Understanding your AR accounts: What every small business needs to know

Are your accounts receivable growing, and you’re not sure how to manage them effectively?

To ensure effective accounts receivable management, you first need to understand how it works.

Imagine you run a digital marketing agency in Chicago, and you have three outstanding invoices from clients worth $2,000 each. That’s $6,000 in accounts receivable (AR) waiting to be collected.

In theory, high AR numbers might seem like a good thing for your business.

B2B and service businesses like consulting firms, marketing agencies, and freelancers usually have higher receivables because they deliver services before invoicing. This is especially true if they bill by the hour since the total isn’t clear until the work is done, or if they are suppliers with typical 30-day and 60-day terms.

While B2C and product businesses, on the other hand, usually get paid upfront— they too can see high AR levels thanks to the rising use of credit cards in the US

But if you’re not careful, it can lead to problems.

How?

It’s common for businesses to extend products on credit or deliver services before invoicing, but this can be a problem without a solid policy in place, leading to past-due accounts.

While it’s understandable that offering credit can attract more customers and boost sales, this often happens in the startup phase of small businesses because expectations aren’t set clearly, credit is granted without consistent criteria, and follow-ups are lax. 

Fun fact

Among boomers and seniors, 66% prefer credit for large in-store purchases and 73% prefer credit for large online purchases.

~ Fiserv Research

As per a survey-based experimental study, consumers using credit cards are more likely to make larger purchases and opt for premium options. That’s great for sales and traction, but in an attempt to be flexible and to maintain good client/customer relationships, businesses risk being unnecessarily lenient with late-paying clients/customers – especially when US companies have been experiencing an upward trend in late payments from B2B trade on credit (55% of all B2B invoiced sales were overdue in 2019).

As a small business owner, you must understand that considerable outstanding receivables cost your business money. You’ve already spent time, resources, and cash providing a product or service without receiving payment—almost like giving your customers a gift. If you don’t manage AR well, your cash flow becomes unpredictable, collection costs go up, and your balance sheet looks weak—all of which are critical when you need that cash to obtain credit, invest in growth, or attract investors.

By understanding and optimizing your AR processes, you can transform potential financial obstacles into opportunities for growth and efficiency. 

What is accounts receivable in simple words?

When your customers buy something from you but don’t pay right away, it creates accounts receivable. It’s like having a promise from your customers to pay you back later.

Why are accounts receivable important to a company?

Accounts receivable are part of how your company keeps track of its finances. They’re counted as assets because you’re supposed to get this money back once the invoices are paid. This means you can use them to show that your business has things of value, which can help if you need to borrow money.

Usually, the money owed to you through accounts receivable has to be paid back within a short time, like a few weeks or months. This is because it’s money you’ve already spent or need to spend to keep your business going.

When you see accounts receivable on your financial documents, it means you’ve sold things to your customers on credit. It’s like your customers have given you a short-term IOU, a promise in writing to pay you back soon.

What do accounts receivable tell us?

Accounts receivable are a key part of determining how well your business is doing. They show up as money your company expects to get soon. Think of them like checking if your company has enough money to pay its bills quickly without needing extra cash.

People who study businesses often check how quickly they get their money back from accounts receivable. It’s called the accounts receivable turnover ratio, which tells them how many times a company gets its money back from customers in a certain time.

Another thing they look at is called days sales outstanding (DSO). This tells them how long it usually takes for a company to get paid after making a sale.

By looking at these things, experts can get a good idea of how well a business is doing financially.  

Where do I find a company’s accounts receivable?

Accounts receivable information is typically found in your company’s financial statements and accounting records. These records are essential for understanding your business’s financial health and performance.

Here’s where you can typically locate your accounts receivable data:

Balance sheet:

The balance sheet is one of the primary financial statements that provides a snapshot of a company’s financial position at a specific point in time. 

Typically, accounts receivable are listed under the “Current Assets” section, along with othershort-term assets like cash, inventory, and prepaid expenses.

