Accounts Receivable Definition
Accounts receivable (AR) refers to the outstanding payments that a company is owed by its customers or clients for goods or services that have been delivered but not yet paid for. It represents the money that is owed to a business by its customers for credit sales. When a company sells goods or services on credit, it creates an account receivable entry in its books.
It is a crucial aspect of a company's working capital management, as it reflects the amount of money the company expects to receive based on an outstanding invoice.
Managing accounts receivable effectively is important for maintaining a healthy cash flow and ensuring that the company has the funds to meet its obligations.
For example, when a company sells products to a customer with NET 30-day payment terms, the customer's owed amount is included in the company's accounts receivable until payment is received. Net terms can also be 45, 60, or 90 days.
Accounts Receivable Example
Imagine that Company A sells $10,000 worth of computer equipment to Company B on credit with payment terms of net 30 days.
The transaction would be recorded:
Sales Transaction: Company A recognizes the sale:
- Debit: Accounts Receivable $10,000
- Credit: Sales Revenue $10,000
Accounts Receivable Aging: After the sale, Company A lists the $10,000 in its accounts receivable ledger under the customer Company B.
Payment Due: The terms are net 30 days, meaning Company B has 30 days to pay the invoice.
Payment Collection: After 25 days, Company B pays the invoice:
- Debit: Cash (or Bank) $10,000
- Credit: Accounts Receivable $10,000
Now, the accounts receivable for Company B are cleared, and Company A has received the payment for the goods sold.
This is a simplified example, and in real-world scenarios, there will be additional factors like early payment discounts, late fees, or other terms that impact the handling of accounts receivable.
What is an accounts receivable process?
The accounts receivable process involves the steps a business takes to manage and collect payments from customers who have purchased goods or services on credit. The accounts receivable collection process includes generating invoices, tracking receivables, sending statements, and managing the collection of outstanding payments. Its goal is to optimize cash flow, minimize late payments, and ensure timely receipt of funds.
What is accounts receivable turnover ratio?
The accounts receivable turnover ratio (ARTR) is a financial metric that measures how efficiently a company collects payments from its customers during a specific period. It is calculated by dividing the average accounts receivable by the net credit sales. A higher turnover ratio shows more effective management of accounts receivable and quicker cash conversion.
ARTR is calculated using:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
- Net Credit Sales represents the total credit sales minus any returns or allowances.
- Average Accounts Receivable is the average of the beginning and ending accounts receivable for a specific period.
Accounts Receivable Importance
Companies leverage accounts receivable for several reasons, and it is a common aspect of doing business, especially when transactions involve the sale of goods or services on credit.
- Credit Sales: Companies often sell goods or services on credit to their customers (showed through a credit memo). This means that customers receive the products or services immediately but are allowed a certain period, known as the credit terms, to make the payment. Accounts receivable represents the outstanding payments on a credit memo.
- Sales Growth: Offering credit terms attracts more customers and stimulates sales. Many businesses find it necessary to extend credit to remain competitive and make larger or repeat purchases.
- Customer Relationships: Providing credit enhances customer relationships. It allows businesses to build trust and maintain long-term partnerships with customers. It is also a strategic move to accommodate customers who may not have immediate access to cash.
- Seasonal or Cyclical Sales: In industries where sales are subject to seasonal or cyclical fluctuations, companies can offer credit to smooth out cash flow. This helps them manage periods of low sales without relying solely on immediate cash payments.
- Industry Norms: In some industries, offering credit is a standard practice. For example, businesses in the wholesale or manufacturing sector often provide credit terms as it is customary within the industry.
- Cash Flow Management: Accounts receivable allow companies to manage their cash flow effectively. While waiting for customers to make payments, companies can use other financing options or invest their cash in the interim.
- Competitive Advantage: Providing flexible net terms, such as longer credit periods, can be advantageous. It may attract customers who prefer more extended payment terms and contribute to customer loyalty.
- Diversification of Customer Base: Offering credit can help companies attract a more diverse customer base, including those who might not make immediate payments but are creditworthy in the long run.
While accounts receivable are essential for business operations, companies also need to manage them to minimize the risk of late payments, bad debts, and to ensure a steady cash flow.
Accounts Receivable Challenges
Accounts receivable management can pose various challenges for businesses. Some common challenges include:
- Late Payments: Customers may delay payments, affecting the company's cash flow forecast and financial stability.
- Bad Debt: Sometimes, a customer payment can be defaulted, leading to bad debts that can affect profitability.
- Inaccurate Invoicing: Errors in invoicing can lead to disputes, delayed payments, and strained customer relationships.
- High Days Sales Outstanding: A prolonged DSO shows it takes a longer time for the company to collect overdue invoices, affecting liquidity.
- Lack of Automation: Manual processes for invoicing and tracking unpaid invoices can be time-consuming and error-prone.
- Credit Risk: Assessing and managing the creditworthiness of customers is crucial to avoid potential bad debts.
- Inefficient Collection Strategies: Ineffective methods for following up on overdue payments can cause delayed collections.
- Changing Regulations: Compliance with financial regulations may pose challenges in managing accounts receivable.
- Customer Disputes: Disputes over invoices, goods, or services can lead to delayed payments and strained customer relationships.
- High Transaction Volumes: Handling many transactions can strain resources and increase the likelihood of errors.
Accounts Receivables vs. Accounts Payable
Both AP and AR are essential for a company's financial management, but they represent different aspects of transactions.
Accounts Payable represents the money a company owes to its suppliers or vendors for goods and services it receives on credit. When a company purchases goods or services on credit, it creates a journal entry to reflect the amount owed.
The company is essentially a debtor in this scenario, and the obligation to pay is recorded as a liability on the balance sheet until the payment is made. Managing accounts payable effectively is important for maintaining good relationships with suppliers and ensuring timely payments.
AR represents the money owed to a company by its customers for goods or services that have been delivered but not yet paid for. When a company makes sales on credit, it creates an accounts receivable entry to track the amount receivable from customers.
Accounts receivable are considered a current asset on the balance sheet, representing the company's claim to future cash inflows.
Accounts receivable is a critical component of a company's financial management, representing the outstanding payments owed by customers for goods or services provided on credit. Efficient management of accounts receivable is essential for maintaining a healthy cash flow, ensuring timely collection of payments, and sustaining positive relationships with customers. The accounts receivable process involves generating invoices, tracking receivables, and employing effective collection strategies.