Q: How do you translate A/R and Inventory Days into dollars of cash flow?
A: A ready way to calculate the cash flow impact of a change in A/R or Inventory Days is to first calculate actual A/R or Inventory Days. With that calculation complete, one can recalculate the A/R balance using any combination of revised, or “what if”, values in the formula, e.g., “what if” A/R days were 50 days or Sales were $10,000,000, to compute a “what if” A/R balance. We can then simply compare the actual A/R balance and the “what if” A/R balance to identify the cash flow impact of a change in A/R Days or a change in Sales or a change in both.
The formula for A/R Days is ((A/R) / (Sales)) x (365). Using the Seaside Marble, Inc financial statements that you’ll receive in the Solutions for the Exercise, we calculate actual 2017 and 2018 A/R Days as follows:
- 2017 A/R Days = ($1,010,373 / $10,694,441) x (365) = 34.5 Days
- 2018 A/R Days = ($1,184,472 / $15,717,587) x (365) = 27.5 Days
If we project 2019 A/R Days to be 35.0 Days (a return to the 2017 level of A/R Days) instead of 2018 level of 27.5 Days, we now calculate the change in the A/R balance using projected A/R Days and projected Sales. We make the calculation by re-arranging the formula for A/R Days and solving for the 2019 A/R balance as follows:
- Projected 2019 A/R at 35 Days = ((Projected 2019 A/R Days) / (365)) x (Projected 2019 Sales)
- Projected 2019 A/R at 35 Days = ((35.0) / (365)) x ($18,861,104) = $1,808,599
Had we assumed that A/R Days would remain at the 2018 level of 27.5 Days, our projected 2019 A/R balance would be $1,421,042, as follows:
- Projected 2019 A/R at 27.5 Days = ((27.5) / (365)) x ($18,861,104) = $1,421,042
By comparing the projected A/R balance at the 2018 level of 27.5 days with the projected A/R balance at 35.0 days, we identify the impact of the change in projected A/R Days from 27.5 to 35.0 days. The difference between the two balances is $387,557 or $1,808,599 – $1,421,042 = $387,557, which is the cash impact – a cash outflow – resulting from the 7.5 day increase in A/R Days.
Since we know the cash impact from the 7.5 day increase in A/R Days, we can compute the cash impact from projected sales growth of 20% from $15,717,587 in 2018 to $18,861,104 in 2019. The change in the A/R balance from 2018 to 2019 is $624,127. The balance increases from $1,184,472 in 2018 to a projected balance of $1,808,599 in 2019 at 35 Days for Accounts Receivable. $387,557 of this increase is explained by the 7.5 increase in A/R Days. Therefore, the remaining $236,570 is explained by sales growth of 20% in 2019.
To compute the cash impact from the change in Inventory Days and the change in the growth of COGS, use the same approach as we’ve outlined above.
Course overview: Analytical Focus in the Credit Write-Up