Accounts Receivable
What are Accounts Receivable and Why Do They Matter?
Accounts Receivable are one of the most important components of your revenue line. Very simply, accounts receivable are money you are expecting to flow into your business as a result of work performed or goods and services dispensed.
As a business owner you sell a product or provide services to your clients or customers. In some cases, customers pay you at the time of sale, for example, at the register while checking out. This transaction happens at retail stores and places where services are rendered in real time. In other cases, services or products are delivered over a period of time or at a distance. In those cases, the business owner will send along an invoice for the agreed upon amount for those products or services.
That invoice, until it is paid, falls under the category of Accounts Receivable. While a major goal as a business owner is to maximize sales, it’s also important to to manage your Accounts Receivable to be as low as possible. You want your revenue to be paid within a reasonable amount of time so that you can manage your cash flow. Managing your accounts receivable (commonly referred to as AR) are an important part of managing your business and improving profitability.
How do Accounts Receivable Fit Into Your Business Metrics: Profit and Loss Statement, Cash Flow Statement and Balance Sheet?
It’s important to understand how your AR fit into your Profit and Loss Statement, Balance Sheet, Cash Flow, Accounting, and Forecasting.
AR on Your Profit and Loss (Income) Statement and Cash Flow
Your Accounts Receivable will generally be included in your P&L on the revenue line even though they are not included in your cash flow statement. This methodology is consistent with Generally Accepted Accounting Practices (GAAP) accounting. Your Net Profit line will reflect the revenue generated in a given month, collected and uncollected, as well as the costs associated with delivering your products and/or services.
Most small businesses calculate their profits in hand, and thus their taxable income, using a cash flow model. A cash flow model is as it sounds – a reflection of actual money and money out each month. Cash on hand is important as it serves as the resources from which you pay your bills, your employees, and your cost of goods.
The SEC only requires publicly traded companies to report GAAP-compliant financial statements. Private companies generally do not need to follow GAAP. The only reason why a small business would utilize GAAP is if they need to share financial performance with certain investors or investment bankers.
Balance Sheet Accounts Receivable Representation
Any amount of money owed by customers for purchases made on credit is AR. On a small business’ balance sheet, AR show up as an asset, alongside cash and inventory, because there is a legal obligation for a your customer to pay their debt. They are considered a liquid asset because the money owed can be used as collateral to secure a loan to meet short-term cash needs. As such, accounts receivable are part of a company’s working capital, though not yet calculated as part of cash flow.
The money due is expected to be paid in the short-term. Short-term is usually defined by a few days to a fiscal or calendar year.
Accounts Payable, in turn, are located on the liabilities side of the balance sheet as they are payments due to someone else, such as a vendor or service provider.
How do Accounts Receivable Reflect in and Impact Your Financial Forecast?
Accounts Receivable are a very important part of a small business’ forecast. It’s vital that they are reflected clearly which means that to have a complete forecast a small business needs to include both a P&L forecast and a cash flow forecast. Forecasts are obviously not “accurate” but a best guess as to what will happen with your business in the future. These results are a product of the decisions you make along the way. Accounts Receivable will be impacted by these as well.
If you believe your business will have more revenue coming in because you invest more in sales and marketing or spend money on something new, your collected revenue and your forecasted Accounts Receivable will be projected to increase. You might consider the relative risk of this new uncollected revenue and the impacts to cash flow. Will the increased AR be more likely to pay on time or less likely? Because Accounts Receivable are a type of loan, will you be carrying more risk on your books in the form of AR or fewer?
It’s also important to consider the level of effort it might take to collect on your Accounts Receivable going forward. If you can increase revenue from the same sources as your existing revenue, you will have a better idea how they will convert to cash and also benefit from the economies of scale that come with collecting from fewer revenue sources. The more customers you have, the more time it takes time to invoice, track, and collect payments. At the same time, if you have concentrated revenue from just a few customers, you may have higher risk in total if one or more of them can’t or won’t pay.
How Do You Manage Accounts Receivables?
