Accounts receivable (A/R) are created when a business provides goods or services to a customer who agrees to pay for them at a later time. The A/R amount typically is shown on the balance sheet as a current asset and is used as part of accrual basis accounting. Any business that uses A/R will need to include the A/R amounts on their financial reporting to provide a complete picture of the business’s financial health.
How Accounts Receivable Works
Not every business sells goods and/or services on credit. Instead, some companies operate in cash sales only. Think of your local convenience store—you give them your money, and they give you the items you want. This is a cash-basis business. However, many businesses allow customers to take ownership of goods or provide services to them that the customer agrees to pay for at a later date. This creates an A/R. It is an account the business has the legal right to receive.
What Type of Account Is Accounts Receivable?
Money owed to a business is only an A/R account when the amount owed is expected to be paid within one year. This is why A/R is considered a current asset on the balance sheet. If an amount owed to the business is expected to be collected during a time period longer than one year, it is no longer a current asset. It then becomes a long-term asset or notes receivable on the balance sheet.
What Are Accounts Receivable Terms?
Payment terms include the time an invoice is due for payment and the specifications of any discounts that may be taken for early payment of the invoice. A common payment term for an A/R invoice is “net 30 days.” This means the invoice is due within 30 days, and the business is not offering any discounts for early payment of the invoice.
If a business decides to offer a discount for early payment and the invoice is still due within 30 days, the terms will look something like “2/10, n/30.” This notation means two separate things. The first section, “2/10,” means the customer may take a 2% discount if the invoice is paid within 10 days. The second section, “n/30,” means the invoice is due within 30 days. So, in this case, if the invoice is paid within 10 days, the customer can pay 2% less than the invoice amount. However, if the invoice is not paid within 10 days, the full amount is due within 30 days.
Accounts Receivable vs Accounts Payable
When a business owes money to its suppliers, these are accounts payable (A/P). They are accounts that need to be paid by your business to a vendor or supplier for goods or services that have been received. Almost all businesses have A/P. Even if your business pays vendors in cash when your order is placed or delivered, this still leaves monthly bills, such as utilities and rent, that are payable for your business every month.
A/P and A/R are not dependent on one another, so a business can have accounts payable and not have accounts receivable. Think of our convenience store owners again: they may order inventory to sell and not pay for those items until they receive the invoice from their supplier, creating an A/P for their store. However, it is a cash-only business, so they do not allow customers to charge purchases on an account and pay later and, therefore, do not have any accounts receivable.
Who Accounts Receivable Is Right For
Many businesses operate on a cash-only basis. However, some businesses rely on A/R to be successful. Here are a few types of businesses that need to have A/R:
- Businesses with large transactions: If your business sells large ticket items, such as copiers and equipment, you need to consider A/R. Businesses that sell these types of items usually have an in-house credit department that finances customers according to their credit policy and then sends the account to the accounting department for maintenance.
- Subscription services: Some businesses have subscriptions for services, such as website maintenance, or monthly fees like a gym membership. These types of recurring charges can often benefit from A/R. Invoices can be emailed every month to subscription customers and paid online. You can also set up recurring bank drafts or other types of payments for these services.
- Construction and contractors: Most of the time, large projects performed by construction companies or contractors require a down payment. The remainder owed is an A/R that must be paid at a later date. The down payment is considered a payment on account.
Examples of Accounts Receivable
As a business that allows customers to purchase products and services with credit, you must have a credit policy in place and a credit agreement the customers must sign before they take possession of the merchandise. The signed agreement ensures you have the legal right to collect the debt if the customer stops paying. Let’s consider Molly again.
Let’s say Molly makes three payments on her furniture and then stops making payments. The furniture store notices the delinquent status of Molly’s account and sends her a few late payment reminders in the mail. The furniture store still does not receive payment from Molly. The store’s bookkeeper tries to call Molly, but the phone number has been disconnected.
At this point, when the bookkeeper determines the account cannot be collected, Molly’s delinquent account will be referred or sold to a collection agency or written off as bad debt.
Alternatives to Accounts Receivable
The only alternative to A/R is to operate a cash-only business. This means you do not extend credit to customers, and they must pay for their purchases before taking ownership of the products or receiving the services. With a cash-only business, you do not allow customers to purchase anything on credit and be invoiced later. Your customers must pay for what they want when they want it. Some examples of cash-only businesses are convenience stores, restaurants, and laundromats.
These types of businesses do not have to worry about bad debt or collections. Some businesses get more sales when they offer credit to their customers. However, other business models, such as the ones listed above, are suited better as a cash-only business.
Frequently Asked Questions (FAQs)
How do I calculate my accounts receivable turnover ratio?
The accounts receivable turnover ratio is calculated by taking the total net of credit sales and dividing that number by the average A/R balance. The formula for the A/R turnover ratio is:
(Net credit sales / (Beginning A/R balance + Ending A/R balance) / 2)
What is invoice factoring?
Invoice factoring involves securing financing for your business using the amount owed to your business through its A/R accounts. Typically, an A/R financing company will consider invoices on your books that are due within 90 days. The finance company typically pays out 80% of your total A/R. Once the invoices are paid, the finance company pays you the remaining 20% of the value of the invoices, minus any fees and charges.
How do I know if my business should be extending credit to customers?
All business owners encounter different situations in which they wonder if they should be extending credit to their customers. There are many things to consider, but the main question is, will your business benefit from extending credit to customers, or will your business experience a dramatic cash flow drop? If your business can withstand several months of low cash flow until customer invoices are paid, extending credit could be a good way to increase sales. However, if your business often needs all the monthly revenue to operate, it’s probably not a good idea to extend credit to your customers.
Accounts receivable can increase sales for your business. However, if your accounts receivable are not managed properly, it can be a huge cut to your revenue. If your business has a large number of accounts that are not paid regularly, this creates time and effort for your staff to collect on those invoices, sell the bad accounts, or write off the uncollectible amounts.
Deciding to utilize accounts receivable in your business is a big decision. Consider your financial situation, the products and services you offer, your customer base, and how you might best use accounts receivable to the benefit of your business. Using accounting software like QuickBooks Online will allow you to invoice and receive payments electronically, which often results in lower A/R balances.