What Is Accounts Receivable?
Accounts receivable (AR) are the amounts owed by customers for goods or services purchased on credit. The money owed to the company is called 'accounts receivable' and is tracked as an account in the general ledger, and then reported as a line on the balance sheet.
Where Do You Find Accounts Receivable?
Look for accounts receivable on the company’s balance sheet under the current assets category. Because accounts receivable converts to a cash payment at some time in the future, it will be listed as a current asset. Current assets are those that are expected to be paid within 12 months.
Who Uses Accounts Receivable?
Most businesses use accounts receivable to extend payment terms to their customers.
Businesses also examine their accounts receivable and the A/R turnover rate (described below) to understand how quickly and how well they are collecting payments due to them.
How to Calculate Accounts Receivable
To calculate accounts receivable, add up all of the company’s sales on net credit terms. Net terms may be represented as net 15, net 30, net 60, and so on. The number refers to the amount of time extended to the customer to pay the invoice. For example, “net 15” would mean that the customer must pay in full within 15 days.
Accounts Receivable Example
Let’s assume that an office supply company receives an order from a New York consulting firm for $1,000 in office supplies. The office supply company ships the order and extends net 60 credit terms to their customer.
Once the office supply company receives the order and sends the invoice, it decreases its inventory account by $1,000 and increases its accounts receivable by $1,000.
The consulting firm pays their invoice within 60 days. The office supply company now increases their cash by $1,000 and reduces its accounts receivable by $1,000.
What Is the Accounts Receivable Turnover Ratio?
The accounts receivable turnover ratio is used to assess how well a company collects payment from its customers.
Collecting accounts receivable on time is important because companies need cash to pay for their own operations. A high accounts receivable balance can lead to cash flow shortages for a company until it is able to collect on its debt. It may indicate that the company has a problem collecting its debts.
A/R turnover ratio is calculated as:
Net credit sales = the total number of sales minus returns for a given period.
Average accounts receivable = starting balance of A/R + ending balance of A/R for the period divided by 2.
Example of Accounts Receivable Turnover Ratio
Using the previous example of an office supply firm, let’s look at their A/R turnover ratio.
If the total number of sales for the office supply company for the quarter is $20,000 (with no returns), the net credit sales is $20,000. Assuming the starting A/R balance is $3,000 and the ending balance is $1,000, we get $4,000/2 = $2,000.
$20,000 = 10
The A/R turnover ratio means that the company has collected its A/R 10 times that quarter. Comparing that figure to the A/R turnover ratio from other quarters can help management assess whether the company is improving its ability to collect on A/R – or whether it is having difficulty collecting.
Aging Schedule for Accounts Receivable
An aging schedule for accounts receivable displays the amount of A/R owed by time period. It can help a company estimate how much A/R remains outstanding and predict cash flow. It can also be used to project “doubtful debt”, which is any debt that might be completely uncollectible in the future.
Companies can use past aging schedules to assess how much aging debt may need to be written off. They can review their history of collecting on debts at each stage of the aging schedule and then make an informed guess as to how much might become “bad” debt.
The Advantages and Disadvantages of Accounts Receivable
Using accounts receivable has several advantages:
- Using payment terms and invoicing customers is a standard business practice and is thus favorably received.
- It allows customers to receive goods and services on credit and pay according to terms.
- Businesses can sell more through payment terms.
It has some disadvantages, however:
- Companies may find it challenging to collect on open balances. They may need to send multiple reminders – or even send collection agencies – to collect on the debts owed to them.
- Cash flow may be tight during times when the company has many outstanding receivables.
Accounts Receivable vs. Accounts Payable
Accounts receivable is the money owed to a company. Accounts payable is money the company owes to others. An easy way to remember the difference: A/R is for “received” payment and A/P is for “paying others.” Receivables are classified as short-term assets, while payables are short term liabilities.
Accounts Receivable vs. Revenue
When looking at accounts receivable vs. revenue, it can help to consider how they fit into the whole accounting picture:
- A/R refers to the amount of money that customers owe to a company for the sale of goods or services. It appears as a line item under current assets on a company’s balance sheet.
- Revenue refers to all of the sales of a company. The revenue figure may include accounts receivable, but it will also include paid invoices, too. Revenue appears on the income statement.
Cash Basis Accounting vs. Accounts Receivable
Cash basis accounting does not recognize accounts receivable or payable. Instead, sales are recognized when they are made and paid, and the business pays for supplies immediately upon purchase and receipt.
Consider a small business owner who sells crafts at fairs and flea markets. He may pay in cash for his materials (e.g. paint, glue) and insists on cash payments. Cash basis accounting offers the simplest method for such a business owner to track sales and expenses.
Bad Debt vs. Accounts Receivable
Bad debt refers to accounts receivable that are unlikely to be collected. These occur when companies deliver goods on credit (net terms) and fail to collect payment.
Bad debt is expensed as a cost of doing business. It is frequently categorized under SG & A (sales and general administrative expenses) and leads to an offsetting reduction against accounts receivable on the balance sheet.