Accounts receivable aging report:

This report provides a detailed breakdown of outstanding accounts receivable balances categorized by the length of time they have been outstanding. 

Accounts are usually grouped into columns based on the number of days since the invoice was issued (e.g., current, 30 days past due, 60 days past due, etc.). The aging report helps businesses track overdue payments and identify potential collection issues.

Income statement:

While the income statement primarily focuses on a company’s revenues and expenses over a specific period, it may also contain relevant information related to accounts receivable.

For instance, if bad debt expenses are incurred due to uncollectible accounts, they would be recorded on the income statement, impacting the net income of the business.

Also read: How to read (and understand) an income statement

Accounting software

For businesses using accounting software such as QuickBooks, Xero, or FreshBooks, accounts receivable information is readily accessible within the software’s interface. Users can generate reports, view aging summaries, and track individual customer balances within the accounting software.

Customer invoices

Each invoice issued to a customer contains details of the transaction, including the amount owed, payment terms, and due date. By referencing customer invoices, businesses can track outstanding receivables on a customer-by-customer basis.

Accessing accounts receivable information is crucial for monitoring cash flow, assessing creditworthiness, and managing collections effectively. By regularly reviewing accounts receivable records and reports, businesses can identify trends, address payment delays, and maintain healthy financial operations.

What happens if customers never pay what’s due?

As a small business owner, you might be under the impression that customers will pay you quickly, but sadly, that’s not always the case. The reality is that delays in payment are common and can significantly affect your operations.

When customers fail to pay their outstanding balances, it can have significant implications for businesses, impacting cash flow, profitability, and overall financial stability.

For instance, let’s revisit the scenario of the small printing business mentioned earlier.

Suppose the local restaurant owner, Sarah, fails to pay the $800 invoice for the custom-designed flyers she ordered. This non-payment, coupled with other non-payments, can disrupt the printing business’s cash flow, making it challenging to cover operating expenses such as raw materials, utilities, and payroll.

Moreover, if unpaid accounts receivable accumulate over time, they can lead to increased bad debt expenses and potentially lower profitability. In extreme cases, businesses may need to pursue legal action or engage in debt collection efforts to recover unpaid balances, which can further strain resources and time. 

Therefore, managing accounts receivable effectively and implementing proactive measures to address non-payment risks is essential for safeguarding the financial health of businesses.

The Impact of accounts receivable on business valuation

Accounts receivable play a significant role in determining the value of a business, particularly in the context of mergers and acquisitions, investment decisions, or seeking financing. Understanding how accounts receivable affect business valuation is essential for stakeholders evaluating the financial health and potential of a company. Here are key considerations regarding the impact of accounts receivable on business valuation:

Asset valuation

Accounts receivable are considered assets on a company’s balance sheet, representing money owed by customers for goods sold or services rendered. When assessing the value of a business, accounts receivable are included in the calculation of total assets.

Higher accounts receivable balances may indicate strong sales performance but can also signal potential liquidity risks if collections are delayed or uncertain.

Cash flow projection

Accounts receivable impact cash flow projections and forecasting models used in business valuation. The timing of collections from accounts receivable directly influences a company’s liquidity and ability to meet financial obligations.

Businesses with a high proportion of overdue accounts receivable may experience cash flow constraints, affecting their valuation and attractiveness to investors or buyers.

Risk assessment

The quality and collectibility of accounts receivable are critical factors in assessing business risk. Accounts receivable aging reports provide insights into the composition of outstanding balances, including the length of time invoices have been outstanding and the likelihood of collection. Businesses with a history of slow-paying or uncollectible accounts receivable may be viewed as riskier investments, potentially lowering their valuation.

Working capital management

Efficient management of accounts receivable is essential for optimizing working capital and sustaining business operations. Businesses with streamlined accounts receivable processes, shorter payment cycles, and proactive collections practices demonstrate stronger working capital management capabilities. Effective accounts receivable management positively impacts business valuation by reducing financial risk and enhancing liquidity.

