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Аccounts Receivable Explained: How to Manage Your Working Capital

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Originally published on May 11, 2017. Recently updated on October 25, 2020

A deep understanding of accounts receivable is critical for much more than just good accounting — it’s the key to fostering a profitable business.

Do you know the definition of “accounts receivable“? 

More importantly, do you understand how accounts receivable impact your business finances? These balance sheet items can make or break your venture.

Deep knowledge of accounts receivable can help you improve your cash flow management, capitalize on time-sensitive opportunities, and maintain flexibility. 

Let’s explore the essentials and particulars of accounts receivable. We’ll also discuss key financial terms like accounts payable, trade receivables, and notes receivable.

Accounts Receivable 101

Accounts receivable is the amount of money your business has a right to collect in exchange for goods or services (on credit) already provided to a customer.

The longer your accounts receivable last (i.e., the longer you don’t collect your money), the longer you face limits to investing in production for your next order. Uncollected payments tie up working capital and lead to longer business cycles.

In the world of cash flow best practices, you should collect all due accounts as soon as possible. 

Failure to do so will choke up available cash flow for other business purposes.

Now, what does an example of accounts receivable look like.

The most common accounts receivable examples include the traditional billing practices of utilities companies.

For example, think about the accounting practices of an electricity or water company. These companies provide these resources to customers and then bill them after usage. While the companies await payment for the utilities delivered, they will record unpaid invoices in the accounts receivables portion of their balance sheet.

​Let’s dig a little deeper into the definition of accounts receivable to improve your business’ health.

Assets and Liabilities: How They Shape Your Capital

accounts receivable and accounts payable

If your cash flow slows to a trickle, your company will face a cash crunch. It’s essential to monitor your finances regularly. That starts with two balance sheet basics: ​

What type of account is accounts receivable?

As noted above, the account for accounts receivable is tied to the money owed to a business for goods and services that have been provided. 

The accounts receivable is recorded by an accountant or small business owner as a “current asset.” This means that the customer will be paying the account balance within the next 12 months or less.

This is an important accounting distinction. If the accounts receivable is not set for payment within 12 months, it will be registered on the balance sheet as a long-term asset.

Accounts payable vs accounts receivable

In accounting, accounts payable and accounts receivable are opposites. The following definitions provide a brief description of their differences.

Accounts payable (AP):

The amounts your company owes a third party for purchasing stock or services on credit.

Accounts receivable (AR):

The amounts your company has the right to collect from clients for providing them with goods or services on credit.

Sure, accounts receivable and receivables sound similar, but they’re very different.

On the balance sheet, AP falls under liabilities. AR are part of your assets

Beyond simply balancing the two, creating a healthy business requires a deeper understanding of AP and AR and plenty of planning.

Common Questions:​

Is Accounts Receivable a debit or credit on balance sheet?

On the balance sheet, AP falls under liabilities. AR are part of your assets

Beyond simply balancing the two, creating a healthy business requires a deeper understanding of AP and AR and plenty of planning.

Is accounts receivable a current asset?

Any money that is due to a company for products or services that they have delivered to customers is considered a current asset – so long as the payment will come within 12 months. Any payment that is not set to be paid in full within that time frame is considered a “long-term asset.”

Is account receivable a revenue?

Accounts receivable are considered an asset account. This is different from a revenue account. Once a payment has been made on an asset account, it converts into revenue.

What's the difference between receivables and accounts receivable?

AАccounts Receivable terms explained

Sometimes, the following terms appear to be synonyms. 

However, they don’t always refer to the same thing. You need to understand the differences when reviewing financial papers.

Receivables:

These include all monetary obligations owed to your company. This is the biggest blanket category. There are two types of receivables: trade and non-trade receivables.

Trade receivables:

These encompass all credits owed to your company by customers who’ve purchased merchandise or services. This usually results in an accumulation of assets (hence the name trade receivables). Accounts receivable are included within trade receivables and are reported as current assets on a company’s balance sheet.

Non-trade receivables:

Non-trade receivables are a result of transactions outside the standard line of business of offering goods and services. They include insurance reimbursements, employee advances receivables, tax refunds, or insurance claims receivable.

