What is Accounts Receivable?
Many businesses offer credit terms to their customers, meaning they provide the goods or services now and collect payment later. This model comes in handy when trying to boost sales and customer retention – which is why most businesses use it. Now let’s look at what accounts receivables are about.
When selling on credit, businesses must monitor all the money their clients owe. That’s when accounts receivables come in. If you’re wondering how AR works, how to keep track of them, and how to measure their performance, this article is for you.
What are Accounts Receivables?
Accounts receivable (AR) is simply the amount of cash your customers haven’t paid yet from past purchases. During a credit sale, your customers take your goods or services along with an invoice. Instead of paying you on the spot, the customer will pay on an agreed-upon date in the future, typically after a few weeks. All of that uncollected money gets recorded as accounts receivable.
The Accounts Receivable Cycle
Say you’re running a company that fixes commercial roofs. Here’s how AR runs from beginning to end:
- You start repairing a multi-family roof Monday.
- You finished the job Wednesday and sent an invoice to your customer asking for payment after 30 days.
- Starting Monday until the day you get paid, you’ll have an account receivable, which you record as a debit in the accounts receivable of your trial balance and credit on your cash account.
- You’ll also record this exact amount in your balance sheet’s accounts receivable balance under current assets.
- Once the customer pays, you’ll credit your accounts receivable balance and debit your cash balance.
- The amount is now removed from the AR balance and added to the total cash balance.
What Do Accounts Receivable Journal Entries Look Like?
Here are examples of what AR entries will look like in your general journal:
Company XYZ sells consumer goods in bulk. They sold their goods to a local department store on 10-January. The sale amounted to $30,000.00, which the store must pay within 30 days.
The credit sale transaction must be recorded in this way on the journal:
After 30 days, the store has made a full payment of $30,000.00. Company XYZ must also record this cash payment transaction:
In this example, the $30,000.00 payment gets credited in the accounts receivable balance and debited from cash. The $30,000 amount gets removed from AR and added to the company’s total cash balance.
Using the example above, say after 30 days, the store only managed to pay $15,000.00 instead of the total balance of thirty-thousand.
This is how it’ll go on the journal:
The process goes like in example-B, but instead of recording the full amount, the company only registers $15,000.00. The company added $15,000.00 to their cash account, but another $15,000.00 still remains in accounts receivable.
How to Measure Accounts Receivable Performance
Monitoring and examining AR allows you, your team, investors, and creditors to gauge your company’s future cash flow, liquidity, and overall financial stability. AR that piles up is never a good thing and is the main reason why many companies experience cash shortages.
Sound AR management requires staying on top of relevant metrics and KPIs. Two of the most important metrics in analyzing AR performance are the accounts receivable turnover ratio and collection period.
Accounts Receivable Turnover
The accounts receivable turnover ratio measures how often you’re collecting outstanding receivables. Here is the AR turnover formula:
- Net Credit Sales – the total credit sales made over your chosen period minus all sales returns and allowances over that same period
- Average Accounts Receivable Balance – the average AR amount of the period which you calculate based on your balance sheet records
- Accounts Receivable Turnover Ratio – the ratio that shows the number of times your company collects its average accounts receivables over a period.
Company XYZ had a net credit sales of $1.7M and an average AR balance of $200,000 over a prior 12-month period. Using the accounts receivable turnover formula shown above: $1,800,000/$200,000, we get 9. Company XYZ 9 collected its average AR 9 times during the prior 12-month period.
Accounts Receivable Collection Period
The AR collection period tells you how quickly you collect what customers owe.
- Days – the number of days within your chosen period
- Accounts Receivable Turnover Ratio – the ratio that measures how many times your company collects average AR over a period (the one we’ve already gone through above)
- AR Collection Period – how quickly your company collects AR in days
Since Company XYZ had an accounts receivable turnover of 9 over the last 12 months (365 days), we can easily calculate its AR collection period. Using the formula above: 365/9 gives us 40.5. Company XYZ took 40.5 days on average to collect what its customers owed over the period.
What Happens if Customers Don’t Pay?
When it becomes evident that a customer won’t be able to pay, such as when their company goes bankrupt, you’ll have no other choice but write off the accounts receivable balance.
Using the example above, say after a couple of months, Company XYZ still hasn’t gotten any payment from the local store where they sold their consumer goods amounting to $30,000. After doing a bit of digging, the company found out the store had already closed down, leaving no chance of fulfilling the obligation. Company XYZ decides to write off the balance, deeming it uncollectible.
In this case, the written-off amount of $30,000 gets reported as bad debt expense, which will appear in the income statement under Operational Expenses. The company then removes the exact amount from the balance sheet’s account receivable balance under current assets.
Cash Remains King
Staying on top of accounts receivables is all-important if you’re going to stay liquid in the long run. We’ve laid out some proven strategies for you to control your cash flow like a complete pro. So head on over to that post to make sure you always know how to keep your cash flow pumping.
Failure to collect AR is one of the reasons why many companies fail. Cash remains king, and managing cash flow should be top priority for any business. Cash management practices and technology have come a long way. With today’s technology, you can automate cash management and AR tasks, cutting down work hours and spending by a huge margin.
With cash management software, you can automate invoicing, reminders, recording, and forecasting. You’ll also have the tools to get paid faster and easier. Peakflo does all of that and more. We’re also 100% free forever.