Customer relationships

Accounts receivable can reflect the strength of customer relationships and the overall creditworthiness of a customer base. Businesses with loyal, creditworthy customers tend to have lower instances of overdue accounts receivable and higher collection rates. Strong customer relationships contribute to predictable cash flows and stable revenue streams, positively influencing business valuation.

Due diligence considerations:

During due diligence processes for mergers, acquisitions, or investment transactions, a thorough analysis of accounts receivable is conducted to assess their accuracy, collectibility, and impact on the transaction. Buyers or investors may scrutinize accounts receivable aging reports, historical collection trends, and customer credit policies to evaluate potential risks and opportunities.

Accounts receivable and accounts payable: how are they different?

While both accounts receivable and accounts payable are crucial for assessing your business’s financial well-being, they serve different purposes.

Accounts receivable is an asset account showing the money that your customers owe you.

Imagine you run a small printing business, and you’ve just delivered a batch of custom-designed flyers to a local restaurant. 

The total cost of the flyers comes to $800.

Now, the restaurant owner, Sarah, receives the invoice for the flyers. In Sarah’s books, this $800 becomes an accounts payable. This means she now owes your printing business $800 for the flyers she received.

On your end, as the printing business owner, you log this transaction as an accounts receivable. This $800 represents the money you expect to receive from Sarah for the flyers you provided.

So, while Sarah sees the $800 as something she owes, you see it as something you’re owed.

Is accounts receivable the same as revenue?

No. Accounts receivable is actually different from revenue

It’s considered an asset, not revenue. But in a system called accrual accounting, you record revenue when you also record an accounts receivable.

Here’s the thing to keep in mind: in another system called cash basis accounting, there’s no such thing as accounts receivable. In this setup, a sale doesn’t count until the money is in your bank account.

The bottom line

Managing your accounts receivable effectively is crucial for ensuring steady cash flow and minimizing financial risks. With CoCountant’s comprehensive accounting services including invoicing support and collections, you get accurate financial reporting, timely payment reminders, and perfect invoices.

This not only helps you keep the cash flowing but also allows you to confidently offer flexible payment options, boosting sales and improving customer relationships. Optimize your AR processes with CoCountant and turn potential financial obstacles into opportunities for growth and efficiency.

FAQs

Is accounts receivable a debit or credit?

In accounting, accounts receivable is recorded as a debit. Being an asset account, increases are debited and decreases are credited.

How to calculate accounts receivable turnover?

Accounts receivable turnover is calculated by dividing total net sales by the average accounts receivable during the same period. This ratio measures how many times a business can turn its accounts receivable into cash within a year.

What is accounts receivable on a balance sheet?

On a balance sheet, accounts receivable is listed as a current asset, indicating the amount of money owed to the business by its customers for sales made on credit.

How to calculate accounts receivable?

To calculate accounts receivable, sum up all outstanding amounts owed by customers. This total represents the accounts receivable balance at any given time.

Is accounts receivable a cash equivalent?

No, accounts receivable is not considered a cash equivalent. Although it represents money owed to the company, it is not available cash until the customers pay their invoices.

Is accounts receivable an asset?

Yes, accounts receivable is considered a current asset because it is expected to be converted into cash within one year or within the business operating cycle.

Is accounts receivable a current asset?

Yes, accounts receivable is classified as a current asset on the balance sheet because it is generally convertible into cash within one year.

How to calculate average accounts receivable?

Average accounts receivable is typically calculated by adding the beginning and ending accounts receivable for a period and dividing by two. This average can be used to assess the collection and credit practices over that period.

Is accounts receivable an asset or liability?

Accounts receivable is an asset, specifically a current asset, because it represents future economic benefits that the company expects to receive in cash from its debtors.

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Disclaimer

CoCountant assumes no responsibility for actions taken in reliance upon the information contained herein. This resource is to be used for informational purposes only and does not constitute legal, business, or tax advice.  Make sure to consult your personal attorney, business advisor, or tax advisor with respect to believing or acting on the information included or referenced in this post.