Question

You are estimating your company’s external financing needs for the next year. Your first-pass pro forma financial statements showed a large financing deficit for next year. How do you think reducing the collection period will change to your company’s operating plan would reduce the financing deficit if incorporated in revised pro forma financial statements?

Answer 1

The average collection period measures the length of time it takes to turn your average sales into cash. A longer average collection period represents a higher investment in accounts receivable and less cash available. Reducing your average collection period will improve your cash flow. The average collection period in days is calculated by dividing your present accounts receivable balance by your average daily sales:

current accounts receivable balance x 365/annual sales = Average collection period

If a cash flow gap, where the balance is negative at any time, is predicted early enough, you can take cash flow management steps to ensure that it is closed, or at least narrowed, in order to keep your business going. These steps might include: increase sales – by lowering prices, or increasing marketing or utilisation rates (although this could worsen the gap if your cash flow management is already poor) increase margins – by cutting costs and/or raising prices (although you need to be mindful of putting off customers or squeezing suppliers) tighten cash processes – such as collections or inventory management decrease anticipated cash outflows – by cutting back on inventory purchases or cutting operating expenses such as wages postpone a major purchase sell assets (but not those core assets essential to the business unless you can arrange a sale-and-leaseback deal on, for example, property) roll over a debt repayment (much tougher in a credit crunch) seek outside sources of cash, such as a short-term loan.