What Are Accounts Receivable

Accounts receivable (AR) represent money that is owed to a business by its customers for goods or services that have been delivered but not yet paid for. Managing accounts receivable efficiently is crucial for healthy cash flow, as outstanding AR can tie up substantial amounts of working capital for extended periods.

Understanding how accounts receivable work and taking steps to optimize your AR processes can help improve operational efficiency and ensure adequate operating liquidity.

What Are Accounts Receivable?

Accounts receivable refers to products or services that have been provided to customers on credit and for which payment has not yet been received. It is shown on a company’s balance sheet as an asset, since there is an expectation that money will eventually be collected from customers. The phrases “accounts receivable” and “trade receivables” are often used interchangeably.

Specifically, accounts receivable represents an oral promise from a customer to pay for goods or services received. For companies that provide terms to their customers, allowing them to pay 30, 60 or 90 days after an invoice is sent, recording accounts receivable is necessary to track how much money customers owe. The amount recorded in AR represents an expectation that the company will receive payment in the future.

Key Things to Know About Accounts Receivable

There are several important things to understand about accounts receivable in order to manage cash flow properly:

• Accounts receivable have real monetary value, even though no cash has been collected yet. Having substantial AR means liquidity is tied up in outstanding obligations.
• The terms of sales agreements dictate when payment on AR is expected. Typical terms range from net-30 days to net-90 days.
• Not all accounts receivable may be collectible. There is always a risk that customers will not pay, either due to financial difficulties or disputes over the goods/services.
• Large amounts of accounts receivable compared to sales revenue could indicate inefficiency in collections or high instances of delinquent customers. This ties up capital unnecessarily.
• Accounts receivable is different from accounts payable, which represents money a company owes to its own creditors and suppliers.

In summary, accounts receivable represents future expected cash inflows, whereas accounts payable represents expected cash outflows. Managing the difference between the two is imperative for maintaining adequate liquidity and operating capital.

Why Do Businesses Provide Trade Credit Terms?

Most B2B companies, as well as some B2C firms, provide trade credit terms to their customers instead of requiring immediate payment upon delivery of goods. There are several advantages to providing credit terms, which outweigh the risks and costs of allowing customers more time to pay:

• Increased Sales: Allowing delayed payment can incentivize higher purchase volumes since customers do not have to pay right away. This serves as a sales tool.
• Customer Retention: Credit terms indicate a degree of financial trust between supplier and customer. This helps strengthen business relationships over time.
• Flexibility: Customers appreciate having the option to pay a bit later, allowing them greater flexibility with their own operating capital needs.
• Spreading the Administrative Workload: Requiring immediate payment would overwhelm administrative staff. Credit terms spread out the invoicing and collections workload.

While trade credit increases risk, it is a standard practice due to the overall benefits it provides in greasing the wheels of commerce. The key is to strike the right balance between credit terms, administrative costs, and collectibility.

The Accounts Receivable Life Cycle

Understanding the accounts receivable life cycle enables businesses to better manage cash inflows. Key steps in the cycle include:

1. Providing Products/Services: The sales process triggers an exchange of value between customer and seller. Terms are agreed governing timing and methods of future payment.
2. Issuing an Invoice: The seller issues an invoice documenting the transaction details including amount owed, items purchased and due date. Sending invoices promptly is vital for timely payment.
3. Recording of Sale and Accounts Receivable: The seller records the transaction as revenue for accounting purposes. An accounts receivable balance is created representing expected future cash.
4. Collections: Based on agreed terms, the seller requests payment from the buyer after a set period of days elapses (e.g. net-30). Efficient collections avoid late payments.
5. Payment Receipt & Cash Application: Upon receiving payment, the seller credits cash and reduces the outstanding accounts receivable balance for that customer.
6. Accounting for Time Value of Money: If there are significant time lags between when revenue is booked and cash is collected, companies must account for the time value of receivables. Generally Accepted Accounting Principles (GAAP) require companies to estimate uncollectible accounts and bad debts. Once recorded on financial statements, accounts receivable should accurately reflect anticipated future cash flows.

Maintaining Efficient Accounts Receivable Processes

Since outstanding accounts receivable tie up financial resources companies could otherwise leverage for growth or operations, AR teams strive for efficiency in their processes. Common optimization techniques include:

• Send Invoices ASAP – Issue invoices promptly after delivering goods/services instead of allowing delays
• Set Clear Payment Terms – Specify due dates, late fees, discounts, acceptable payment methods etc.
• Track Accounts Closely – Maintain aging reports to spot delinquent accounts requiring action
• Measure Performance – Key performance indicators for AR include Days Sales Outstanding (average time to collect), Bad Debt Percentage (uncollectibles) and more. Benchmark against past periods and set goals for improvement.
• Automate Tasks – Leverage technology tools for automated reminders, status tracking, customer self-service etc. to reduce administrative workload
• Offer Early Payment Discounts – Give customers incentives for paying invoices faster than the due date when possible
• Outsource Tasks – Third party outsourcing of certain collections activities may provide flexibility and advanced expertise

The Impact of Accounts Receivable on Cash Flow

Managing accounts receivable efficiently directly affects cash flow in several key ways:

1. Delayed Cash Availability: Until outstanding AR is actually collected, companies must rely on cash reserves or financing to bridge their own accounts payable and payroll obligations. High or growing AR uses up operating liquidity that would ideally be invested to grow the business.
2. Uncertainty from Late/Delinquent Payments: Accounts not paid on time severely reduce net working capital, raise risk and inhibit financial planning abilities. Pursuing past due accounts also consumes staff resources.
3. Bad Debt Risk from Uncollectible Accounts: No matter how reliable customers seem, there is always a change some accounts will end up uncollectible due to customer bankruptcy etc. These bad debts turn expected future cash into total losses, lowering profitability.
4. Administrative and Capital Costs: Extensive accounts receivable requires sizable investment in staff time for invoicing, monitoring and following up on accounts in a timely manner. Capital costs also arise from financing large credit line facilities and/or working capital from investors to bridge accounts receivable timing gaps.

Steps to Optimize Cash Flow Through Receivables Management

To maximize operating cash flow in light of the challenges posed by waiting to receive customer payments, businesses can take several important steps:

1. Adopt Accurate Credit Approval Policies: Only extend credit terms once internal research on a customer’s creditworthiness and payment history passes approval thresholds to minimize risk of delinquency down the road.
2. Keep Receivables Balances As Low As Possible: Work to accelerate collections activities. Consider offering sales discounts for early payments.
3. Assign Accounts Limits: Capping the dollar amount or purchase volumes approved for any customer protects against excessive concentration.
4. Monitor the Collections Process: Stay on top of account status through detailed aging reports. Reach out to overdue customers with letters, calls or recourse actions if needed.
5. Compare Costs vs. Benefits of Different Terms: For example, provide net-60 instead of net-90 terms if data shows faster payment turnaround.
6. Smooth Cash Flow Fluctuations: Potential options include business loans, revolving credit facilities, or invoice factoring. The risks and rewards of each option should align with business needs and risk tolerance.

Final Words!

In today’s interconnected global supply chain, establishing trade credit and customer term payments remains vital — but can strain businesses unable to efficiently monitor accounts receivable status.

By understanding the underlying cash flow dynamics associated with AR and applying best practices around diligent customer research, monitoring and process management, companies gain resilience and liquidity to handle temporary blips as well as drive growth over the long run.