3 Most Effective Strategies for Forecasting Accounts Receivable

Forecasting accounts receivable is a crucial financial process that helps businesses predict future cash inflows from customer payments. By understanding the accounts receivable forecasting process and estimating when and how much money will come in from unpaid invoices, companies can make smarter decisions about spending, investments, and overall financial strategy.

Accounts receivable forecasting involves estimating the amount of money a company expects to receive from customers who owe them payment. It’s a way to predict future cash flows based on outstanding invoices and historical payment patterns. The goal is to get a reasonably accurate picture of when customer payments will come in and how much they’ll be. This helps with planning expenses, managing cash flow, and making financial decisions.

Forecasting accounts receivable provides several key benefits for businesses:

Better cash flow management

More accurate financial planning

Improved working capital management

Earlier detection of potential issues

More informed business decisions

Enhanced communication with stakeholders

Accurate forecasting of accounts receivable is essential for predicting future cash flow, which is crucial for maintaining financial health and making informed business decisions.

By estimating upcoming cash inflows, companies can time their expenses and investments more strategically. This helps avoid cash crunches and allows for more precise planning around revenues, expenses, and profits. Understanding future cash receipts also helps optimise working capital and reduces the need for external financing.

AR forecasts can reveal concerning trends in customer payments before they become major problems. This enables leadership to make smarter choices about growth investments, hiring, and more. Additionally, forecasts provide valuable data to share with investors, lenders, and other key stakeholders about the company’s financial health and outlook.

There are several common methods for forecasting accounts receivable. Each approach has its own strengths and limitations, so many companies use a combination of methods to create their AR forecasts.

Many forecasting methods rely on historical sales data to predict future accounts receivable, making it essential to analyse past sales trends and customer payment behaviours.

1. Percentage of Sales Method

This simple method assumes that accounts receivable will be a consistent percentage of total sales. Here’s how it works:

Calculate the historical AR percentage by dividing total accounts receivable by total sales for recent periods.

Project future sales for upcoming periods by creating a sales forecast.

Apply the AR percentage to projected sales to forecast future accounts receivable.

For example, if AR has historically been 20% of sales and you project $100,000 in sales next month, you’d forecast $20,000 in accounts receivable. This method is quick and easy to calculate, but it doesn’t account for changes in payment patterns or terms.

2. Days Sales Outstanding (DSO) Method

The DSO method uses the average time it takes customers to pay as the basis for forecasting. To implement this approach:

Calculate DSO by dividing accounts receivable by average daily sales for a period.

Project future sales for upcoming periods.

Apply DSO to sales projections by multiplying projected daily sales by the DSO to forecast AR.

For instance, if your DSO is 45 days and you expect $3,000 in daily sales next month, you’d forecast $135,000 in accounts receivable (45 x $3,000). This method accounts for payment timing, not just total AR, and helps create more accurate accounts receivable forecasts by assuming consistent payment patterns across customers.

3. Ageing Schedule Method

This approach uses historical data on how quickly different invoices are paid to create a more detailed forecast. It’s the most complex of the common methods but can provide the most accurate results. Using the ageing schedule method can significantly improve accounts receivable forecasting by providing a more detailed and accurate analysis of payment patterns.

To use the ageing schedule method:

Create an ageing schedule that groups outstanding invoices by age (e.g., 0-30 days, 31-60 days, etc.).

Calculate collection percentages to determine what percentage of invoices in each age group typically get paid.

Apply these percentages to current AR to estimate collections from existing receivables.

Factor in new sales by adding projected new receivables based on sales forecasts.

While this method requires more data and analysis, it accounts for variations in payment timing and can provide a more nuanced forecast.

The best forecasting approach for your business depends on several factors, including data availability, business model, industry norms, available resources, and desired accuracy. For most companies, using a combination of methods can lead to the most reliable forecast.

Here are a few tips for selecting the right method:

Assess your data: If you have access to detailed historical payment data and robust accounting systems, the ageing schedule method may offer the most precision. If your data is limited, starting with the percentage of sales or DSO method can still provide useful insights.

Consider industry standards: Certain industries may have longer or shorter payment cycles, which can impact the effectiveness of different methods. For example, businesses in industries with extended payment terms may find the DSO method particularly helpful in managing their cash flow.

Evaluate complexity vs. accuracy: More sophisticated methods, like the ageing schedule, generally provide more accurate results but require more time and resources. If your business has complex cash flow needs or variable payment patterns, investing in a more detailed forecast might be worthwhile.

Factor in customer behaviour: If you have a customer base with varying payment habits, such as clients who consistently delay payments, it's crucial to factor these behaviours into your forecast. The ageing schedule method excels in such scenarios by providing a clearer picture of potential delays.

Update forecasts regularly: Accounts receivable forecasting isn’t a one-time task. Regular updates ensure you’re working with the latest data, accounting for any changes in customer behaviour, sales trends, or payment patterns. By adjusting your forecasts, you can stay agile and make better decisions.

Many businesses use specialised software to streamline and automate their accounts receivable forecasting. These tools can pull data directly from accounting systems, create detailed projections, and even track payment patterns over time. Some common features of AR forecasting tools include:

Real-time data integration: Automatic updates from your accounting platform allow for more accurate and up-to-date forecasts.

Customisable reports: Many tools offer tailored reporting options, so businesses can drill down into specific areas, such as overdue accounts or customer payment trends.

Predictive analytics: Advanced forecasting software may use machine learning to anticipate future cash flows based on a wide range of factors, improving forecast accuracy over time.

Accounts receivable forecasting is an essential component of financial planning that helps businesses manage cash flow, optimise working capital, and make informed decisions about spending and investment. By choosing the right forecasting methods, regularly updating projections, and potentially leveraging technology, companies can gain better control over their financial health and future stability.