What Is an Account Receivable & Why Does It Matter?

Businesses frequently engage in transactions where goods or services are provided to customers before payment is received. This common practice of selling on credit establishes a promise of future payment from the customer to the business. This promise represents a fundamental component of a company’s financial structure, signifying an expected inflow of cash.

Defining Accounts Receivable

Accounts receivable (AR) refers to the money owed to a business by its customers for goods or services that have already been delivered but not yet paid for. This arises from credit sales, where a customer is granted a period (e.g., 30 or 60 days) to pay after receiving the product or service. AR is recorded as a current asset on a company’s balance sheet, expected to be converted into cash within one year or the normal operating cycle. For example, when a plumbing service completes a repair for a client and sends an invoice with payment due in 30 days, the amount owed becomes an account receivable for the plumbing business until the payment is received. This contrasts with cash sales, where payment is immediate, and no receivable is created. AR represents a short-term asset, crucial for a company’s immediate financial health.

Importance and Impact on Business Operations

Accounts receivable are crucial for a business’s financial health, influencing cash flow, liquidity, and working capital. Timely collection of AR ensures a business has funds to cover operating expenses like payroll, rent, and supplier payments. An increase in accounts receivable indicates more credit sales without corresponding cash collection, which can reduce operating cash flow. Conversely, a decrease in accounts receivable means customers are paying invoices, boosting operating cash flow by converting credit sales into cash.

Efficient management of accounts receivable is vital for a business to maintain liquidity, its ability to meet short-term financial obligations. Without prompt collection, a company may face cash shortages, even if it appears profitable on paper. The money tied up in uncollected receivables cannot be used for investment, expansion, or managing other liabilities. Strong AR management supports a business’s capacity to grow and adapt.

Managing Accounts Receivable

Effective accounts receivable management involves a structured process from sale to payment collection. This process begins with issuing clear and accurate invoices to customers immediately after goods or services are delivered. Invoices detail products or services, the amount due, and payment terms like “Net 30,” meaning payment is due within 30 days of the invoice date. Common payment terms can also include “Net 7,” “Net 15,” “Net 60,” or “End of Month (EOM).”

Businesses track outstanding balances using accounting systems to monitor due payments. A key tool is accounts receivable “aging,” which categorizes invoices by how long they have been outstanding. Common aging categories include 0-30 days, 31-60 days, 61-90 days, and 90+ days. This aging report helps businesses prioritize collection efforts, as older receivables risk becoming uncollectible. Timely follow-up on overdue payments is essential to maintain healthy cash flow and reduce bad debt.

Accounts Receivable on Financial Statements

Accounts receivable is displayed on a company’s balance sheet as a current asset. This signifies these amounts are expected to be converted into cash within one year or the business’s normal operating cycle. The presence of accounts receivable on the balance sheet is a result of accrual accounting principles, where revenue is recognized when goods or services are delivered, not when cash is received. Thus, even if a customer has not paid, revenue is recorded, and the outstanding amount becomes an account receivable.

While accounts receivable is a balance sheet item, its changes are reflected in the operating activities section of the cash flow statement. An increase in accounts receivable reduces operating cash flow, as cash has not been received for sales. Conversely, a decrease in accounts receivable increases operating cash flow, indicating credit sales have converted into cash. Accounts receivable also plays a role in key financial ratios, such as the current ratio (assessing a company’s ability to cover short-term liabilities) and the receivables turnover ratio (which measures collection efficiency).