What Is Accounts Receivable and How Does It Work?

Accounts receivable (AR) is a fundamental concept in business finance, representing money owed to a business for goods or services already provided. This financial component is important for understanding a company’s overall financial health and its ability to manage cash flow. Effective AR management helps ensure a business has the necessary funds to operate and invest.

Defining Accounts Receivable

Accounts receivable (AR) refers to money a business is owed by its customers for products or services delivered but not yet paid. This typically arises from credit sales, where customers receive goods or services with an agreement to pay at a later date. Unlike cash sales, where payment is immediate, AR signifies that the business has extended short-term credit to its clients.

AR is classified as a current asset on a company’s balance sheet. This means the money is expected to be collected within one year or less from the invoice date. The inclusion of AR as an asset reflects the legal obligation customers have to pay the debt, providing a future economic benefit to the business.

How Accounts Receivable is Created

The creation of accounts receivable begins when a business provides a product or service to a customer without immediate payment. This transaction establishes a claim for payment. After delivery, the business issues an invoice to the customer.

This invoice details the amount due, a description of the goods or services provided, and the agreed-upon payment terms. Common terms include “Net 30,” meaning payment is due within 30 days. Once issued, the AR balance is recorded in the company’s financial records, reflecting the money owed.

Managing Accounts Receivable

Effective management of accounts receivable is important for maintaining a business’s cash flow and financial stability.

Credit Policies

A key practice involves establishing clear credit policies for customers before extending credit. These policies should outline criteria for credit approval, set credit limits, and define payment terms, such as net payment periods or incentives for early payment. This initial vetting helps assess a customer’s creditworthiness and reduces the risk of late payments.

Invoicing

Invoicing is a central part of managing accounts receivable. Businesses should send invoices promptly with clear instructions. An invoice includes the invoice date, a unique invoice number, details of the goods or services provided, the total amount due, and the payment due date. Establishing a consistent billing cycle also helps customers anticipate payment deadlines.

Tracking and Follow-Up

Tracking outstanding invoices is another important step, which can be done through an invoice tracking system or accounting software. This allows businesses to monitor payment statuses and identify overdue accounts. When payments are not received by the due date, a structured follow-up process is initiated. This process can involve sending reminders before the due date, followed by immediate contact after a missed payment, potentially escalating efforts for significantly overdue accounts.

Accounts Receivable on Financial Statements

Accounts receivable is presented on a company’s balance sheet within the current assets section. The value shown signifies the total money customers owe for credit sales. This figure is often reported as “accounts receivable, net of allowance for doubtful accounts,” adjusted to reflect the amount the company realistically expects to collect. The net AR balance provides insight into a company’s liquidity, indicating anticipated future cash inflow from sales. A healthy AR balance, coupled with efficient collection, contributes to working capital and the ability to meet short-term financial commitments.