Accounts receivable are considered a receivable, but not all receivables are considered AR. We will now dig a little deeper into why this is so.

Net accounts receivables:

Businesses always face the risk that a customer may not pay them for products or services delivered.

In accounting, net accounts receivable is the net amount of money that remains in an account after a business subtracts any provision for debt that will not be paid.

This is primarily used by businesses that sell on credit.

Trade receivables explained: This is where your money comes from

These are the amounts billed by your company to your clients when you’ve completed the delivery of goods or services. This kind of credit is like a gift to your customer until the outstanding invoice has been cleared.

It is important to note that trade receivables don’t carry interest (thus the gift analogy).

When you file an invoice, your accounting software creates a debit to the AR account and a credit to the sales account. However, this doesn’t mean you have that cash. You only actually receive cash when the invoice is paid.

Once the amount due has been cleared, a cash receipt transaction is registered by the system. This translates into a credit to the AR account and a debit to the cash account.

For a better view of your trade receivables, you can always take a look at your AR aging report.

Notes receivable: How to collect your accounts efficiently

When your customer gives you a written promise to pay their credit, you’ve just received a notes receivable. Such credits give you (the lender) more legal options when collecting overdue accounts relative to other accounts receivable options.

This is because notes receivable are taken into consideration when extending credit to a new client, especially one with bad or no credit history. The debtor is usually required to pay interest.

Trade receivables financing

It is no secret that investors are always looking for ways to improve the returns on their portfolios. At the same time, many companies struggle to maintain a healthy level of working capital. Fortunately, there are great opportunities for investors and businesses to work together to solve both problems.

Trade receivables financing refers to when parties collaborate by exchanging liquid assets in anticipation of future profits. If your business struggles to collect its payments or the operating cycle is just too long, this kind of external financing can be the difference between success and failure.

Two of the most common types of trade receivables financing are:

Factoring

Here, a finance company buys some of the supplier’s invoices at a discount. The factor then has to collect payment from the supplier’s clients when the accounts are due. In this type of financing, the supplier receives immediate payment.

Accounts receivable factoring, typically just known as factoring, is a practice where a company sells its accounts receivable to another business in exchange for cash.

Invoice discounting

This is very similar to factoring, the major difference being that the supplier is involved in the collection process. The debtor may not be aware of the fact that third-party financing was used. This type of funding ensures discretion.

High accounts receivable turnover: A sign of a healthy business cycle

Your company relies on your ability to collect all accounts promptly. Keeping track of how often this happens will give you a distinct picture of how effective your company is at collecting its debts. 

Companies can use accounts receivable financing to help solve this problem.

Your accounts receivable turnover defines the number of times per year your business collects its average AR. A low turnover ratio is characteristic of companies with low-quality customers and/or poorly functioning collection departments and should tell you some changes need to be made. Read on how factoring accounts receivable can help with turnover.

To have a high turnover rate, you need to be able to issue credits efficiently and collect your cash within a reasonable time frame. Taking care of this problem is a critical component of having a healthy and successful business.

Common Questions

What is a good accounts receivable turnover ratio?

The average accounts receivable turnover is 31 days. The accounts receivable turnover ratio formula net credit sales divided by the average accounts receivable.

Is a higher AR turnover better?

A higher AR turnover is better for a company’s finances. The higher the number, the more efficient that a company’s finances become. The high figure indicates that a company’s customers pay their debts quickly.

How do you increase accounts receivable turnover ratio?

The 6 best ways to increase your accounts receivable turnover ratio:

  1. Improve your billing efficiency.
  2. Take initial deposits at the start of a project
  3. Regularly audit your balance sheet.
  4. Use your digital calendar to set reminders on payments
  5. Be proactive in your invoicing practices
  6. Provide discounts or incentives for early payments.

Cash Flow Best Practices

Whether you’re a first-time business owner or a seasoned MBA graduate, you must know your options when it comes to accounts receivable. 

As a concept, AR is deceptively simple, leading too many businesses to neglect associated opportunities.

Reach out to our team if you’re interested in learning more. We can help you improve your cash flow planning and assess ways to boost cash flow in the next 24 hours. 

We can discuss advanced tools like invoice factoring services and discounting. 

Reach out to our team, right here

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