What is accounts receivable?

Accounts receivable (AR) is the term used to describe money owed to a business by its customers for purchases made on credit. It’s listed as a current asset on the balance sheet, representing the total value of outstanding invoices for products or services sold but not yet paid for.

Total accounts receivable in a business are made up of individual accounts receivable, also known as trade receivables. Only purchases made on credit terms are accounts receivable, as cash payments are received immediately. However, suppliers extending credit to their buyers is a common feature of supply chains, with 30-day and 60-day terms both typical.

Accounts receivable are current assets because of the short-term nature of standard payment terms. When the outstanding invoices are paid, their value turns into liquid working capital that the business can use.

In some cases, outstanding accounts receivable can be considerable, representing a significant percentage of total working capital. This makes collecting them promptly and efficiently a central business concern. The quicker and more reliably accounts receivable can be collected, the faster businesses can use the money they’re owed productively. This may be for fuelling growth, building resilience, or covering operating costs.

Accounts receivable vs. accounts payable

Accounts receivable is the opposite of accounts payable. Where accounts receivable describes money owed to a business in the form of sent but unpaid invoices, accounts payable represents the money a business owes in the form of received but unpaid invoices.

In a buyer-supplier relationship, accounts payable pertains to the buyer and accounts receivable to the supplier. Accounts payable is a liability, while accounts receivable is an asset.

Accounts receivable example

To clarify things, here’s an example illustrating how the accounts receivable process works.

1. Company A (the supplier) sells X goods to Company B (the buyer) at a quoted cost of $10,000.
2. Company A sends an invoice to Company B, including the amount due and payment terms that outline a 30-day credit period.
3. At the point of sending the invoice, Company A lists $10,000 on its balance sheet under accounts receivable.
4. At the same time, Company B lists $10,000 on its balance sheet under accounts payable.
5. Under normal conditions, Company B must pay Company A within 30 days of receiving the invoice.
6. When they make the payment, the $10,000 Company A listed as accounts receivable switches to become realized revenue instead.
7. The $10,000 Company B listed as accounts payable becomes a realized cost.

It’s important to note that there are circumstances where this example doesn’t reflect how things go – such as in the case of a buyer defaulting on their payment or a supplier using a financing program to capture their receivables quicker.

Accounts receivable as a department and a process

Accounts receivable primarily refers to the amount owed to a business in unpaid invoices sent to buyers, but that’s not its only meaning. It’s also the term used to refer to the department that deals with collecting that money and the process they use to collect it.

The people responsible for accounts receivable in any business play an essential role in healthy operations. When they work efficiently, cash flow is simpler to forecast and manage. When there are inefficiencies in their established process, several issues can arise:

• Slow accounts receivables collections resulting in cash flow difficulties, ranging from minor to existential.
• Increased risk of customer payments defaulting unexpectedly, leaving the business out of pocket with bad debt.
• Opportunity cost – in the form of time – spent making inefficient processes work at the expense of working on more valuable tasks.

Given how important the efficient and reliable collection of accounts receivable is to healthy business operations, the potential value of improving the way the department and process operates within a business has clear benefits. The first step in improving performance is understanding how to measure current performance.

Accounts receivable performance in a business can be measured with a range of metrics, but accounts receivable turnover ratio, days sales outstanding (DSO), and cash conversion cycle (CCC) are chief among them:

• Accounts receivable turnover ratio is an accounting metric that measures the number of times accounts receivable are turned into cash during a given period.
• DSO is a different view of the same facet of performance, measuring the average number of days it takes a business to collect its accounts receivable.
• CCC is the total time a business takes to convert its cash into inventory through procurement and manufacturing, then back to cash through sales and accounts receivable collection.

By using these metrics to measure the performance of the accounts receivable team and the process they use, businesses can identify shortcomings and work on improving them.

Accounts receivable financing solutions

When businesses strive to optimize their cash flow, reducing DPO (by collecting accounts receivable more quickly) is often a priority. When money owed to a business is collected more quickly, it can be used as working capital in a shorter time frame. This allows businesses to expedite growth plans, capture short-term opportunities, and protect themselves against cash flow risk.

Accounts receivable financing is one solution that allows businesses to significantly reduce how long they have to wait for their accounts receivable to come in. It’s a financing arrangement that involves a business selling its accounts receivable to a third-party financer, collecting the value of the receivables immediately. The financer then receives the money from the buyer in the transaction when they pay the invoice on or before the due date.

Receivables financing solutions can significantly speed up cash flow, allowing businesses to invest the collected money more quickly.

Offering early payment discounts is another method of speeding up accounts receivable collection, incentivizing buyers to pay their invoices within a specific time frame to capture a risk-free return.