Have you ever been told not to count your chickens before they hatch? Or that a bird in the hand is worth two in the bush?
It can be risky to base decisions on expectation alone. It’s also unwise, however, to ignore unrealized gains entirely. This is particularly true for business owners, who need to be able to make predictions and adjust strategy based on future outcomes.
Let’s say that you own a small chicken farm. Should you count each egg as a definite future chicken? Of course not. But you also shouldn’t ignore your count of fertilized eggs. These eggs are a strong indicator of the number of chickens you should expect to welcome come hatching season. Just as an experienced poultry farmer knows what percentage of her eggs are likely to hatch in a given season, an experienced small business owner (with a streamlined accounting system) knows what percentage of the money owed to her she can expect to collect in a given period of time. These gains, although not yet realized, are the strongest available predictor of the future.
Whether you deal in eggs or dollars, recording expected gains in accounts receivable allows you to manage assets and monitor your success rate. It’s critical to collecting on debts—and to raising a handsome crop of poultry.
What is accounts receivable?
Accounts receivable (AR) is an asset account that tracks the money due to a business from clients or other debtors. Essentially, the number in this account represents sales made by extending credit to a customer up until the point that the business receives the expected funds.
Accounts receivable is considered a current asset account, meaning that it only records funds with a due date within one calendar year. As such, it represents short-term obligations: if you initiate a five-year contract under which a customer will pay a set amount annually, the receivable balance listed on your balance sheet would only include the amount due within one year.
Accounts receivable is used under an accrual accounting method, the accounting system in which income and expenses are entered when a transaction occurs, not when funds are received or debited.
How does an accounts receivable process work?
Recording (and collecting on) accounts receivable follows a simple process:
- A customer requests to purchase goods or services via a signed contract or purchase order.
- Goods or services are delivered.
- The merchant provides the customer with an invoice and notes the amount of money due as a credit in accounts receivable.
- The customer pays the balance and the merchant debits that amount from accounts receivable and records it as a deposit.
Let’s say that you run an ecommerce business that sells handmade clay tiles, and a client submits a purchase order for 300 square-cut tiles priced at $1.50 each, for a total of $450. The purchase order will contain payment terms and specify a due date for funds, which is expressed from the date of invoice—“net 60,” for example, means that funds are due within 60 days of the date that the invoice is issued.
You’d accept the order, make and ship the tiles, and invoice the customer for $450, plus tax and shipping as applicable. The total amount your customer owes would then be recorded as a credit on your balance sheet under accounts receivable.
Once this sum is paid, the total would be deducted from accounts receivable and recorded as a deposit under revenue.
Accounts receivable vs. accounts payable
Accounts receivable is key to managing cash flows: in addition to knowing the amount of money you have, it's helpful to know the amount of money you will have in the near future.
It’s also helpful to know the amount of money you owe, which is where accounts payable (AP) comes in. Accounts payable refers to money that a business owes to its creditors. It can include material costs, overhead such as facility and utility fees, and contractor agreements. This number is also recorded on your balance sheet under accounts payable. AP is essentially the inverse of AR.
Advantages of recording accounts receivable
There are many benefits to recording accounts receivable, from allowing you to extend credit to customers to measuring how efficiently you are collecting the money owed to your business. It can also help you manage cash flow and streamline your accounting systems, freeing you up to focus on running your business.
Improved customer relations
Extending credit to customers is made possible by a system that tracks the amount of money they owe. By recording credits in accounts receivable, business owners can make sure that customers pay their bills without being forced to collect cash upfront—and extending credit lowers the barrier to purchase, increasing your sales. Extending credit also builds goodwill: requiring upfront payment can be cumbersome for both you and your customers, and clients are sometimes hesitant to pay for a good or service that they have yet to receive.
Streamlined accounting systems
Tracking accounts receivable can help you organize your balance sheet and streamline your invoicing processes.
Under an accrual accounting system, each customer payment shows up three times on your balance sheet: as a credit to accounts receivable, as a debit from accounts receivable, and as a credit to revenue. This allows you to easily cross-reference your transactions and ensure accuracy. An organized balance sheet also helps you collect money owed to you by making it easy to keep an eye on your total amount of outstanding debt.
Ecommerce accounting software can even automate parts of this process by automatically crediting accounts receivable when an invoice is issued and debiting accounts receivable (and crediting revenue) when a payment is received. This eliminates the need for you to manually enter these transactions during invoicing. It also streamlines your invoicing process, reduces the likelihood of error, and lightens your administrative burden.
Cash flow management and measuring liquidity
Your accounts receivable balance is a critical indicator of your business’s financial outlook. Without it, your balance sheet can’t provide an accurate picture of your liquidity. It can also help you manage cash flows, allowing you to meet your obligations while operating with a smaller amount of cash on hand.
When you record accounts receivable, you will also track something known as the accounts receivable turnover ratio. This is calculated using the formula accounts receivable turnover ratio = net credit sales / average accounts receivable, where net credit sales (the total amount of sales made on credit) and average accounts receivable balance are each calculated over the same period of time.
This metric helps you measure how efficient your business is at collecting payment for goods or services purchased on credit. If your company sells $100,000 on credit per quarter and the average balance of accounts receivable in that year is $10,000, your accounts receivable turnover ratio is 10:1, or 10.
If your average accounts receivable balance over this same period is $120,000, however, your accounts receivable turnover ratio is less than one, coming in at 0.8. If this ratio doesn’t increase, you’re actually losing money over time, even if business is booming—and the more you increase sales on credit, the more money you’ll lose.
Combined with your accounts receivable balance, your accounts receivable turnover ratio gives you a strong picture of your business’s overall financial outlook.
Accounts receivable is a critical part of an accrual accounting system, allowing business owners to manage cash flow and keep an accurate, organized balance sheet while extending credit to customers.
In conjunction with accounts payable, it allows your accounting team to keep an eye on long-term financial prospects and provides you with metrics to make sure that customers pay their bills on time.
If you’re new to accrual accounting, recording credits for money you don’t actually have in hand can feel a little bit nerve-wracking. An experienced accounting partner (or modern accounting software) can help you confidently track these transactions and use the information to plan for the future.