The ‘cash component of revenue’: a dangerous myth?

Some academics and investors often talk about ‘the cash component of revenue’. I understand why they use this shorthand label, but it risks causing misunderstanding. In this post, I examine the following:

• what is the ‘cash component of revenue’?
• an accounting identity linking revenue and cash receipts
• judgement in measuring trade receivables
• the ‘cash component of earnings’

What is the ‘cash component of revenue’

When people talk about the ‘cash component of revenue’, they typically mean the amount of cash received from customers during the period. Of course, that amount often interests users of financial statements, but I believe the focus on this number, labelled as ‘cash component of revenue’ occurs for 2 reasons:

• some academic researchers build quantitative models focusing on an equation: an accounting identity linking changes in trade receivables to revenue and to cash receipts. Those models analyse revenue into (a) cash receipts and (b) changes in trade receivables.
• some users of financial statements see ‘revenue’ as distorted too much by judgement and prefer to use a ‘cash’ number less affected by judgement.

An accounting identity linking revenue and cash receipts

The following tautological equation is mathematically true.

Here is an example using that identity. Suppose that:

• trade receivables were £200 at the start of year
• revenue for the year was £1,000
• cash of £900 was collected from customers during the period
• because of those transactions, trade receivables were £300 at the end of the year.

Here is the accounting identity using those numbers:

People sometimes use the label ‘cash component of revenue’ for the amount of £900, labelled above as ‘cash receipts from customers’.

The only transactions shown in the above accounting identity and example are revenue (for goods or services sold to customers) and cash receipts from customers. More complete versions of the identity (and of the example) would include other changes in trade receivables—such as bad debts (and changes in estimates of bad debts), changes in foreign exchange rates and effects of business combinations or of business disposals.

Because those other changes do not affect the points made here, the rest of this post ignores those other changes. For simplicity, I also assume throughout this post that all sales transactions are sales of a single item of inventory, at a single date and with no uncertainty about when seller should recognise all the revenue for that sale.

The label ‘cash component of revenue’

The above accounting identity is automatically correct. But the label ‘cash component of revenue’ is a complete mis-description A cash receipt isn’t part of revenue at all. A cash receipt is a completely different kind of transaction from a sale to a customer, and they have opposite effects on trade receivables:

• a sale to a customer increases trade receivables—and causes revenue.
• receiving cash subsequently from the customer decreases trade receivables—and does not affect revenue.  

Expanding the example

Let me show this using the above example, expanded with one more piece of information: cash sales during the year were £10. (As a reminder, I am assuming that no bad debts occurred, and that no bad debts are expected.) Table 1 now summarises the components of revenue for the year and cash receipts for the year.

What the expanded example shows

Table 1 shows clearly that the revenue for the current year has 3 components:

• credit sales of £990. Of this, £690 has already been received, leaving £300 still to be received.
• cash sales of £10.
• cash receipts of £200 for credit sales made last year (or even earlier).

As noted above, some academic researchers build quantitative models that analyse revenue into 2 components: (a) a ‘cash component’ (cash receipts); and (b) an ‘accruals component’ (the change in trade receivables). Table 1 shows clearly that the cash receipts of £900 for the current year are not a component of revenue for the year. In fact, the only item that could perhaps be said to be a ‘cash component of revenue’ for the period is the £10 of cash sales.

I am not saying that the figure of £900 is invalid or unusable. It is an important and useful number. But the label ‘cash component of revenue’ mis-labels it. It is a cash receipt, not part of revenue.

The accounting identity is valid, but …

I am also not arguing with the accounting identity shown above. It is valid, and trivially so. Some academics investigate the properties of cash receipts separately from the properties of other changes in the amount of trade receivables. They find that accounting identity helpful in carrying out that investigation. I don’t object to that methodology. But I do think it is dangerous to apply the label ‘cash component of revenue’ to the amount of cash received.  

Why is the label dangerous?

The label ‘cash component of revenue’ is dangerous because it mis-represents the transactions during the year. That label perpetuates and fuels a misguided belief that cash transactions are the only ‘real’ transactions, and that normal accrual accounting provides only an overlay of conscious or unconscious distortions.

In the above example, that label suggests that the company ‘really’ made cash sales of £900, before ‘adjusting’ that ‘real’ number to arrive at the ‘fictional’ accrual accounting revenue of £1,000.

In fact, though, the company made real sales of £1,000 (£990 on credit and £10 for cash). It then collected cash of £700 for those sales, and also collected £200 for sales made in earlier years. In future years, it will collect cash of £300 for the rest of those credit sales (or less if any of the trade receivables turn bad).

For credit sales, the label ‘cash component of revenue’ mis-describes the transaction cycle for credit sales by implying that the cash collection occurred first before the sale: in reality, the sale occurred first, then the collection occurs later (unless the debt turns bad).

Judgement in measuring trade receivables

One common comment about accrual accounting is that it involves judgement and subjectivity. Some users of financial statements prefer to base their analysis wholly or mainly on information about cash flows, in order to minimise reliance on subjective numbers. So, they focus more on cash receipts than on revenue.

For most trade receivables, the level of subjective judgment involved is low. Some judgement is needed to assess:

• whether trade receivables are collectible, though the risk of large bad debts is usually quite low, except in extreme cases.
• when revenue should be recognised. In many straight-forward cases, little judgement is needed, but more judgement is needed in more complex cases. And in those complex cases, cash accounting by itself provides less information than accrual accounting does.

To my mind, ignoring accrual accounting entirely and concentrating only on cash flow information does not lead to better decisions. Although cash flow information is important and plays a useful role together with accrual-based information, it is not sufficient by itself because it does not capture some of the relationships that accrual accounting captures. And the cash flow information is likely to be misunderstood if it is mis-labelled.

And the ‘cash component of earnings’?

Many of the above comments about the ‘cash component of revenue’ also apply to the common label ‘cash component of earnings’. ‘Earnings’ is of course a much more complex number than ‘revenue, because ‘earnings’ contains many more moving parts and many of them involve more judgment than the simpler case of trade receivables (especially trade receivables in the slightly stylised example I used above).

Nevertheless, my main point is also valid for the ‘cash component of earnings’. This label mis-represents the transaction cycle for many transactions captured in normal accrual accounting:

• selling goods or services on credit (as illustrated above), and not receiving the cash until later;
• buying goods and services on credit, and not paying cash for them until later;
• receiving cash deposits in advance before selling goods or services;
• paying cash deposits in advance before receiving goods or services; and
• buying inventory but not selling it until later.

For each of the above transactions, the label ‘cash component of earnings’ implies, misleadingly, that the cash leg of the transaction is the transaction’s primary leg—or even its only ‘real’ leg.

Conclusion

Analysing whether a company gets paid for what it sells is an important task for users of financial statements. Also, analysing cash receipts separately from other changes in trade receivables can be a valuable tool for academics.

Nevertheless, in carrying out those analyses, it is important not to mis-label cash receipts from customers as some sort of ‘cash component of revenue’. That mis-labelling risks making people:  

• misunderstand the sales transaction cycle;
• think wrongly that cash receipts are part of revenue; and
• think wrongly that credit sales are the same as cash sales, but that accrual accounting throws some arcane and unjustified distortion on top for credit sales.