What are Accounts Receivable?

“Accounts receivable,” often referred to by the abbreviation “AR” or “A/R,” represents money owed following a business transaction in which the buyer has not yet paid for goods or services which they have received.

AR are most often generated by an invoice raised by the seller. Invoices set out the conditions (due date, instalment dates, discounts for early payment, etc.) under which the amount is to be paid. These conditions are referred to as the “payment terms.”

Outstanding payments due to a company in the form of AR are listed on the company’s balance sheet as current assets. The AR process starts when the invoice is raised and ends when payment is collected. Successful businesses manage the process to extend attractive payment terms to customers while maintaining a healthy working capital.

The AR process begins with the sale of a product or delivery of a service. If the transaction is not settled immediately, the seller extends a credit line, on the agreement that payment will be made at a later date.

The seller then raises an invoice, a legally enforceable, dated document which records the transaction and sets out the payment terms. Invoices are usually generated electronically and either printed or emailed to both parties.

The payment terms specify the date upon which payment is due and any other options agreed upon at the time of transaction. Typical payment terms include Cash on Delivery, (payment due upon delivery of the service or good), Line of Credit (credit is extended and instalments are made at set intervals), and Net 30, 60 or 90 days (payment is due in a specified number of days following the date on the invoice).

Once the invoice containing the payment terms has been issued, the credit must be tracked to ensure timely payment. In an ideal world, all invoices would be settled in line with the agreed payment terms. However, every business knows that this is not always the case. When this happens, there may be a need to initiate debt collection procedures. 

An “age analysis” of accounts receivable can be used to identify overdue payments. Reminders can be issued to customers whose invoices have not been settled within the agreed timescale. In some circumstances, payment terms may be renegotiated.

However, even with the most stringent debt management systems, some invoices may simply never be settled. This may be due to insolvency, bankruptcy, or negligence. When a company has exhausted all avenues for recovering a debt, and no longer considers it to be recoverable, the debt must be written off as a “bad debt.”

This is one unfortunate risk of extending credit to customers. However, with astute AR management, most invoices are settled in full and on time. When payment is received, the company credits (i.e. decreases) their accounts receivable and debits (i.e. increases) their cash account, as the money is no longer owed.

Strategically managing credit and debt is crucial to good financial health. One of the ways can be measured is by analysing how efficient a company is at extending credit and collecting debt from its customers.

The Accounts Receivable Turnover Ratio is a simple accounting tool to measure how well a company manages its customer debt. According to Investopedia, the accounts receivable turnover ratio “measures the number of times a company collects its average accounts receivable balance.” A company which is highly efficient at recovering debts will have a higher Accounts Receivable Turnover Ratio than one which does not have the skills or time to do so. The Accounts Receivable Turnover Ratio is calculated by dividing the net credit sales by the average accounts receivable.

A high ratio indicates that credit management processes are working well and that customers are settling their debts on time. A low ratio indicates that credit may have been extended to unreliable or uncreditworthy customers, or that in-house debt collection procedures are inefficient.

A related concept is the Days Sales Outstanding (DSO) metric, which measures the average number of days it takes a company to receive payment for the goods and services it sells on credit. The lower the DSO, the faster payments are being collected. Carefully monitoring the DSO can give insights into customers’ financial health and can indicate where processes need to be improved.

Accounts Receivable are a standard feature of most B2B transactions and many B2C transactions as well. Here is an example:

A retail store purchases washing machines from a supplier for €10,000. The washing machines are delivered to the store and the supplier raises an invoice for €10,000, payable within 30 days. During these 30 days, when the retail store has not settled the invoice but physically has the goods, the supplier will record this €10,000 as Accounts Receivable. Conversely, the retail store will record this amount as “Accounts Payable.” Thirty days later, when the retail store pays the supplier, the supplier will reduce its accounts receivable by €10,000 and increase their cash account by the same amount.

One way a business can raise funds is to sell unsettled invoices in exchange for cash. This process is known as Accounts Receivable Factoring. Factoring companies pay a percentage of the outstanding invoices and take over the debt recovery process. Once the debt is recovered, the factoring company pays the full amount back, minus fees. The fees charged are usually set as a percentage of the value of the debt and may extend over the number of months the debt remains outstanding.

This can be an expensive way of recovering debt, but it may be the only option for companies without the in-house expertise or capacity to chase debts and who need to bridge gaps in cash flow.

Accounts Receivable Factoring should not be confused with Accounts Receivable Financing, which is a type of business loan. Accounts Receivable Financing takes place when a company leverages the amount of money due to it to raise additional funds. Financial institutions may extend finance to companies based on their AR. When invoices are settled, the loan is repaid.

The key difference between Accounts Receivable Factoring and Accounts Receivable Financing is that the former refers to the sale of debt in exchange for a fee, while the latter refers to a loan extended to a company on the basis of the collateral represented by their Accounts Receivable.

For small- and medium-sized businesses, good fiscal management involves prudently extending credit and meticulously recovering debt. Stringent risk management and monitoring procedures are required to ensure that invoices are likely to be settle on time and that bad debts are minimised. 

Companies need to balance extending attractive payment terms to their customers with making sure that debts can be recovered. Customers appreciate longer, more flexible payment terms, but this can generate cash-flow difficulties. A strategic analysis of the accounts receivable process is required.

As soon as any small- or medium-sized business is up and running, the issue of extending credit and managing debt becomes a key concern. Finding the right balance between attracting customers with flexible payment terms and ensuring regular and reliable cash flow into the business is essential to ensuring good corporate financial health.

When credit is extended to a customer, this amount is recorded as a debit balance under Accounts Receivable. When these payments are made, the Accounts Receivable entry is credited (it decreases). The Accounts Receivable Process is usually managed in-house, often with the help of dedicated accounting software and automated procedures. When the process falls short, companies may outsource debt recovery to an Accounts Receivable Factoring service, in exchange for a fee.

Making sure that your Accounts Receivable Cycle is carefully managed and monitored is key to the financial health of your company. Find out more about how Allianz Trade can help ensure your procedures are in optimal condition.