In accrual accounting, determining exactly how a company generates or burns its cash is not as straightforward as you may expect. Because of the way companies must record their accounts payable and accounts receivable, measuring the efficiency of a company's cash flow requires a deeper understanding than simply saying "cash in versus cash out."
Let's take a minute to understand how these two accounts work together to affect cash flow with a few examples and some simple math.
How accounts payable affects cash flow
Sometimes when a company purchases supplies, it doesn't pay right away. Its suppliers allow the company 30, 60, 90, or even 120 days before they're required to pay up. For the purchasing company, these instances are recorded on the balance sheet as a short-term liability called accounts payable.
Over time, how a company uses its accounts payable can have a big impact on its cash flow. Accounts payable are considered a source of cash, meaning that by taking advantage of these arrangements with suppliers, a company can actually increase its cash flow and cash on hand.
At first, the concept can seem a bit abstract, so let's consider a quick hypothetical.
Let's say that a company has accounts payable of $100,000 at year end and cash on hand of $50,000. Over the course of the following year, its suppliers allow the company to double the amount of time they can wait before paying their bill from one month to two months.
This change would have the effect of doubling their accounts payable, assuming the company takes full advantage of the arrangement. When the new arrangement goes into effect, the purchasing company wouldn't have to pay the bill that month, because of the extra month it now has available to wait. A simple way to think about this dynamic is to view the extra time as a free month this year where the purchaser doesn't have to make any payments to its suppliers.
By not having to pay the bill that month, the company gets to keep that cash. So at year end the following year, the accounts payable will double to $200,000, and the cash on hand will increase by $100,000 as well, equal to the amount it saved in its "free month" from its suppliers.
The math swings both ways, however. If the scenario were reversed and the suppliers cut the company's time to pay from 60 days to 30, then the company's cash flow would take a big hit. Instead of getting a "free month," it would effectively have to pay double one month to meet the new payment requirement.
How accounts receivable impacts cash flow
The suppliers in our scenario have their own cash flow considerations in setting how long they're willing to wait to receive payment. For the supplier, letting a customer wait for a little while before paying is called an account receivable. These short-term credits are recorded as current assets on the balance sheet, and they have an inverse impact on cash flow as accounts payable. Accounts receivable, therefore, are a use of cash.
You can think about it by reversing the example. Let's say the supplier starts the first year with $50,000 in cash and accounts receivable of $100,000 (remember, this is money to be collected, not to be paid). If the supplier allows its customer to pay in 60 days instead of 30, that means the customer gets a free month while the supplier has to wait an extra 30 days to collect that cash. In the subsequent year, that means the supplier's cash flow would have only 11 monthly payments instead of 12. That extra month would, at the end of the year, reduce the supplier's cash flow by $100,000. In this case, that would put its cash balance into the red. Not good.
Just as in the first example, the inverse is also true. If the supplier reduced its accounts receivable, that would cause its cash flow to increase. It would, in essence, collect 13 months of payments from its customers as the customer has to catch up to the new repayment terms.
Doing the calculation
The calculation of exactly how much cash flow changes because of accounts payable and accounts receivable is fairly straightforward.
The first step is to subtract the current period's dollar amount for accounts payable from the dollar amount from the last period. This could be annually, quarterly, or any other period.
If the difference in accounts payable is a positive number, that means accounts payable increased by that dollar amount over the given period. Increasing accounts payable is a source of cash, so cash flow increased by that exact amount. A negative number means cash flow decreased by that amount.
Next, do the same thing for accounts receivable. For accounts receivable, a positive number represents a use of cash, so cash flow declined by that amount. A negative change in accounts receivable has the inverse effect, increasing cash flow by that amount.
The cash conversion cycle
What we have discussed here is a component of a larger process called the cash conversion cycle. Like accounts receivable and accounts payable, there are numerous other accounts on the financial statements that affect cash flow. Inventory, capital spending, profits and losses, investments, borrowings, and a myriad other factors all play an important role.
For public companies, there's a much easier way to find the end result instead of doing all the math yourself. Save yourself the time and effort and just review the company's statement of cash flows, included with its financial statements. The statement of cash flows includes the cash impact of changes to accounts payable and accounts receivable, as well as every other material impact on cash from both the income statement and balance sheet.
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