Accounts Receivable (AR) Definition, with Example

What exactly is Accounts Receivable (AR)?

Accounts receivable (AR) typically reflects a company's credit sales for which money has not yet been collected from its customers. Businesses enable their customers to pay for goods and services over a reasonable time as long as the conditions are agreed upon. A consumer may earn a slight discount for paying the amount owed to the firm early in certain transactions.

In financial modelling, the average 'AR days indicator' is useful for projecting changes in non-cash working capital.

In-depth Understanding of Accounts Receivable

Accounts receivable are overdue bills or money owed to a corporation by customers. The term refers to the accounts a corporation has the right to get from supplying a product or service. Accounts receivable, often known as receivables, are a credit issued by a company with terms that require payments to be paid within a short period. It might range from a few days to a fiscal or calendar year.

Accounts receivable are reported on balance sheets as assets since the client legally must pay the amount. They are categorized as liquid assets because they may be used as collateral to get a loan to help fulfil short-term obligations. Receivables are a type of working capital.

Accounts receivable are also current asset, which implies the account balance is due from the debtor within a year. If a corporation has receivables, it has made a credit sale but has not received payment from the buyer. Simply put, the corporation has taken a short-term IOU from its client and is expected to receive payments soon.

Why do companies have Accounts Receivable?

To facilitate payment, several firms allow for credit sales. Consider a post-paid phone service. Every time someone calls, the supplier may want assistance in collecting money. Instead, it typically bills the consumer at the end of each month for the full service used. The amount will be recorded in accounts receivable unless the monthly invoice is paid.

Allowing credit transactions encourages more purchases. Customers are more likely to buy items if they can pay later.

Understanding the cash conversion cycle - the time it takes a company to convert its inventory into sales and, ultimately, cash - is important for anybody working in finance, equity research, or investment banking since it provides essential information about the company's cash flow.

What is the workflow of Accounts Receivable?

The accounts receivable process involves:

Credit

It is the initial stage in the order-to-cash cycle. A credit professional determines how much credit to extend to a consumer.

To assess how much credit to provide a customer, a credit specialist will get credit reports from the credit agencies, speak with the customer's bank, and inquire with other companies about their dealings with the consumer (referred to as trade reports).

Invoicing

Accounts receivable experts must invoice the client for the amount owed when a firm delivers an item or service. This might be a paper bill mailed to the individual or, increasingly, Presentment or electronic billing. Older forms such as faxes and phones are also included in electronic invoicing (interactive voice response). Emailed bills and bills provided through e-portals are two newer, more efficient ways.

Quickly generating and distributing invoices to clients is critical and time-sensitive. The sooner a consumer receives an invoice, the sooner they can pay, and the firm will realize cash.

Payment Acceptance

Consumers will strive to pay their providers in the most convenient and advantageous methods. Examples are paper cheques, ACH payments, wire transfers, and virtual credit cards.

The provider must pick the type of payment they are prepared to take and put up systems to enhance the efficiency of accepting payments through various channels.

Although incorporating each payment method may incur additional costs and efforts, firms must balance respecting their customers' payment choices with their own interests.

Cash Application

Cash must be "applied" to accounts once payments have arrived via the different payment methods. This entails identifying the receipt of a specific quantity of money and marking an invoice as PAID.

This is more complicated than it appears. Each month, businesses may get hundreds or thousands of dollars. The cash received must subsequently be "matched" with invoices by Cash Application professionals.

The sooner cash is received, the sooner a firm may rely on it for operations. The sooner a customer's credit is refilled, the more they may order.

Collections

The account becomes overdue when a payment is not received by the due date. It is then informed to the collections team, possibly a collection agency (called collectors).

Collectors are responsible for contacting consumers and attempting to persuade them to pay. A collector (possibly from a collection agency) has the difficult task of connecting with customers, understanding their reasons for delinquency, and attempting to work with them to obtain payment for the company.

How to record Accounts Receivable?

Accounts receivable are shown as a current asset on the balance sheet and a sale or revenue on the income statement, much like products or services paid for promptly. Some accounting software computes accounts receivable automatically when the user prepares client invoices.

Accruals are funds earned but not collected; therefore, accounts receivable are documented in accrual accounting. Once the client paid, the transaction would be documented in cash accounting.

What are the risks associated with outstanding accounts receivable balances?

Carrying a big AR balance has several risks, including:

• Uncollected Debt: High A/R uncollected for an extended period is written off as bad debt. This happens when consumers who buy on credit go bankrupt or fail to pay their bills.
• Deficits in Cash Flow: A firm needs cash flow to operate. Selling on credit may increase revenue and profits, but it provides no cash inflow. It is appropriate in the short term. But, in the long run, it may lead the firm to run out of cash and incur further obligations to support its operations.

Example of Accounts Receivable

An electricity firm that invoices its customers after consuming the power is an example of accounts receivable. While waiting for its consumers to pay their bills, the electric company registers outstanding invoices as accounts receivable.

Most businesses allow some of their transactions to be made on credit. Companies may grant this credit to regular or special consumers who receive periodic bills. Customers can avoid the hassle of physically making payments as each transaction occurs. In other circumstances, firms commonly let their customers pay after obtaining the service.

What is the significance of accounts receivable?

Having a large number of customers is fantastic. But, if they pay late, they may harm the company. Customer late payments are one of the businesses' most common causes of cash flow or liquidity issues.

When management or higher-ups have a strategy to manage the working capital, they can avoid problems like these. Measuring the company's accounts receivable turnover ratio is one of the most effective methods to keep track of late payments and ensure they don't spiral out of control.

What distinguishes Accounts Receivable from Accounts Payable?

Accounts receivable are amounts of money owing to the company for services supplied and are recorded as an asset. On the other hand, accounts payable indicate amounts that the company owes to others, such as payments owed to suppliers or creditors. Payables are classified as liabilities.

The Bottom Line

The primary purpose of accounts receivable is to record how much money is owed to a company by its customers. Overall, it is also necessary that a corporation cares not only about paying the due amount but also about receiving speedy payments within time. It is critical to note that while accounts receivable is reported as an asset, it is not cash in hand - it is money owing. Sometimes, it takes longer than planned to receive payment, or it never happens. Therefore, companies should have effective plans in place for the timely recovery of funds.