Accounts receivable: what is it and what does it mean for your small business?
Sales are the lifeblood of your small business. Without reliable cash flow, paying the bills, your employees and reinvesting in growth is near-impossible.
But capital doesn’t always come in the form of sales. The debts owed to you by customers and creditors can also equate to liquid assets against your financial statements.
In this guide, you’re going to learn what accounts receivable is, and how it can be a viable option for businesses in situations where cash is not favored or available.
Table of contents
- What is accounts receivable?
- An example of accounts receivable
- How does accounts receivable work?
- Weighing up the pros and cons of accounts receivable
- Wrapping up
What is accounts receivable?
Accounts receivable is the amount due to a company for goods or services rendered that has not yet been paid by clients or customers. It most often refers to outstanding invoices sent to customers that are awaiting payment.
The accounts receivable phase refers to an amount of money that your company has a right to receive, as goods have been delivered or the execution of services has begun or been fulfilled.
Quick Tip: Struggling to get your invoices paid on time? Learn how to chase clients the right way via helpful and effective email templates in our guide on chasing invoices here.
Essentially, accounts receivable represents a line of credit with terms of payment attached to it. While accounts payable refers to the amount a company owes, accounts receivable is the amount a company is owed. These terms are usually extended from a few days to several weeks, or even a calendar month or fiscal year.
An example of accounts receivable
Our fictional customer, Jessica, wants to purchase a large order of baked goods for an event she’s running. The total amount for all goods comes to £2,000. However, Jessica won’t have the funds to pay the total amount until 30 days after the event has taken place.
Instead of refusing Jessica’s business, Wilson Bakery (Jessica’s favourite) agrees to payment terms of NET 45 (i.e. the invoice must be paid 45 days after it’s received). Wilson Bakery can make this decision at their own discretion, which may take into account factors such as the risk/reward ratio for such a large order, as well as the credibility of the company Jessica works for.
Once the credit has been paid, Wilson Bakery will attribute that amount to sales received or cash flow. But, what if Jessica doesn’t pay Wilson Bakery in time – or at all?
Well, the money will still be owed by Jessica, but Wilson Bakery would be out of pocket. This includes any cost of sales, as well as employee labour. This is where sales and accounts receivable differ. Sales refers to cash received, whereas accounts receivable is cash owed by an individual or organisation.
From here, Wilson Bakery can go through the usual process of chasing up an overdue invoice (as outlined in our guide here). This includes a follow-up sequence and, if necessary, referring the issue to a collections agency.
But Jessica always pays her debts, so it shouldn’t come to that 😉.
How does accounts receivable work?
Understanding accounts receivable is key when evaluating your accounts. If your accounts receivable is too high, it may be a sign that you lack priority in chasing up on credit owed to your company.
On the balance sheet, your accounts receivable will be classed as a “current asset”, as there is a legal obligation for clients to pay what they owe. And as it’s a current asset, it means that the account must be owed or paid within a year (or less). In layman’s terms, accounts receivable is considered an “IOU”.
Many companies operate by allowing a number of sales to be classified as accounts receivable. Some companies offer this line of credit to frequent or reliable customers, as they trust that the amount will be paid in full when it’s due.
Here are some cases where accounts receivable may apply to your business:
- When several sales have been made, and it’s easier for a customer to settle debts in one single transaction rather than multiple actions
- Where businesses agree to invoice after a service has been delivered
- Where goods are not of a physical nature, for example, a water bill is sent after a period where the meter has been read
- When an opportunity arises that can propel business to a new level of growth
In short, accounts receivable are key for a company when analysing their accounts, as well as the amount of liquid assets that they own. It also allows you to estimate if you can pay short-term debts without the concerns of short-term cash flow shortage.
Pro tip: Having an accurate cash flow forecast is imperative when measuring business health. To learn more about what it is and how to create one, check out our complete guide to cash flow forecasting.
A note on accounts receivable turnover ratio
Another important aspect of understanding accounts receivable is the concept of accounts receivable turnover ratio. This is a method of analysing how effective your business is at recovering funds and credit owed to you.
Accounts receivable turnover ratio is calculated using the following formula:
- Take the total accounts receivable from the beginning and end of an accounting period and divide them by two.
- Divide the number of net credit sales (total sales value you generated during that period) by the average accounts receivable value.
As an example, Business A is now into Q2 and wants to know how often it settled up its accounts receivable in Q1.
Its total accounts receivable for the beginning and end of Q1 were £20,000 and £15,000, respectively.
Its gross sales for Q1 were £50,000 and it had £10,000 in returns.
To figure out its accounts receivable, Business A would simply plug those numbers into the formula:
Q1 Accounts Receivable Turnover Ratio = £50,000 – £10,000 / (£20,000 + £15,000) / 2
Q1 Accounts Receivable = £40,000 / £17,500 = 2.3
Business A collected its accounts receivable 2.3 times in Q1.
And voila, you have your accounts receivable turnover ratio.
Weighing up the pros and cons of accounts receivable
How reliable your accounts receivable are depends on the reliability of your debtors. Indeed, if a customer owes you thousands of pounds in overdue invoices, this is a huge risk to your business.
However, there is an upside in terms of creating “working capital” on your books. It can also help you capture and retain more customers, as providing flexible payment options is more likely to generate sales.
At the end of the day, it depends on the level of risk you’re comfortable with, and the reward that it brings.
As you can see, accounts receivable can be a complex beast to understand. While it looks good on your income statement, it doesn’t beat good old fashioned cash flow.
However, it can be a useful (and strategic) tool for your business. For example, if you have a dream client but they have a long payables cycle, it’s up to you to figure out if it’s worth it. For most entrepreneurs, when opportunities like this come along, the juice is usually worth the squeeze.
Photo by Christina Morillo, published on Pexels