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A company's accounts receivable (AR) are among its most crucial assets. They stand for the sum of money that clients owe a company for products or services that have been provided or consumed but have not yet been paid for.
What Are Accounts Receivable?
Accounts receivable are created when a business sells its products or services on credit. This is the situation where a company provides a customer with goods or services, sends an invoice, but does not immediately get payment. Instead, the consumer makes a commitment to pay the bill within a predetermined window of time, typically 30 to 90 days. This also goes by the name of trade credit.Accounts receivable are an asset account on the balance sheet of a business. These display how much cash the company anticipates paying its clients in the near future. The gap between current assets and current liabilities, or working capital, is another term for accounts receivable in a business. The amount of money a company has on hand to pay its immediate debts and make investments in its expansion is known as working capital.
How Are Accounts Receivable Recorded and Managed?
Accounts receivable are recorded using the accrual basis of accounting. As a result, revenue is recorded when the goods or services are provided rather than when payment is made. For instance, even if a company does not receive payment until February for products it sold on credit for $10,000 in January, it will still record $10,000 in revenue and $10,000 in accounts receivable in January.A company must monitor its invoices and customer payments in order to manage accounts receivable. It should also keep an eye on its Days Sales Outstanding (DSO), which is a measure of how quickly and effectively it collects receivables, and its accounts receivable turnover ratio. A business that has a high turnover ratio and a low DSO collects receivables more quickly, improving cash flow and lowering the risk of bad debts. The business collects receivables more slowly when it has a low turnover ratio and a high DSO, which lowers cash flow and raises the risk of bad debts.
The accounts receivable turnover ratio is calculated by dividing net sales by the average accounts receivable for a given period. Net sales are total sales minus any discounts and refunds. Average receivables are calculated by dividing the total at the start and end of the quarter by two. For instance, if a company's net sales are $60,000 and its average amount of accounts receivable over the course of a year is $2,000, its accounts receivable turnover ratio is 30 ($60,000 / $2,000).
The number of days of sales outstanding is derived by dividing the average accounts receivable for a particular period by the daily net sales. Net sales are broken down into daily amounts by the number of days in the period. A company's DSO, for instance, would be 10 ($2,000 / $200) if its average accounts receivable for the year were $2,000 and it had $200 in daily net sales.
Why Are Accounts Receivable Important?
Accounts receivable are important because they affect the cash flow and profitability of a business. Cash flow is the total sum of money that comes into and leaves a company over time. The capacity of a business to produce more income than expenses over time is known as profitability.As receivables from consumers are recovered, cash flow is increased. A company has more cash available to pay its bills, invest in its expansion, or distribute to its owners the quicker it collects its receivables. When receivables from consumers are not collected, cash flow is reduced. The less cash a company has available to satisfy obligations or opportunities, the slower it collects its receivables.
Accounts receivable also affect profitability because they represent revenue that has been earned but not yet received. A business's income statement will show higher revenue and income when its accounts receivable balance is higher. This does not imply, however, that the company actually has more money or profit. Accounts receivable may turn into bad debts that must be written off as an expenditure on the balance sheet if they are not collected in a timely manner or at all.
This implies that the company will suffer a loss of revenue and lose value. A company must therefore effectively and efficiently manage its accounts receivable. One method to do this is to keep an eye on the average collection time, which quantifies how long it takes a company to collect its accounts receivable from its clients. The business can convert its accounts receivable into cash and utilize it for other purposes more quickly the shorter the average collection period.
Using credit policies and practices that reduce the risk of non-payment or late payment by clients is another method of managing accounts receivable. A company might, for instance, run credit checks on clients before issuing credit, demand down payments or up-front cash for significant orders, give discounts for prompt payment, or impose late payment interest or penalties. These techniques can assist a company in reducing its accounts receivable balance and enhancing its cash flow and profitability.
