Definition of Accounts Receivable
Accounts Receivable refers to the current asset generated when a company sells on credit. So the money yet to be received from the customer is termed Accounts Receivable and recorded in the Balance sheet as Current Asset. It shows the credit terms of the company to the customers.
It is an essential part of Working Capital. High working capital indicates that the company sells too much of its product on credit. Accounts Receivable, which is too low, is also not good as the company is strict on its customers and sells only in cash, which could be difficult on sales.
Accounts Receivable Process
- Step 1: The Company will have to set up a procedure for credit sales. There should be proper checks in place to select customers for credit sales. Not every customer is creditworthy, so correct filtration should be done to start credit sales with a particular customer.
- Step 2: Customised bills must be generated by the company with the customer’s consent. If the customer is not ready to pay in the future, this invoice will serve as the legal document. All the details regarding the sale should be mentioned in the invoice. A proper mechanism should be in place to help the customers receive the invoice from the company.
- Step 3: The accounting software will record the bill as sales once the bill is generated. As the cash from the transaction is not yet received, cash will not be debited; instead, the accounts receivable will increase. All the sales for which the company has not yet received cash will be recorded as Accounts Receivable under current assets.
Example
Company XYZ has good terms with Mr. X. All the company’s sales to Mr. X are on credit. The most recent sales are $40,000. The company’s balance sheet reflects the sales as Accounts receivable for $40,000. The company follows a 90day credit cycle. So all the sales must be converted to cash within 90 days. When Mr. X makes the payment within 90days, it will decrease, and money will increase.
Importance of Accounts Receivable
It helps a company to increase its sales. The essential part of any business is revenue. It helps to boost revenue by providing sales on credit. This is a crucial strategy for any business to survive in the long run. The customers will have to be trustworthy to apply this strategy. It is considered the Current asset, which means that the company will rely on Accounts Receivable to meet its operating expenses.
Difference between Accounts Receivable and Accounts Payable
Accounts receivable is the money the customer owes to the business and accounts payable is the money the business owes to its stakeholders. As the company is doing business on credit, it is quite natural that its purchases to run the operation should also be on credit. A company is said to be on the upper hand when the accounts payable are more than the accounts receivable. So it proves that the company is purchasing more in credit than it sells on credit. Days of Accounts Receivable and Accounts Payable are essential parameters to consider when calculating the cash conversion cycle. Cash conversion shows the rate at which cash is pumped into the business and is recovered by operations.
Advantages
Some of the advantages are:
- It increases the sales potential of a business. Cash is a scarce asset, so if a company believes only in a cash basis, it will lose the opportunity of sales maximization that can be achieved through credit sales. It shows the capability of credit sales for a company.
- Current assets are liquid assets that can be converted to cash quickly. So as it falls under existing assets, it can be used to improve a company’s working capital.
- Low Days of accounts receivables show the capability of a company to convert its Accounts receivables into cash. This is a good sign; investors can use this positive sign to invest in the company.
- Good Accounts Receivable management helps a company to grow. As sales are made on credit, many new customers start trading with the company.
Risks
- The main risk of it is the risk of customers failing to pay for the purchases. If it is not recovered, it will be recorded as debt, and the company will incur a loss. So too many credit sales are a risk for the company if the customers are not trustworthy.
- At times, the company sells credit to known partners to increase the sales figure. It gets appreciated, and the cash is not received ever.
Tips for Collecting Accounts Receivable
- Maintain a proper schedule, which shows the maturity of each Accounts Receivable. A suitable triggering system should be set for each maturity of the receivable days.
- Proper accounting platforms should help generate excellent and prompt invoices for customers. The invoices should be sent to customers promptly.
- Discounts should be offered if payment is made early. This is a beautiful scheme and is preferred by many customers. Early payment discounts help customers to make timely payments.
- Have a diversified range of customers. It is always said that all eggs shouldn’t be kept in the same basket. So if the company has a diversified customer base, then chances of them defaulting all at once are rare.
- Have a good recovery team. If a customer is a wilful defaulter, there should be a team for money recovery.
Conclusion
It is an essential current asset that helps to strengthen working capital requirements. Sales are increased with proper management of Accounts receivables. Right accounting tools and management should be in place to maintain Accounts Receivable. A company should be able to draw a line between too high and too low Accounts Receivable.
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