify whether overdue accounts are a common issue in your sector or a problem specific to your business’s collections practices.

The percentage of delinquent accounts (typically those over 90 days outstanding) is another critical number. You may decide to outsource these accounts to third-party collectors to eliminate the hassles of making collections calls and threatening legal actions to collect what you’re owed.

Fraud considerations

Although fraud in accounts receivable is uncommon relative to day-to-day operational challenges, when it does arise it most often involves lapping of customer payments, fictitious customer accounts, or the misclassification of personal expenses through the business. These schemes are not typically identified through standard AR benchmarking tools, but if irregularities are suspected, our forensic accounting team has the expertise and resources to conduct a thorough investigation and safeguard your organization.

Turning insights into action

Benchmarking isn’t just about spotting differences — it’s about acting on them. FMD can help evaluate your company’s AR management, including providing reliable industry-specific benchmarks, brainstorming practical strategies to shorten your collections cycle and investigating any suspicious trends. Contact us for more information.

Audit alert: Beware of Potential Conflicts of Interest

As year end approaches, many businesses will soon be preparing for their annual audits. One key consideration is ensuring there are no potential conflicts of interest that could compromise the integrity of your company’s financial statements. A conflict of interest can cloud an auditor’s judgment and undermine their objectivity. Vigilance in spotting these conflicts is essential to maintain the transparency and reliability of your financial reports.

Understanding conflicts of interest

According to the American Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Companies should be on the lookout for potential conflicts when:

• Hiring an external auditor,

• Upgrading the level of assurance from a compilation or review to an audit, and

• Using the auditor for non-audit purposes, such as investment advisory services and human resource consulting.

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, if an auditor recommends an external payroll provider’s software to an audit client and receives a commission from the provider, a conflict of interest likely exists. Why? While the third-party provider may suit the company’s needs, the payment of a commission raises concerns about the auditor’s motivation in making the recommendation. That’s why the AICPA prohibits an audit firm from accepting commissions from a third party when it involves a company the firm audits.

Now consider a situation in which a company approaches an audit firm to assist in a legal dispute with another company that’s an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

Managing potential conflicts

AICPA standards require audit firms to avoid conflicts of interest. If a potential conflict is unearthed, audit firms have the following options:

• Seek guidance from legal counsel or a professional body on the best path forward,

• Disclose the conflict and secure consent from all parties to proceed,

• Segregate responsibilities within the firm to avoid the potential for conflict, and/or

• Decline or withdraw from the engagement that’s the source of the conflict.

Ask your auditors about the mechanisms the firm has implemented to identify and manage potential conflicts of interest before and during an engagement. For example, partners and staff members are usually required to complete annual compliance-related questionnaires and participate in education programs that cover conflicts of interest. Firms should monitor for conflicts regularly because circumstances may change over time, for example, due to employee turnover or M&A activity.

Safeguarding financial reporting

If left unchecked, conflicts of interest can compromise the credibility of your financial statements and expose your company to unnecessary risks. Our firm takes this issue seriously and adheres to rigorous ethical guidelines. If you suspect a conflict exists, contact FMD to discuss the matter before audit season starts and determine the most appropriate way to handle it.

How do Businesses Report Cloud Computing Implementation Costs?

Today, many organizations rely on cloud-based tools to store and manage data. However, the costs to set up cloud computing services can be significant, and many business owners are unsure whether the implementation costs must be immediately expensed or capitalized. Changes made in recent years provide some much-needed clarity to the rules.

Advantages of cloud storage

Before diving into the accounting rules, it’s important to understand the potential benefits of cloud-computing arrangements, including:

Cost savings. Cloud storage reduces the need for physical servers and IT infrastructure, lowering capital expenses.

Remote access. Cloud systems let your team access data and tools from anywhere. This can be ideal for hybrid or remote work models — or small business owners who frequently travel.

Scalability. As your business grows, cloud services can easily scale to match your data and software needs.

However, it’s critical to vet cloud-service providers carefully. Always choose a provider that offers strong security protocols and automated data backup. This reduces the risk of data loss from hardware failure or human error. As companies grow, they may decide to switch to cloud providers that offer enhanced security or more robust features.

Implementation costs

Whether your business is adopting cloud services for the first time or transitioning from one provider to another, setup costs can be significant. These often range from several thousand to tens of thousands of dollars. First-time implementation costs typically include:

• Consulting and planning,

• System configuration,

• Data migration,

• Integration with existing tools,

• User training, and

• Post-launch support.

Among the most labor-intensive, expensive parts of the process are migrating data securely and ensuring that cloud applications are tailored to your workflow. Additionally, time spent coordinating between your team, vendors and consultants can add up quickly.

Switching cloud providers can also be costly. You’ll likely need to repeat many of the same implementation steps. Plus, you might face other challenges, such as reformatting or cleaning data, re-establishing integrations, retraining employees and minimizing downtime. Some providers may charge exit fees or make data retrieval cumbersome. The more customized your current system is, the harder (and costlier) it may be to transfer your setup to a new platform.

