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What is “Accounts Receivable”? Accounting Explained

Michael Bush

Accounts Receivable is a fundamental concept in the field of accounting. It refers to the money that a company is owed by its customers for goods or services that have been delivered or used, but not yet paid for. This term is often seen on a company’s balance sheet, and is considered an asset because it represents a legal obligation for the customer to remit cash for its short-term debts.

Understanding the concept of Accounts Receivable is crucial for both accountants and business owners. It plays a significant role in managing a company’s cash flow and financial health. In this glossary article, we will delve into the intricacies of Accounts Receivable, exploring its definition, importance, calculation, and more.

Definition of Accounts Receivable

Accounts Receivable (AR) is an accounting term that refers to the amount of money owed to a business by its customers. The customers, who are often referred to as debtors, have purchased goods or services on credit, meaning they have received the product or service but have not yet paid for it. The amount that these customers owe is recorded as an asset on the company’s balance sheet.

AR is essentially a line of credit that a business extends to its customers. The benefit of offering this line of credit is that it can attract more customers and increase sales. However, it also carries the risk that some customers may not pay their debts, which can lead to a loss for the business.

Types of Accounts Receivable

There are two main types of Accounts Receivable: Trade Receivables and Non-Trade Receivables. Trade Receivables are amounts owed by customers for goods sold or services rendered as part of the company’s regular business operations. This is the most common type of AR.

Non-Trade Receivables, on the other hand, are amounts owed to the company that are not related to the sale of goods or services. These could include tax refunds, advances to employees, or loans to suppliers or affiliates.

Importance of Accounts Receivable

Accounts Receivable is a critical component of a company’s financial management. It represents a significant portion of a company’s current assets and plays a vital role in managing the cash flow. A high AR balance indicates that a company has a substantial amount of cash tied up with customers who have not yet paid their bills, which can affect the company’s liquidity.

AR also impacts a company’s profitability. If a company is unable to collect its receivables, it may have to write off these amounts as bad debts, which reduces profits. Therefore, effective management of AR is crucial for maintaining a company’s financial health.

Accounts Receivable Turnover Ratio

The Accounts Receivable Turnover Ratio is a key financial metric that measures how efficiently a company uses its assets. It is calculated by dividing total net sales by the average accounts receivable during a certain period. A high ratio indicates that the company is efficient at collecting its AR and is using its assets effectively.

However, a low ratio may indicate that the company is not effective at collecting its receivables, which could lead to cash flow problems. Therefore, monitoring this ratio can help a company identify issues with its AR management and take corrective action if necessary.

Accounts Receivable Process

The Accounts Receivable process begins when a company sells goods or services to a customer on credit. The company then records the amount owed by the customer as an AR. The company continues to carry the receivable on its books until the customer pays the invoice.

During this process, the company may send reminders or statements to the customer, and may also offer discounts for early payment. If the customer does not pay within the agreed-upon terms, the company may need to take further action, such as hiring a collection agency or taking legal action.

Recording Accounts Receivable

When a company sells goods or services on credit, it records the transaction as an Accounts Receivable in its accounting system. This is done by debiting (increasing) Accounts Receivable and crediting (increasing) Sales Revenue. This increases both the company’s assets and its revenue.

When the customer pays the invoice, the company records the payment by debiting (increasing) Cash and crediting (decreasing) Accounts Receivable. This decreases the company’s AR and increases its cash.

Managing Accounts Receivable

Effective management of Accounts Receivable is crucial for maintaining a company’s financial health. This involves monitoring the AR balance, ensuring timely collection of receivables, and managing credit risk.

Companies often use an aging schedule to manage their AR. This is a report that categorises receivables based on the length of time they have been outstanding. This helps the company identify overdue accounts and take appropriate collection action.

Credit Policies

A company’s credit policies can significantly impact its AR. A lenient credit policy may attract more customers and increase sales, but it also increases the risk of non-payment. Therefore, companies need to carefully balance the benefits and risks of their credit policies.

Some companies may offer discounts for early payment to encourage customers to pay their invoices sooner. This can help reduce the AR balance and improve cash flow.

Bad Debts

Despite a company’s best efforts, some customers may not pay their invoices. These amounts are considered bad debts and must be written off. This reduces the company’s AR and its profits.

However, companies can take steps to minimise bad debts, such as performing credit checks on new customers, enforcing strict payment terms, and pursuing legal action against delinquent customers.

Conclusion

Accounts Receivable is a critical aspect of a company’s financial management. It represents the money that customers owe the company for goods or services sold on credit. Effective management of AR is crucial for maintaining a company’s cash flow and profitability.

While AR can provide a significant source of cash for a company, it also carries risks. Therefore, companies need to carefully manage their AR, monitor their Accounts Receivable Turnover Ratio, and take steps to minimise bad debts.

Last Updated on December 11, 2023 by Michael Bush

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