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Аccounts Receivable Explained: How to Manage Your Working Capital

business owner paying invoice on phone

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. 

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:

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.

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.

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.

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.

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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