What Are Accounts Receivable? Optimizing Your Financial Assets

When you’re running a business, finances are everything. Keeping meticulous records of your spending and the money clients owe you is hands down a must.

Past-due accounts restrict your cash flow and increase your collection costs, making it more difficult to keep your business on firm financial footing. That’s why it’s crucial to track your accounts receivable.

What is an account receivable? Our comprehensive summary will illuminate this fundamental accounting concept. You’ll learn to harness the power of accounts receivable to optimize cash flow and improve customer relationships.

What is an account receivable?

Accounts receivable represent the money you’re owed for goods and services. An account receivable is often linked to a product or service you’ve already delivered. However, customers may owe you money for services they haven't received yet. For example, if your firm provides business consulting services, you may bill customers before you begin.

Your balance sheet should list receivables as assets because you can quickly convert each account into cash. That said, it's not unusual to have a few past-due accounts on the books.

Many companies use accounts receivable aging schedules to monitor their AR activity. An aging schedule lists outstanding invoices and the number of days each is past due.

An aging schedule informs collections decisions. You can better allocate resources toward collecting delinquent payments when you know how far behind the accounts are. For example, you may direct team members to focus on customers who are over 90 days late instead of invoices that are only 30 days past due.

Understanding accounts receivable

It’s crucial to record your accounts receivable correctly. With proper recording, you can calculate your collection rate, average age of debt, and other metrics. You can also use the data to determine if there's enough incoming cash to support company objectives.

Recording accounts receivable

Record accounts receivable as a current asset if you’re using accrual accounting. When a customer pays an invoice, debit accounts receivable and credit the corresponding liabilities account. Using a double-entry accounting system increases accuracy and clearly shows how accounts receivable affect the rest of your business.

You may incorporate an allowance into your budget for more accurate (and realistic) accounting. Allowance is an estimate of the receivables your customers won’t pay.

Accounts receivable turnover ratio

Closely monitoring AR activity helps identify concerning trends before they hurt your business. For example, if you notice an increase in accounts that are 90 days past due, you can adjust your credit policies or enhance your collection activities to address the problem.

Your accounts receivable turnover ratio is a metric denoting your company’s efficacy at granting credit to customers and collecting on debts. To calculate your AR turnover ratio, divide your credit sales by your average accounts receivable. For example, if you have sales of $7 million and average accounts receivable of $1 million, your AR turnover ratio is 7.

This ratio represents your annual collection rate on accounts receivable. The higher your AR turnover ratio is, the better you are at collecting debt.

Using an account receivable in business

It isn’t easy to understand accounting concepts without seeing them in action, so here's an example of how businesses use accounts receivable in the real world:

Hightower Seal Company manufactures O-rings for food production devices. The company is interested in working with Smooth Move, a smoothie company headquartered in Hawaii. Executives at Hightower offer terms of net 90 with 50% prepayment on all orders valued at $2,000 or more.

When Smooth Moves orders $2,700 worth of O-rings, Hightower records the $2,700 as a current asset. Once Smooth Moves pays what it owes, Hightower debits accounts receivable by $2,700 and credits the corresponding liability account by the same amount.

3 benefits of managing accounts receivable

Properly managed accounts receivable provide the following benefits:

1. Improved cash flow: Closely monitoring accounts receivable lets you adjust your collection strategy based on current trends. Improved collection practices increase your cash flow.
2. Enhanced financial stability: Good account receivable management contributes to accurate financial statements, ensuring managers have the information they need to make informed decisions that improve your company’s financial health.
3. Stronger customer relationships: You can set fairer credit policies when you closely monitor your accounts receivable. Fair policies increase customers’ trust and improve your relationships with other firms.

Tips for managing accounts receivable

Here are some best practices to improve your accounts receivable management:

• Verify the receipt of invoices: You don't have to wait until a customer is 30 days or more past due to follow up on their payment. Confirm they've received your invoice to get paid faster and preserve the relationship with the customer.
• Offer credit with reasonable terms: When setting credit policies, you should avoid being too strict or too lenient to ensure you get paid without souring client relationships. Agreeable terms will motivate customers to buy from you without increasing the average age of your past-due accounts.
• Communicate with clients: Stay in close contact with your customers. Good communication helps prevent payment errors.
• Use accounts receivable software: Accounts receivable are challenging to track manually. Increase accuracy by using account receivable software and promptly entering transactions.

Accounts payable versus accounts receivable

Accounts payable and accounts receivable work together to keep your business in balance. Here's how they're alike — and how they differ.

Differences

• Nature and purpose: Accounts payable represent what you owe suppliers and other creditors, whereas accounts receivable represent what your customers owe you.
• Timing and cash flow: Your cash flow increases when a customer makes a payment on an account receivable. When you pay one of your vendors, your cash flow decreases.
• Classification: Receivables are assets. Payables are a liability.

Similarities

• Financial transactions: AR and AP are both essential components of your company's financial transactions. Together, they represent the exchange of goods and services.
• Reporting: Both accounts appear on your balance sheet.

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