In today’s business world, intangibles have grown in importance, but “old school assets and liabilities” such as accounts receivable and payable have grown in relevance. With the rise in SaaS businesses that rely on subscriptions for revenues, understanding how the business recognizes revenues and when those monies arrive in their accounts carries more importance in today’s internet economies.
Subscription businesses such as Adobe, Intuit, Twilio, Netflix, Spotify, and many others rely on the working capital cycle of accounts receivable, accounts payable, and working capital to generate cash to operate their businesses.
Understanding the accounting behind accounts receivable and payable will help us understand the cash flow from its revenues to returns on invested capital, which drives the company’s cash flows and, ultimately, the value.
These terms are also important in the Fintech world, with many of these companies capturing fees or income that they don’t receive right away. But it all goes back to the flow of cash from customers to suppliers to reinvestment to cash flow.
In today’s post, we will learn:
- What are Accounts Receivable?
- What are Accounts Payable?
- Accounts Receivable vs. Accounts Payable
- Working Capital Cycle
- Investor Takeaway
Okay, let’s dive in and learn more about accounts receivable vs. payable and working capital.
What Are Accounts Receivable?
The classic definition of accounts receivable is:
“accounts receivable represents the amount of money a company expects to collect from its customers.”
These receivables grow from sales of products or services from which customers have not yet paid. You can think of these sales as credit sales or sales on account.
The amount that we find on the balance sheet represents the total owed receivables less the estimated uncollectable. The “bad” accounts are an estimate and are uncertain.
An example from Adobe’s 10-k, dated November 2020:
“A receivable is recorded when an unconditional right to invoice and receive payment exists, such that only the passage of time is required before payment of consideration is due. Timing of revenue recognition may differ from the timing of invoicing to customers.
Certain performance obligations may require payment before delivery of the license or service to the customer. Included in trade receivables on the Consolidated Balance Sheets are unbilled receivable balances which have not yet been invoiced, and are typically related to license revenue or services which are delivered prior to invoicing.”
The accounts receivable account is part of a company’s current assets, meaning that Adobe intends to collect any revenues listed as receivables within the calendar year.
The accounts receivable can come from anywhere; it doesn’t have to be customers. It could be a bank, lawyer, or another business.
In Adobe’s case, they tell us that no customer makes up more than 10% of its accounts receivable.
I am focusing on Adobe because it is easy to illustrate how accounts receivable impact the company as their receivable represents a large part of its non-cash working capital that is liquid; it also represents a good example of the SaaS business model to study.
Adobe comes from their subscription agreements when they recognize revenue, typically ranging from 1 to 36 months. Because of those agreements, Adobe reports revenues each quarter from subscription agreements entered in the previous quarter. Meaning accounts receivable is a holding place for longer-term subscriptions and revenue they will receive in the future, minus any bad accounts.
Accounts receivable is a critical piece of the working capital of any company and is one of the more liquid sources of working capital outside of cash.
What Are Accounts Payable?
The classic definition of accounts payable is:
“obligations to a company’s suppliers for merchandise purchases made on the account.”
The accounts payable is a current liability that keeps track of any money Adobe owes suppliers. It is the most liquid of liabilities and is critical to the working capital calculations or part of the capital cycle. They are also part of defining working capital using current assets and current assets known as the quick ratio. The quick ratio can give you a snapshot of the liquidity of the company.
We can think of accounts payable as short-term debt, but we don’t’ pay any interest on the balance. As with accounts receivable, any changes in either account will show up in the cash flow from the operations section of the cash flow statement.
Accounts payable is Adobe’s account to pay suppliers for services and how they use it to manage its cash flow. As a company pushes its accounts payable out longer, Adobe uses that cash for other purposes. That is one of the levers used by Walmart and Amazon to help extend the cash flow for both companies.
Accounts payable is an important line item to keep an eye on because if the accounts payable increases over time, it means the company is buying more services or goods on credit instead of cash. That in and of itself might not mean anything, but it could indicate the company is struggling to generate cash to pay for its supplies.
Managing accounts payable well is critical to managing cash flow and working capital for any company.
Accounts Receivable vs. Accounts Payable
Accounts receivable and accounts payable are part of the working capital cycle of any company. They are not related per se, meaning that each account is not dependent on the other. For example, Adobe generating subscription revenues have little to do with paying suppliers other than the cash received helps them pay that bill.
Instead, they are part of a cycle of companies using their working capital to fund the business’s operations. For example, a company like Intel can’t build its fabs for semiconductors without silicon or store those fabs in a warehouse without its accounts payable or inventories. They also can’t generate revenues without offering subscriptions for different services or supplies that they can pay for over multiple periods or on credit.
Think of accounts receivable and payables as assets and liabilities, and they represent cash inflows (receivables) and cash outflows (payables). When a company lists an item like an account receivable, it indicates they expect to collect that money within the calendar year. And the accounts payable account indicates the company expects to pay for that raw material or service within the same calendar year.
An easy way to think of the difference between the two is:
- Accounts receivable is selling something on credit; the customer owes you money for that service.
- Accounts payable is the company buying supplies on credit; the company owes the supplier money for those supplies.
Like Adobe, many companies list their accounts receivables as Trade Receivables and accounts payables as Trade Payables.
Understanding the Working Capital Cycle
The working capital cycle is the length of time it takes for a company to convert net working capital into cash. Or think of current assets minus current liabilities, represented by the quick ratio. Businesses try to manage this cycle to optimize their cash flow by quickly selling inventory, collecting revenue (receivables) rapidly, and paying their bills (payables) slowly.
As I mentioned above, Amazon and Walmart are masters of this manipulation. Because of their size, both companies manage to extract favorable terms with both accounts payable and accounts receivables by allowing them to extend suppliers, in some cases, for many months before paying them, while collecting all revenues far in advance of that bill payment.
