Accounts Receivable (AR) is a crucial aspect of a company’s financial health, representing the money owed to a firm for goods or services delivered but not yet paid for by customers. This article aims to simplify the concept of Accounts Receivable, exploring its definition, significance, and examples.
Accounts Receivable are recorded on a company’s balance sheet as a current asset. They come into existence when a business allows customers to purchase goods or services on credit. In simpler terms, it’s the money customers owe the company for products or services received on credit.
These receivables are considered a legal obligation, as there’s an expectation for the customer to pay the debt. They are classified as liquid assets, enabling a company to use them as collateral for loans to meet short-term obligations. Accounts Receivable is a part of a company’s working capital.
Key characteristics
- Current Assets: AR is a current asset, indicating that the money is expected to be collected within a year.
- Short-term IOU: Companies essentially accept a short-term IOU from customers who have made a purchase on credit.
- Analysis Tools: The health of a company’s AR can be assessed using tools like the accounts receivable turnover ratio and days sales outstanding.
How accounts receivable works
Companies create invoices for goods or services provided on credit, and these outstanding invoices form their Accounts Receivable. The process involves customer onboarding, invoicing, collections, deductions, exception management, and cash posting after payment collection.
Accounts receivable vs. Accounts payable
While accounts receivable represent funds owed to the company, accounts payable signify money the company owes to others.
For example, if Company A provides a service to Company B, Company B records the invoice in its accounts payable, while Company A records it in its accounts receivable.
Benefits and analysis
Accounts Receivable play a vital role in fundamental analysis, measuring a company’s liquidity and its ability to cover short-term obligations. Analysts often assess turnover ratios and days sales outstanding for a deeper understanding.
Consider an electric company that bills clients after providing electricity. The company records an account receivable for unpaid invoices while waiting for customers to settle their bills.
Provision for doubtful debts
Businesses may estimate uncollectible debts and create a provision for doubtful accounts, reflecting a potential bad debt expense. This helps in managing financial risks.