Accounts receivable, sometimes shortened to "receivables" or "A/R," is money owed to a company by its customers. If a company has delivered products or services but not yet received payment, it's an account receivable.
The nature of a firm's accounts receivable balance depends on the sector in which it does business, as well as the credit policies the corporate management has in place. A company keeps track of its A/R as a current asset on what's called a "balance sheet." Among other values, the balance sheet includes how much money a company expects to be paid (as assets) and how much it expects to pay out (as liabilities). Understanding the A/R matters in finding out a company's overall health.
Recording A/R on the Balance Sheet
The best way to understand accounts receivable is to view a transaction and how it ends up on the balance sheet.
Imagine that Walmart, the buyer, wants to order a new boxed set of books from the publisher, which is the seller.
- Walmart agrees to buy 50,000 units that people can only buy at Walmart. The books are printed and packaged. The seller will charge Walmart $30 per set. Walmart will sell the sets for $90 each to its customers.
- When the seller ships the 50,000 units to Walmart, it will include a bill for $1.5 million, which is 50,000 units at $30 per unit. Walmart then receives the books, and the seller is owed the money but hasn't yet been paid.
- That $1.5 million sits on the seller's balance sheet as an A/R. On the flip side, it sits on Walmart's balance sheet as both an inventory asset and a liability called an "account payable."
Why Payment Terms Matter
A company that sells products on credit, meaning before it gets paid, sets terms for its A/R. The terms include the number of days clients have to pay their bills before they will be charged a late fee. When a buyer doesn't adhere to the payment terms, the seller can approach its customer and offer new terms or some other remedy to collect on the bill.
If no progress takes place, the A/R balance is either turned over to a collection agency, or, in more extreme cases, the firm sues the person or institution that owes it money, seeking relief from a court by seizing assets.
Firms often use any of a number of known A/R terms. These are expressed as "net 10," "net 15," "net 30," "net 60," or "net 90." The numbers refer to the number of days in which the net amount is due and expected to be paid. For instance, if a sale is net 10, you have 10 days from the time of the invoice to pay your balance.
To free up cash flow and increase the speed at which they can access funds, many companies offer an early-pay discount on longer A/R balances to try to get their clients to pay them sooner.
It is in the customer's best interest to take the discount and pay early. The discount saves them more than they could have earned by hanging on to their money.
Large A/R Amounts Can Be Risky
Having a large A/R amount due on the balance sheet might seem appealing. You would think that every company wants a flood of future cash coming its way, but that is not the case. Money in A/R is money that's not in the bank, and it can expose the company to a degree of risk. If Walmart were to go bankrupt or simply not pay, the seller would be forced to write off the A/R balance on its balance sheet by $1.5 million.
Taking on this loss and being stuck with 50,000 units of custom books could be tragic to the seller. If you're thinking about the future growth prospects of a company, make sure to take a look at its accounts receivable book. It should be well diversified.
If one customer or client represents more than 5% or 10% of the accounts payable, there is exposure, which might be cause for concern.
Companies build up cash reserves to prepare for issues such as this. Reserves are specific accounting charges that reduce profits each year. If reserves are not enough or need to be increased, more charges need to be made on the company's income statement. Reserves are used to cover all sorts of issues, ranging from warranty return expectations to bad loan provisions at banks.
An Alternative to A/R
Some companies have a different business model and insist on being paid up front. In this case, the business doesn't record an A/R transaction but instead enters a liability on its balance sheet to an account known as unearned revenue or prepaid revenue.
As the money is earned, either by shipping promised products, using the "percentage of completion" method, or simply as time passes, it gets transferred from unearned revenue on the balance sheet to sales revenue on the income statement. That reduces the liability and increases reported sales.
One good place to look at this is in the asset management industry. Clients often pay fees to a registered investment advisor every four months, billed in advance. The advisory company receives the cash but hasn't yet earned it. For each business day that passes, a certain amount of fees become earned and non-refundable.
An asset management firm that opts to bill in arrears, on the other hand, would temporarily have an A/R balance on its balance sheet, usually for only a day or two as fees are taken from client custody accounts.
Frequently Asked Questions (FAQs)
What is the accounts receivable turnover ratio?
The A/R turnover ratio is a measurement that shows how efficient a company is at collecting its debts. It divides the company's credit sales in a given period by its average A/R during the same period. The result shows you how many times the company collected its average A/R during that time frame. The lower the number, the less efficient a company is at collecting debts.
How would cash collected on accounts receivable affect the balance sheet?
When it collects cash against its A/R balance, a company is converting the balance from one current asset to another. Its A/R balance decreases, while its cash balance increases. Liabilities and equity remain unchanged.
How do accounts receivable affect cash flow?
By its nature, using A/R delays cash payments from customers, which will negatively affect cash flow in the short term. The higher a firm's accounts receivable balance, the less cash it has realized from sales activities. That's why it's important for companies using A/R to track the turnover ratio and be proactive with customers to ensure timely payments.