Accounting rules

Previously, U.S. Generally Accepted Accounting Principles (GAAP) required companies to immediately expense all setup costs for cloud contracts that didn’t include a software license. This treatment impaired a company’s profits in the year it implemented a cloud-computing arrangement.

Fortunately, the Financial Accounting Standards Board updated the accounting rules in 2018. Now, businesses can capitalize and amortize certain implementation costs for service contracts that don’t include a software license. Specifically, costs related to the application development phase — such as configuration, coding and testing — can be capitalized and gradually expensed over the life of the contract. However, costs from the preliminary research phase or post-launch support still must be immediately expensed. Spreading out certain implementation costs over the contract’s life can improve financial ratios and reduce year-over-year volatility in reported profits.

The updated guidance went into effect in 2020 for calendar-year public companies and in 2021 for all other entities. However, you may not be aware of these changes if your company is adopting cloud services for the first time — or if you previously implemented a cloud arrangement under the old rules and are now switching providers.

For more information 

The accounting rules for cloud computing arrangements can be complex, especially when determining which costs qualify and how to apply them across different contracts. Contact FMD for guidance on reporting these arrangements properly under current GAAP. We can help you review agreements, classify implementation costs, and choose a provider that offers both strong security and the functionality your business needs.

Budgeting Basics for Entrepreneurs

Starting a business can be rewarding, but the financial learning curve is often steep. The U.S. Bureau of Labor Statistics estimates that one in five new businesses will fail within one year of opening, roughly half will close within five years, and less than a third will survive for 10 years or longer. A common thread in early failures is weak financial planning and oversight.

A comprehensive, realistic budget can help your start-up minimize growing pains and thrive over the long run. However, accurate budgeting can be difficult when historical data is limited. Here are some tips to help jumpstart your start-up’s budgeting process:

Start at the top

First, forecast the top line of your company’s income statement — revenue. How much do you expect to sell over the next year? Monthly sales forecasts tend to become more reliable as the company builds momentum and management gains experience. But market research, industry benchmarks or small-scale test runs can help start-ups with limited history gauge future demand.

Next, evaluate whether you have the right mix of resources (such as people, equipment, tools, space and systems) to deliver forecasted revenue. If your current setup doesn’t support your goals, you may need to adjust your sales targets, pricing or operational capacity.

Get a handle on breakeven

Many costs — such as materials, labor, sales tax and shipping — vary based on revenue. Estimate how much you expect to earn on each $1 of revenue after subtracting direct costs. This is known as your contribution margin.

Some operating costs — such as rent, salaries and insurance — will be fixed, at least over the short run. Once you know your total monthly overhead costs, you can use your contribution margin to estimate how much you’ll need to sell each month to cover fixed costs. For instance, if your monthly fixed costs are $10,000 and your contribution margin is 40%, you’ll need to generate $25,000 in sales to break even.

However, don’t be discouraged if your small business isn’t profitable right away. Breaking even takes time and hard work. Once you do turn a profit, you’ll need to save room in your budget for income taxes.

Look beyond the income statement 

Next, forecast your balance sheet at the end of each month. Start-ups use assets to generate revenue. For instance, you might need equipment and marketing materials (including a website). Some operating assets (like accounts receivable and inventory) typically move in tandem with revenue. Assets are listed on the balance sheet, typically in order of liquidity (how quickly the item can be converted into cash).

How will you finance your company’s assets? Entrepreneurs may invest personal funds, receive money from other investors or take out loans. These items fall under liabilities and equity on the balance sheet.

Monitor cash flows

Even profitable businesses can run into trouble if they fail to manage cash wisely. That’s why cash flow forecasting is essential. Consider these questions:

• Will your business generate enough cash each month to cover fixed expenses, payroll, debt service and other short-term obligations?

• Can you speed up collection or postpone certain payments?

• Are you stockpiling excess inventory — or running too lean to meet demand?

Forecasting monthly cash flows helps identify when cash shortfalls, as well as seasonal peaks and troughs, are likely to occur. You should have a credit line or another backup plan in case you fall short.

Compare your results to the budget

Budgeting isn’t a static process. Each month, entrepreneurs should revisit their budgets and evaluate whether adjustments are needed based on actual results. For instance, you may have underbudgeted or overbudgeted on some items and, thus, spent more or less than you anticipated.

Some variances may be the result of macroeconomic forces. For example, increased government regulation, new competition or an economic downturn can adversely affect your budget. Although these items may be outside of your control, it’s critical to identify and address them early before variances spiral out of control.

Seek external guidance

Does your start-up struggle with budgeting? FMD can help you prepare a realistic budget based on past performance, industry benchmarks and evolving market trends. Contact us to help your small business build a better budget, evaluate variances and beat the odds in today’s competitive marketplace.