Accounts Receivable

Accounts Receivable (AR) is a current asset on a company's balance sheet that measures how much money is owed to the company by customers and other debtors. Learn about the accounts receivable definition, see AR examples, review AR ratios, and understand how to analyze this line item.

What is Accounts Receivable?

Account Receivable (AR) is a current asset on a company’s balance sheet that shows how much money the company is owed by customers and other debtors. Since payments are not always made at the same time that products are delivered or services are rendered, AR serves as the line item that captures the balance owed to the company.
The opposite account is accounts payable (AP) and shows up as a current liability on a company’s balance sheet. This balance shows how much money the company owes its vendors, suppliers, and other creditors.

Managing cash flow is critical whether you are a small business owner or an operator of a Fortune 500 company. Understanding AR trends and ratios is a vital part of cash flow management. In this post, we will define accounts receivable, talk about how to collect cash sooner, and walk through what is accounts receivable aging.

The accounts receivable process, from selling goods on credit and creating an AR balance to receiving payments and closing out AR.

How to Calculate Accounts Receivable

An accounts receivable balance is created when a business lets a customer purchase products or services on credit. In other words, when an invoice is created and not paid at that time, that amount is recorded and tracked as accounts receivable.

On the balance sheet, a debit will increase the amount of accounts receivable while a credit will decrease the amount of accounts receivable. When the customer eventually makes the credit, the corresponding entry is to close out the account receivable (credit AR) and to increase your cash balance (debit cash).

The amount of accounts receivable for a transaction is equal to the total value that is put on credit. For instance, if a customer receives $10,000 worth of office supplies on net 30 payment terms, the initial transaction would be:

  • Dr 10,000 Accounts Receivable
  • Cr 10,000 Inventory

The customer pays after 25 days. The closing journal entry would be:

  • Dr 10,000 Cash
  • Cr 10,000 Accounts Receivable

If the customer pays a portion in cash on receipt and a portion on credit, only the amount on credit would be applied to AR.

In the event that a customer cannot repay the credit extended, you would need to use a contra account called Sales Discounts and Allowances on the Income Statement to offset this balance.

As you expect, Sales Discounts and Allowances is an expense on the Income Statement and will lower your profit.

Examples of Accounts Receivable

Now let’s dive into a few accounts receivable examples. First, we look at a sale where the customer pays cash. The second example is a sale on credit. The third example is a split between cash and credit.

Company A: Cash Transaction Example

Company A sold $30,000 worth of goods to a customer. The customer paid $30,000 in cash at the time of purchase. Here are the journal entries from the perspective of Company A.

Company A on Day 1

  • Dr 30,000 Cash
  • Cr 30,000 Inventory

This is the entire transaction and there are no other adjustments that need to be made.

Company B: Credit Transaction Example

Company B sold $30,000 worth of goods to a customer. Company B extended net 30 payment terms. The customer paid $30,000 in cash at the end of the payment terms.

Company B on Day 1

  • Dr 30,000 Accounts Receivable
  • Cr 30,000 Inventory

This entry increases the AR balance by $30,000. Note that no cash was received, even though the inventory was provided.

Company B on Day 30

  • Dr 30,000 Cash
  • Cr 30,000 Accounts Receivable

The closing transaction shows that $30,000 of cash was paid to close the $30,000 AR balance.

Company C: Split Transaction Example

Company C sold $30,000 worth of goods to a customer. Company C extended net 30 payment terms. The customer paid $15,000 in cash on receipt of the goods and paid the remaining $15,000 balance at the end of the 30-day period.

Company C on Day 1

  • Dr 15,000 Accounts Receivable
  • Dr 15,000 Cash
  • Cr 30,000 Inventory

Company C on Day 30

  • Dr 15,000 Cash
  • Cr 15,000 Accounts Receivable

In the first journal entry for Company C, we have 3 transactions but the debits and credits still match. This is important as a key concept in double entry accounting is that the debits and credits must always balance.

