Cash flow management is the backbone of success in an organization. Among different financial aspects that should be considered in business finance, an important issue is accounts receivable, which has greatly impacted even the very important scenario of liquidity and the business's overall health.
Understanding all the constituents of accounts receivable, how they function, and techniques for effective management will greatly benefit an organization in terms of cash flow and healthy financial status. This article, therefore, seeks to explain the importance of the subject and give some insights into practical accounts receivable management.
What Is Accounts Receivable (AR)?
An accounts receivable (also often referred to as AR) gives the outstanding invoices to a company or the money customers owe for goods or services that have been received yet awaiting payment. Understanding what type of accounts receivable is crucial for financial reporting.
Simply put, they are credit sales and thus are expected to be collected by the company shortly, typically within a year. As it appears in the company's balance sheet, accounts receivable are current as they are considered short-term receivable. This classification answers the question, are accounts receivable an asset?
The first rule, without exception, that a company must display is the recognition that a company extends credit to customers. Accounts Receivable is the binding link between transferring goods or services and receiving money, by which the companies enable the smooth functioning of their activities.
Example of Accounts Receivable
Let's take a real-life example of accounts receivable. This has to bear with a particular company, XYZ Corporation, which sells goods worth $10,000 to a customer and allows him to take the products on credit with terms that stipulate payment net on 30 days. The products are delivered immediately to the customer, and hence, an accounts receivable entry of $10,000 is made to the balance sheet of XYZ Corporation.
When the customer pays the invoice within 30 days, the company converts the accounts receivable into cash by settling the AR entry. This example demonstrates why the question of whether accounts receivable are an asset is answered affirmatively.
Also Read: Difference between accounts payable and receivable
This sample illustrates how accounts receivable allow enterprises to have well-documented records of the anticipated cash inflows for flexible customer payment options. Timely collection is shown to be very important for preventing cash flow dislocation.
How Does Accounts Receivable Work?
The management of accounts receivable consists of several steps, from the creation of an invoice to collection. Here is how accounts receivable work:
1. Issuing Invoices
In the course of commercial transactions whereby products or services are sold on credit to a third party, an invoice will be generated whereby the total amount to be paid by that third party will be recorded, as well as payment terms, the due date for payment, and any discounts applicable for early payment. The invoice will be treated as accounts receivable when recorded in the company's accounting system.
2. Recording Transactions
In the records kept by the company's finance department, an invoice is taken to mean an entry in amortization of accounts receivable, showing how much money the customer owes the company. It will be recorded under current assets since it represents the expected cash inflow within one year.
3. Tracking and Management
Good accounts receivable management is associated with tracking outstanding invoices, sending customers payment reminders, and calling them about overdue accounts. Knowing what type of accounts receivable helps in accurate classification. Companies often use ageing reports to classify their receivables based on how long an invoice has been outstanding to prioritize their efforts in the collection.
4. Receipt of Payments
The firm acknowledges customer cash receipts through payments or checks and charges them on the accounts receivable balance. The shortcoming here is that collecting receivables promptly is another factor in keeping companies' cash flow intermittent and, therefore, healthy.
5. Bad Debts
Sometimes, clients might unduly delay settling their invoices, leading to bad debts. Such debts are usually supposed to be deductible and presented within the company's financial statements. In contrast, bad debts are deductible under doubtful accounts, estimating that some receivables are less likely to be collectable. Thus, writing off bad debts clears the financial statements from the company's perspective of holding an accurate financial position.
Benefits of Accounts Receivable Financing
Accounts receivable financing services manage their working capital and maintain their financial health when it is expanding or during seasonal fluctuations in demand. The several benefits of accounts receivable financing are:
How Drip Capital Can Help
Drip Capital is revolutionizing value management and upholding futuristic techniques in accounts receivable management for businesses through accounts receivable financing. It further helps release a cash flow trap unlocked by unpaid invoices with AR finance. This financing option allows companies to sell their receivables to Drip Capital at a discounted rate in exchange for an early inflow of funds.
Frequently Asked Questions
1. How are accounts receivable different from accounts payable?
Accounts receivable is money received from customers for the goods or services sold by the company. This also clarifies the common query: is accounts receivable an asset? On the contrary, accounts payable count amounts the company carries in books but are not billed for upon receipt of services or goods. Accounts receivable are assets, while accounts payable are a liability.
2. What are net receivables?
Net receivables imply accounts receivable after considerations for doubtful accounts; thus, net receivables mean what the company estimates it will collect from its receivables after bad debts have been accounted for. This figure is much more accurate in showing cash inflows expected from the company and is also helpful in analyzing the quality of the receivables.
3. What happens if customers never pay what's due?
Uncollectible invoices from customers will involve bad debts for the company. Bad debts are accounted for by reducing the accounts receivable and recording a bad debt expense on the income statement. Bad debts threaten the financial statement, cash flow, and profits. That is why an effective credit risk management strategy should be used to avoid or reduce incidences of bad debts.
4. When to call something ‘bad debt’?
A bad debt account is one for which all reasonable efforts at collection have failed, making it appear uncollectible. Often, a business will consider an account bad when it becomes apparent that the customer will not or cannot pay the amount owed. Recognition of bad debt guarantees an accurate representation of the company's financial position and performance through financial statements.
