What Makes Up Accounts Receivable for a Business?
Unpack what constitutes accounts receivable for businesses, revealing its critical connection to financial well-being and effective resource management.
Accounts receivable (AR) represents the money customers owe a business for goods or services they have received but not yet paid for. On a company’s balance sheet, accounts receivable is categorized as a current asset, signifying that these amounts are expected to be collected within one year.
Fundamental Elements of Accounts Receivable
Accounts receivable originates primarily from credit sales, where a business delivers its products or performs services before receiving cash payment. Each instance of a credit sale creates a receivable, which is formally documented by an invoice. This invoice serves as a bill, detailing the specific goods or services provided, the quantity, the agreed-upon price, and the total amount due.
The invoice also outlines the payment terms, which specify when the customer is expected to pay. Common payment terms include “Net 30,” meaning payment is due 30 days from the invoice date, or “Net 60” for 60 days. Sometimes, terms like “2/10 Net 30” are offered, providing a small discount if the invoice is paid within a shorter period, such as 10 days. Each outstanding invoice from a customer contributes to the total accounts receivable balance.
Accounts Receivable and Business Health
Until accounts receivable amounts are received, they cannot be used to cover operational expenses, invest in new projects, or distribute to owners. Efficient collection of receivables ensures a steady inflow of cash, which is necessary for a business to meet its daily financial obligations.
The level of accounts receivable also directly impacts a company’s liquidity, which is its ability to convert assets into cash quickly to satisfy short-term debts. A large amount of uncollected receivables can strain a company’s liquidity, making it difficult to pay suppliers, employees, or rent on time. Accounts receivable is also a component of working capital, which is the difference between current assets and current liabilities. Effective management of receivables helps maintain sufficient working capital, allowing a business to fund its ongoing operations and respond to unexpected financial needs.
Key Practices in Accounts Receivable Management
Effective management of accounts receivable begins with establishing clear credit policies before extending credit to customers. These policies often involve assessing a customer’s creditworthiness to minimize the risk of non-payment. Once credit is extended, creating and sending accurate invoices promptly is a foundational step, ensuring customers receive timely and correct billing information.
Businesses also implement systematic follow-up procedures for overdue payments, which may involve sending polite reminders before the due date and escalating communications if payments become significantly late. Common analytical tools are used to monitor and manage accounts receivable effectively. An accounts receivable aging schedule categorizes outstanding invoices based on how long they have been due, typically in 30-day increments, helping businesses prioritize collection efforts for older, higher-risk balances. The accounts receivable turnover ratio, another tool, measures how efficiently a company collects its receivables over a period, providing insight into the speed of cash conversion from credit sales.