Having a consistent, easy, and trackable invoicing system is essential to manage your Accounts Receivable. For each product or service sold, the customer should receive an invoice or bill that itemizes what they owe:
- Product or service
- Pricing per product or service
- Total due
- EIN for your business
- Address of your business
- How you want the payment addressed (i.e. payable to: )
- Way you want them to pay (check, ACH, other)
- Timing for payment – how long are you giving the customer to pay for the product or service? The term used to describe the timing is Net 30 for 30 days, Net 45 for 45 days, etc. A payment is considered late if the payment is received after the due date.
When picking an invoicing system, consider its cost, its functionality, and its ease of access. Many invoicing systems will enable a business owner to create consistent invoices, include all of the relevant information, record payments, and remind customers to pay. In addition, many invoicing systems will provide access via a mobile app, table, or computer.
Keeping up on Accounts Receivable by marking payments as they come in, knowing which ones are still outstanding, which ones are late, and which ones may never be paid will ensure you are managing your business effectively.
What are Metrics for Accounts Receivable?
Tracking and measuring your Accounts Receivable is an important exercise. Accounts Receivable are considered a current asset as well as a liquid asset, so it is a measure of the company’s liquidity. Liquidity is an important metric as it reflects the company’s ability to cover short-term cash needs without requiring additional inflows of cash from loans or other sources.
Turnover is one measure of Accounts Receivable. Turnover measures the number of times a company has collected on its Accounts Receivable balance during an accounting period. The AR Turnover Ratio is calculated by dividing net sales by average account receivables. Net sales is calculated as sales on credit less any returns.
The higher the turnover ratio, the more efficient you are at collecting payments.
Days Outstanding is another measure of the efficiency of Accounts Receivable. Days Sales Outstanding (DSO) is the metric often associated with this analysis and it is calculated as the average number of days that it takes to collect payment after a sale is made and an invoice is sent.
As discussed in the post, How To Improve Your Cashflow Cash Conversion Cycle, a metric called cash conversion cycle (CCC) expresses the time, measured in days, that it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the net operating cycle or simply cash cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills. Improving your time to collect improves your CCC metric.
What To Do If Someone Misses Their Payment Date? The Risk of Accounts Receivable
There are risks associated with Accounts Receivable. Because AR is credit, there is a risk of not getting paid by your customer, either on time or at all. There are two types of risk associated with Accounts Receivable: cash flow risk and bad debt.
Cash Flow: While selling on credit increases a company’s revenue, it does not increase a company’s cash inflows. Therefore, increasing accounts receivables that are not being converted into cash quickly can result in a company being unable to meet its short-term obligations due to a lack of cash flow.
Bad Debt: Customers who purchased the goods or services on credit may not be able to pay for them when they are due. And they may not be able to pay them at all. Often, customers can’t pay for one of several reasons: their cash flow is tight or even negative and they pay others before they pay you, they simply choose not to pay you, or if things have gotten really dire on their end, they have declared bankruptcy.
When the account is not paid on time, the receivable is moved into delinquency. At this point, it’s important for the small business owner to try to collect that payment, in whole or in part. The SMB owner could try to collect the payment over time, if the customer is unable to pay all at once. There are a number of ways to collect overdue payments:
- Send a delinquency notice – essentially another invoice with clear notation that the payment is past due
- Provide a payment plan
- Suggest a lower payment amount to recoup some of the payment owed
- Work with a Collections Agency
- Sell the accounts receivable to a buyer of distressed debt
When an account receivable is not paid by a customer past a certain point in time, say 180 days, it is written off as a bad debt expense.
Key Takeaways
- Accounts Receivable are an important asset for your business that need to be incorporated into your forecast and planning
- Having a process for invoicing and efficiently collecting on your Accounts Receivable helps make a healthy business – don’t allow your Accounts Receivable to go unattended
- Accounts Receivable factor into your working capital but not your cash flow – you can use them as collateral for loans but because they are not yet collected will not be available as cash to spend until they are paid
- There are a number of metrics that will help you understand your Accounts Receivable performance, including Liquidity, Turnover, Days Outstanding, and Cash Conversion Cycle
Accounts Receivable are a vital part of any business. Understanding them and managing them well can help every small business owner thrive.
