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May 22, 2024

Accounts Receivables: The Key to Unlocking Business Liquidity and Growth

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Shebi Sharma

Suvit

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Accounts Receivables (AR) play a pivotal role, acting as the lifeblood that sustains the financial health of businesses. At its core, AR represents the credit sales of a company that have not yet been collected from customers. It’s a legal claim for payment for goods delivered or services provided as part of the business operations.

As businesses navigate the ebb and flow of economic tides, the importance of AR in business operations emerges as a beacon of stability. It is a testament to a company’s market activity and a predictor of its financial future. In this blog, we will delve deeper into the definition, examples, and processes surrounding Accounts Receivables, and explore why they are so crucial in steering a business towards success.

Definition of Accounts Receivables

Accounts Receivables (AR) are a fundamental financial concept that represents the credit that a business extends to its customers for goods delivered or services rendered. In simpler terms, when a company sells something on credit, it does not receive cash immediately; instead, it generates AR, which is the amount the customers owe the company.

From a financial standpoint, AR is classified as a current asset on a company’s balance sheet. It is expected to be converted into cash within a short period, typically within one fiscal year or the operating cycle of the business, whichever is longer. AR is recorded at the original invoice amount and does not include interest if collected within the standard terms, which are usually 30, 60, or 90 days.

Examples of Accounts Receivables

Accounts Receivables (AR) are encountered in a myriad of scenarios across various industries. Here are some common situations where AR is utilized:

1. Service-Based Businesses

  • A web design company completes a website for a client and invoices them for payment at a later date.

  • A consulting firm provides business advice to a company and bills them for the services rendered on a net 30 payment term.

2. Product-Based Businesses

  • A wholesaler delivers goods to a retailer, who will pay for the inventory after selling it.

  • A manufacturer ships a large order to a distributor with an agreement to receive payment in 60 days.

3. Medical and Healthcare Services

  • Hospitals and clinics bill insurance companies for patient care, awaiting reimbursement.

  • Pharmaceutical companies sell medications to pharmacies on credit terms.

4. Subscription-Based Models

  • Software companies that offer annual subscriptions, billing customers at the start of the subscription period.

  • Gyms and fitness centers that charge monthly membership fees are recorded as AR until paid by members.

Different Types of AR Transactions

AR transactions can vary based on the terms agreed upon between the business and the customer. Some of the types include:

  • Standard Trade Receivables: These are typical credit sales where the customer is billed after the sale and is expected to pay within the agreed credit period.

  • Notes Receivable: In some cases, a formal promissory note is issued, especially for larger amounts or longer credit terms. These notes often carry interest and have a specific maturity date.

  • Recurring Billing: Regularly scheduled invoices for ongoing services or subscriptions fall under this category.

  • Retainers and Advances: Some businesses require a retainer or advance payment that is recorded as AR until the service is fully delivered.

Each of these scenarios reflects the versatility and ubiquity of AR in the business world. They underscore the necessity for businesses to keep a vigilant eye on their AR to ensure a steady cash flow and a robust financial foundation.

Also Read: Guide to Accounting Terms for Business Owners

The Accounts Receivable Process

Managing Accounts Receivable (AR) is a multifaceted process that requires meticulous attention to detail and strategic planning. Here’s a breakdown of the key steps involved in the AR process:

Establishing Credit Policies

  • Criteria for Extending Credit: Businesses must assess the creditworthiness of customers before extending credit. This involves evaluating their payment history, credit score, financial stability, and overall reputation.

  • Setting Credit Limits and Payment Terms: Based on the credit assessment, companies set maximum credit limits and define clear payment terms (e.g., net 30, net 60) to manage risk and ensure timely collections.

Invoicing Customers

  • Creating and Sending Invoices: Once a sale is made on credit, an invoice is generated detailing the amount due, description of goods or services, and payment terms. This invoice is then sent to the customer as a formal request for payment.

  • Essential Details to Include in an Invoice: An effective invoice should include the invoice date, due date, unique invoice number, customer’s contact information, an itemized list of charges, total amount due, and payment instructions.

Tracking and Monitoring AR

  • Methods for Tracking Outstanding Invoices: Businesses should regularly review their AR ageing report to monitor unpaid invoices and follow up with customers as necessary.

  • Tools and Software That Can Assist: Various AR management software and tools are available to automate invoicing, track payments, and send reminders, thereby streamlining the AR process.

Accounting for AR

  • Recording AR in Financial Statements: AR is recorded as a debit to the AR account and a credit to the sales revenue account at the time of the sale. As payments are received, AR is credited, and cash is debited.

  • Impact on Cash Flow and Financial Analysis: Efficient AR management is crucial for maintaining positive cash flow. It affects liquidity ratios and can provide insights into a company’s operational efficiency and financial health.

By adhering to a structured AR process, businesses can enhance their financial stability and build strong relationships with their customers through trust and reliability.

Also Read: 3 Tricks To Improve Your Cash Flow Using Accounting Automation

Importance of Effective Accounts Receivable Management

The art of managing Accounts Receivable (AR) is akin to steering a ship through the ever-changing tides of business finance. Effective AR management is crucial for several reasons, particularly in its impact on cash flow and the overarching role it plays in business sustainability and growth.

How AR Management Affects Cash Flow

  • Ensuring Liquidity: The timely collection of AR ensures that a business has the necessary liquidity to cover its short-term obligations, such as paying suppliers and employees.

  • Reducing the Cash Conversion Cycle: Efficient AR management shortens the time between making a sale and receiving cash, which can significantly improve a company’s cash conversion cycle.

  • Preventing Cash Flow Shortfalls: By actively managing AR, businesses can anticipate and prevent cash flow shortfalls that might otherwise necessitate borrowing or other financial measures.

The Role of AR in Business Sustainability and Growth

  • Facilitating Expansion: Access to cash allows businesses to invest in new opportunities, expand operations, and enter new markets.

  • Building Creditworthiness: Consistent and effective AR management can enhance a company’s credit profile, making it easier to obtain financing at favorable terms.

  • Supporting Strategic Decision-Making: AR data provides insights into customer payment behaviors and sales trends, which are valuable for strategic planning and decision-making.

In essence, AR is not just an account on the balance sheet; it is a dynamic element that reflects the company’s operational efficiency and financial agility. By prioritizing effective AR management, businesses can maintain a robust cash flow, foster sustainable growth, and navigate the competitive landscape with confidence.

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