Here are the steps most companies follow in the working capital cycle:
- The company purchases supplies on credit to create its product. For example, they might have 51 days to pay for the raw materials (payable days).
- The company sells through its inventory, typically in 91 days (inventory days).
- The company receives payment for products or services sold to customers in 33 days (receivable days).
For example, the company buys the supplies and materials to produce its product in the first step. In Intel’s case, they buy the silicon to produce the semiconductor chips, but they don’t put out any cash for the purchase (accounts payable). Per their agreement, they will have to pay for that silicon in 51 days.
Now, 33 days after buying the silicon, Intel finishes the semiconductor chips and starts to sell them, but the company doesn’t receive cash for the sales, as they are sold on credit (accounts receivable).
Twenty days after selling the chips, Intel receives its cash, and the circle of working capital is complete.
The working capital formula, based on the above illustration:
Working Capital Cycle = Inventory Days + Receivable Days – Payable Days
Plugging in the numbers from above:
- Inventory days – 91
- Receivable days – 33
- Payable days – 51
Working Capital Cycle = 91 + 33 – 51 = 73 days
That means that Intel is only out of pocket cash for 73 days before receiving full payment for its chips.
To better understand how to calculate inventory days, receivable days, and payable days, please refer to the excellent article:
Let’s look at Amazon to get an idea of how this idea will work. I am going to pull some numbers from the latest 10-k to illustrate these ideas:
And the income statement for the revenues and cost of goods sold:
Okay, now we can calculate our working capital cycle with the above-highlighted numbers.
- Accounts Receivable Year 1 = $20,816
- Accounts Receivable Year 2 = $24,542
- Revenues = $386,604
- Days in calendar year = 365
- Accounts Payable Year 1 = $47,183
- Accounts Payable Year 2 = $72,530
- Cost of Goods Sold = $291,824
- Days in Calendar year = 365
- Year One Inventories = $20,497
- Year Two Inventories = $23,795
- Cost of goods sold = $291,824
- Days in calendar year = 365
Now that we have all of our cash conversions calculated, we can determine what Amazon’s working capital cycle is:
- Accounts Receivable = 21.44
- Inventory = 27.70
- Accounts Payable = 78.88
Amazon’s working capital cycle = 21.44 + 27.70 – 78.88 = -25.73 days. That tells us that Amazon collects the cash 25 plus days before it pays its bills. It is also one reason for the success of Amazon’s model; they can collect their monies before paying their bills which helps them manage their cash flows by putting the burden on suppliers. It is also one reason why so many people dislike Amazon and its business practices, the same with Walmart.
Now, this is a process we can use for subscription-based businesses such as Adobe as well. The company’s main product, for example, is a software subscription allowing customers to access their PDF editing software. Because of the nature of their business, they don’t carry inventories, which means we remove that item from the working capital cycle.
Instead of walking through all of that again, I will pull the numbers from Adobe’s latest 10-k, and we will look at its working capital cycle based on the accounts receivable and accounts payable.
Accounts Receivable Days Outstanding
- Nov 2019 Accounts Receivable = $1,535
- Nov 2020 Accounts Receivable = $1,398
- Nov 2020 Revenue = $12,868
- Accounts Receivable days outstanding = 41.60
Accounts Payable Days Outstanding
- Nov 2019 Accounts Payable = $209
- Nov 2020 Accounts Payable = $306
- Nov 2020 Cost of Goods Sold = $1,722
- Accounts Payable days outstanding = 54.58
Now, we take those numbers and plug them into our working capital cycle, and we get:
Working capital cycle = 41.60 – 54.58 = -12.58 days
All of this tells us that Adobe receives its money before paying its bills, helping its cash flow.
Okay, now that we have a firm understanding of how to calculate the working capital cycle, we can look at Adobe’s average over the last five years, including its trailing twelve months, to see how management controls its working capital cycle.
- Nov 2017 = 14.86
- Nov 2018 = 5.42
- Nov 2019 = 3.45
- Nov 2020 = -12.98
- TTM = -19.80
- Average = -1.81 days to convert cash
Here are the working capital cycles of a few more businesses for reference:
Accounts receivable and accounts payable were always items I didn’t fully understand until I spent some time working through the working capital cycles to understand the impacts on the company’s cash flows.
Accounts receivable is money the company hasn’t collected yet, while accounts payable is money the company hasn’t paid yet. Think of it as credit extended and credit received.
A few other ideas to consider when thinking about accounts receivable and accounts payable.
Businesses with normal operating cycles often require financing to make it from point A to point B to help cover the gap between payment from customers and paying their bills.
That concept is particularly true for rapidly growing companies. A common philosophy regarding the relationship to growth and working capital is to “not grow the company out of money.”
To deal with this common issue, many companies will set up credit or credit revolvers lines to help them deal with the temporary gaps in cash. Many of the banks will use the inventories or accounts receivable as collateral.
With the increase in subscription-based businesses or SaaS companies, we will start to see working capital cycles become less of an issue. For example, as Microsoft has morphed into a subscription-style business, they have moved their working capital cycle from around 20 days to -15 days.
These business styles are less capital intensive on an inventory side, leading to quicker turnarounds in working capital and providing more liquidity for those businesses to grow. You will also see these types of businesses with higher returns on invested capital because that capital is less intensive and allows for greater flexibility.
A good rule of thumb is to look at the working capital cycle of the business, along with analyzing its return on invested capital. Both are good measures of efficiency in using capital to generate growth.
And with that, we will wrap up our discussion on accounts receivable vs. accounts payable and working capital for today.
As always, thank you for taking the time to read today’s post, and I hope you find some value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time take and be safe out there,