What is Accounts Receivable (AR)?
The purpose of a business is to make money. That means selling products or services to bring in revenue. These positive cash inflows are part of accounts receivable. What is accounts receivable (AR)? In a nutshell, it’s the sum of outstanding debts owed to the business by its customers. It’s a subset of a company’s working capital, classified as a current asset on the balance sheet. In simpler terms: it’s the promise of future realized cash.
Accounts receivable is a major indicator for a company’s cash flow. It offsets accounts payable, which are the debts a company owes. A strong presence of accounts receivable on the balance sheet is a positive for the company; however, that cash isn’t realized yet, which can mean a company has a strong balance sheet but is cash poor currently.
Here’s a look at how accounts receivable works and how it factors into the cash flow accounting of a company.
On the balance sheet, accounts receivable reside under “current assets.” Due to accrual basis accounting, the transaction has already occurred on paper, even if the funds aren’t present in the bank. That means the customer owes a debt.
For example, ABC Company sells 1,000 widgets to a customer at a cost of $1 per widget. They’re owed $1,000 and send the customer an invoice with NET 30 terms. For the next 30 days, that transaction appears in the company’s accounts receivable, since the customer hasn’t paid yet. When the customer pays the invoice, the company’s balance sheet will update, moving $1,000 from accounts payable to its cash account. Until then, the debt is an asset.
It’s advantageous for businesses invoicing customers to control net terms in a way that ensures accounts receivable come in before other accounts payable are due. This balances cash flow in favor of the business, giving it a buffer between when it gets paid and when it needs to pay its own debts.
Bad Debt Expense
What happens if a customer never pays? When it becomes futile or impossible to collect on a debt, it becomes a “bad debt expense.” This typically happens when the customer is insolvent or defaults. Bad debt expense is the primary risk of extending credit to customers and appears on the company’s balance sheet as a “non-collectable account.”
Non-collectable accounts are subject to either write-offs or allowances. Write-offs effectively erase the amount as earned income in the eyes of tax authorities, so the company isn’t taxed on revenue it never received. Allowances anticipate delinquent or non-collectable sums to account for them ahead of time. Companies then debit them against the allowance.
Monitoring Accounts Receivable Trends
Like accounts payable, accounts receivable offers insights into a company’s financial health and its operational decisions. It can be a good measure of a company’s ability to do business and manage cash flow accordingly.
For example, an uptrend in accounts payable shows that the company is transacting with more customers on credit. A health accounts receivable column is a positive for investors because it signifies both willingness of customers to do business with the company and the ability of the company to extend credit. A reduction in accounts receivable or an increase in bad debt expense may signal financial burdens and cash flow problems.
It’s often more difficult to manipulate accounts receivable than accounts payable. Instead, companies seek to control it by negotiating shorter net terms with customers or offering incentives for faster payment.
Accounts Receivable vs. Accounts Payable
Did you know accounts receivable and accounts payable are two sides of the same coin? The former represents cash inflows; the latter represents cash outflows. It’s the goal of businesses to balance them. As the business works with more customers to sell more goods on credit, its accounts receivable will grow. Likewise, as it does business with more suppliers for greater volumes, accounts payable grows. Controlling net terms on both sides and encouraging customers to pay on-time and in-full puts the company in a better position for healthy accounts receivable, thus improving cash flow.
Ultimately, the more consistent accounts receivable reconciliation is, the stronger the company’s cash flow. Even with heavy liabilities, strong accounts receivable puts companies in a position to grow.
Accounts Receivable Are Not Revenue
It’s important to note that AR is not synonymous with sales revenue. Accounts receivable is an asset account, not a sales account. There is no credit involved in a traditional sales transaction, which means it’s reflected directly in cash. Accounts receivable deals specifically with transactions involving credit. As such, accounts receivable aren’t necessarily indicative of the health of a company’s sales. They merely represent its ability to extend credit to customers as an incentive to do business with them.
AR Offers Insights into Operations
Accounts receivable gives powerful insight into a company’s cash flow. A large number of outstanding invoices signals future boon for the company’s cash accounts, as well as its ability to extend credit to customers without hampering itself. Accounts receivable isn’t without risk, though. Accrued revenue isn’t realized until a customer pays their invoice.
Investors looking at a company’s balance sheet should pay attention to not only accounts receivable, but how it stacks up to accounts payable. Both sides of the equation matter. And together, they tell the story of cash flow operations and the general financial health of the business. That said, more assets and accrued revenue are never bad things to see.