The final journal entry on day 30 closes out the AR balance, which is only $15,000 in this case.

Accounts Receivable Aging Schedule

An accounts receivable aging schedule is a table that shows all unpaid customer invoices by date range. This tool is used to determine which invoices are overdue and which customers have what outstanding balances.

While the schedule will be different per company, a typical aging report will follow this format:

  • Customer Name
  • Total Accounts Receivable Balance
  • Due in 0-30 Days
  • Due in 31-60 Days
  • Due in 61-90 Days
  • Due in 90+ Days
Example of accounts receivable aging schedule with four sample customers.

This table provides plenty of information in an organized format, making it a great tool for companies that have a predictable bad debt allowance.

For instance, a business might know that 2% of items within the 31-60 days is likely to be written off, 5% of items within 61-90 days, and 10% of items within 90+ days. Breaking the numbers into these categories lets the operators see how much cash they will actually collect, instead of thinking they will receive 100% of the balances for all date ranges.

Lastly, the schedule can highlight if the same customers always have late payments. It would be worth considering special payment terms for customers that are late.

Cash Flow Management

Whether you are a startup CEO, controller of a mid-sized corporation, or a public market investor, cash flow management matters. A number of businesses struggle with cash, especially for brief moments throughout the year when expenses pile up and cash seems to be tied up in accounts receivable.

A temporary disruption in a company’s cash flow can be devastating, including leading to shutting the doors.

Offering customer credit is beneficial, as it can increase revenue and reduce the length of the sales cycle. However, extending too much credit or having poor credit terms can be problematic.

Here are our suggestions to improve your cash position…

Offer Standard Credit Terms: The industry standard for customer credit is called “2/10 Net 30”, which means that buyers are eligible to receive a 2% discount on the total purchase price if they pay within 10 days. Otherwise the full made is within 30 days.
Isolate Problematic Customers: If there are some customers who always pay late or are erratic in their payment, you can provide special payment terms of them. For example, imposing a late fee for payments made between 31-60 days and doubling that fee for payments made after 60 days. On the other hand, you can also decide to stop extending credit to these customers only.
Build an AR Aging Schedule: A table that shows all receivables broken out by date range. A great way to keep track of your AR, ensuring that late payments do not cause cash flow problems. We suggest reviewing the schedule once a week.
Track Accounts Receivable Turnover Ratio: AR Turnover is a simple but powerful formula that can let you know if you are getting better or worse at collections. The formula is Net Credit Sales / Average Accounts Receivable. It is important to use credit sales (not total sales) as the numerator. We suggest tracking this metric monthly.
Track Accounts Receivable Days: AR Days shows how many days it takes, on average, to collect your accounts receivable. The formula is 365 / Accounts Receivable Turnover. If your receivable turnover ratio was 5.0x, then your AR days would be 73 days. We suggest tracking this metric monthly.

Remember that the difference between a struggling business and a successful business could be their ability to estimate accurately and collect quickly.

Final Thoughts

Accounts receivable are an asset account, as they show the money that your company is owed but have not collected as cash yet. Extending credit to your customers can be a powerful tool as it can accelerate growth. But, if poorly managed, there can be negative long term consequences – like thinking you have more cash than you do.
The amount of money and amount of time (typically between 30 and 90 days) that you offer credit varies per industry. In the cases where particular customers are difficult, you should look into providing them with specific payment terms or prevent them from purchasing on credit.

To better understand AR, we recommend using an accounts receivable aging schedule and AR ratios. If your accounts receivable turnover is too low or your AR days are too high, it might work against the traditional benefits of accounts receivable. It can tie up countless hours trying to create payment plans or working with a collections agency in order to recoup some of the AR balance.

Companies that have cash flow problems should carefully monitor their accounts receivable average balance, look into offering a discount for early payments, and track AR ratios to ensure they are within reasonable levels.

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