What are accounts receivable?

Cash flow is critical when you’re trying to run a successful business. Accounts receivable are an important part of managing the finances of a business, and by keeping totally on top of your balance sheet, you’ll be in a far stronger position to make the best of your business.

If you’re wondering, “What does accounts receivable mean?” you’ve come to the right place. Being able to distinguish between accounts receivable and accounts payable, and knowing their importance to your business finances, are a must.  

What are accounts receivable?  

Accounts receivable are the debts owed to a company by a customer as part of a balance that has not yet been paid. A company’s accounts receivable are all outstanding invoices that its customers owe, having delivered goods or services.   

If you sell to customers on credit, you won’t collect cash at the point of sale but will instead give them an invoice containing the accounts receivable to your business.  

The phrase “accounts receivable” simply refers to the accounts your company has a right to receive because it has already delivered goods or services to the customer. Generally, the invoice containing your accounts receivable will outline the payment terms that your customer must adhere to. This period can range from a few working days to a full calendar or fiscal year.  

A company must record its accounts receivable since its customers have a legal obligation to pay the debt. Since they are considered a liquid asset, they are a part of a company’s working capital and, if necessary, can be used as collateral to secure a loan.  

How to calculate accounts receivable turnover  

If a business operates in a capacity that allows customers to purchase goods or services on credit, then this must be considered when balancing the books.  

The efficiency with which a business can collect debt and extend credit is measured by its accounts receivable turnover ratio. This metric is calculated by dividing a business’s net credit sales by the average value of its accounts receivable over a period of time.  

If the ratio of this calculation is high, it indicates that the business effectively manages its customer credit.  

If your company had $100,000 in net credit sales over a year, and its average accounts receivable was $25,000, the ratio is calculated as below. 

100,000 (net annual credit sales) ÷ 25,000 (average accounts receivable)  

= 4 (accounts receivable turnover ratio) 

According to Gridlex, a good accounts receivable turnover ratio for a business is 7.8, but this can vary from sector to sector. It’s also worth noting that an accounts receivable turnover ratio has limitations; it doesn’t consider the creditworthiness of customers, for example, nor the terms of the sales.  

What is the difference between accounts receivable and accounts payable?  

Accounts receivable are essentially the opposite of accounts payable. When a company owes its own debts to another supplier, these are accounts payable.  

If Company A places a large order of timber from a wood supplier, Company B, and cash is not exchanged at the point of sale, then Company B sends Company A an invoice. For Company A, this invoice is recorded in its accounts payable column. Company B, which is awaiting the payment, records the bill in its accounts receivable column.  

Benefits of accounts receivable   

If a business maintains its accounts receivable, it will ensure a steady cash flow. In exchanging goods and services, accounts receivable can create a more streamlined and reliable payment process if your systems are automated.  

As a supplier of goods and services, offering accounts receivable terms can help to attract international or bulk buyers who may want to order from you and only pay once their purchase has been shipped and delivered.  

It can also offer potential savings in transaction costs. If a business has a regular, reliable customer, invoicing them periodically rather than processing each smaller order can save time and resources. 

Why it’s important to manage accounts receivable  

Keeping track of your accounts receivable is a must and will ensure you remain on top of your company’s financial situation.  

When you have a formal collection policy to ensure your accounts receivable are paid, you ensure the smooth running of future cash flows—an essential element to your business operations. If you can’t collect the cash you are owed, you’ll struggle to operate efficiently.  

Accurately tracking your accounts receivable will allow your business to predict how much it can expect to make over a period – per month, quarter, or year.  

Accounts receivable help you keep on top of what your customers owe you and having a system in place to receive those payments is critical in embedding a streamlined cash flow.  

The longer a credit is offered to your customers, the longer it may take to convert it to cash. This may hinder your cash flow, so you’re better off having a higher accounts receivable turnover ratio.  

If your accounts receivable are accurate and well-managed, you will find it easier to generate instant funds. By factoring your accounts receivable, you can sell your invoices to a third party at a discount to provide an instant cash injection into your business should the need arise.  

The bottom line  

Accounts receivable can be an integral financial cog for businesses that offer credit for goods and services. It can attract returning customers and be factored into a holistic overview of a business’s finances should it need to raise more capital or take out a loan.  

However, it’s recommended that any business runs a tight ship when approaching accounts receivable. If it loses track of payments or has a low accounts receivable turnover ratio, the likelihood of growth (or even survival) is limited.  

Speaking to a financial advisor is a great way for businesses to establish an effective approach to accounts receivable. Find your perfect financial advisor today.