What Are Accounts and Notes Receivable?

In business, understanding how money flows is important for financial stability. Companies frequently sell goods or services on credit, meaning they deliver products or complete work before receiving payment. This practice creates financial assets known as receivables, which represent claims a business has against others for money, goods, or services. These claims are recorded on a company’s balance sheet, reflecting amounts owed by customers or other entities. Managing these outstanding amounts is important for maintaining healthy cash flow and assessing a business’s overall financial strength.

Accounts Receivable Explained

Accounts receivable (AR) arise from everyday sales transactions where a business provides goods or services on credit. Payment is due within 30 to 90 days, as specified by credit terms like “Net 30” or “Net 60.” These receivables are informal claims, documented by an invoice rather than a separate formal agreement. An invoice serves as a bill for goods or services rendered, detailing the amount owed, payment terms, and the due date.

For instance, a wholesale supplier delivering inventory to a retail store on credit generates an accounts receivable. A consulting firm completing a project for a client before billing them also creates an accounts receivable. These amounts do not accrue interest. Accounts receivable are classified as current assets on a company’s balance sheet, reflecting their expected conversion to cash within one year.

Notes Receivable Explained

Notes receivable (NR) represent a more formal claim for money owed to a business. They are supported by a written promise to pay a specific sum, known as a promissory note. This legally binding document outlines the principal amount, interest rate, payment schedule, and the maturity date. Notes receivable often arise from formal loans made by a company, such as lending money to an employee or another business, or extending credit for a significant purchase.

They can also originate when an existing, overdue accounts receivable is converted into a note to formalize the debt and add interest charges. Repayment terms for notes receivable are longer than accounts receivable, often extending from a few months to several years. For example, if a business sells equipment and allows the buyer to pay over two years with interest, this is recorded as a note receivable. These notes may be classified as current or non-current assets on the balance sheet, depending on whether their maturity date falls within or beyond one year.

Distinguishing Between Accounts and Notes Receivable

The primary distinction between accounts receivable and notes receivable lies in their formality and underlying terms. Accounts receivable are informal claims, supported by an invoice and lacking a separate written agreement. They are short-term, with payment expected within 30 to 90 days, and do not bear interest. Their legal enforceability stems from the sales contract and invoice terms.

Notes receivable, conversely, are formal, legally binding instruments evidenced by a promissory note. They include provisions for interest payments and can have longer repayment periods, ranging from several months to multiple years. The formal nature of a promissory note provides stronger legal recourse for collection compared to an invoice. Notes receivable may also be secured by collateral, offering additional protection to the lender, unlike the unsecured nature of accounts receivable.

Why These Receivables Matter

Both accounts and notes receivable are important current assets on a company’s balance sheet, directly influencing its liquidity and financial health. They represent future cash inflows, important for covering operational expenses and funding growth initiatives. Effective management of these receivables ensures a business has sufficient working capital to operate smoothly.

Monitoring receivables helps a business assess its credit risk and manage potential bad debts, which are amounts unlikely to be collected. Businesses use various metrics, such as the accounts receivable turnover ratio, to evaluate how efficiently they collect these outstanding amounts. Properly managing and collecting receivables is important for accurate financial planning, enabling a company to forecast its cash position and make informed decisions about investments and expenditures.