It has been proven time and again that proper management of Account Receivables is vital to ensuring your company has the necessary cash flow to meet operational needs and invest in future growth, but, nontheless, the famous question still stands: Is Accounts Receivable an Asset or a Liability?
This guide will answer that and many other questions you might have related to AR: what they really are, how they work, and, most importantly, how to turn them into cash efficiently and consistently.
What are Account Receivables?
Account Receivables (AR) is the term used when referring to receivables on the balance sheet. Receivables, on their side, refer to the outstanding payments that a company is entitled to receive from its customers who have made purchases on credit. This means that the customers have received the goods or services but have yet to make the payment in full.
Usually, the payment period for the credit granted is within 30 days, but there are cases where it can vary from a few days to several months or even a year, depending on the terms of the sale agreement and the size of the purchase made. During this time, the company records the sale as an asset in its balance sheet, which represents the amount that the customers owe to the company.
Accounts Receivable is an important aspect of your company's financial management as it represents the amount of cash that is expected to be received in the near future.
When do they get created?
It’s a simple turn of events that create an Accounts Receivable. You just need two things: a sale, and a purchase made on credit.
A company sells an item or service to a buyer and extends credit to that buyer so that the total cost of the sale can be paid later, on terms that are agreed upon by the seller and the buyer. When the buyer agrees to the terms set by the seller, the purchase occurs, and the Accounts Receivable is created.
On the contrary, if the extension of credit is not given on a said purchase, meaning that the buyer pays in full at the time of sale, no account receivable is originated.
Is Accounts Receivable an Asset or a Liability?
One of the most common questions that arises when discussing Accounts Receivable (AR) is whether it's considered an asset or a liability. This question is fundamental to understanding the role of AR in your company's financial health and how it impacts your balance sheet.
Is Accounts Receivable an asset? Yes. Because it represents money that is owed to your company by its customers. When you sell goods or services on credit, you are essentially extending a short-term loan to your customers. The expectation is that they will repay this loan within the agreed-upon terms, typically within 30 to 90 days. Until that repayment is made, the amount owed is recorded as an asset on your balance sheet.
This might seem counterintuitive. After all, isn't money that is owed to you a liability? Not in the world of accounting. In accounting terms, a liability is money that you owe to others. In contrast, an asset is something of value that you own or control. Since Accounts Receivable represents money that others owe to you, it is considered an asset.
However, it's important to remember that while AR is technically an asset, it's not as liquid as cash in hand. The money is tied up until your customers make their payments. This is why efficient and consistent debt collection is crucial. It's also why AR management is such an important part of maintaining healthy cash flow.
Remember, while AR is an asset, it can quickly become a liability if not managed properly. If customers consistently fail to pay their debts on time, or at all, your AR can become a drain on your resources. This is why it's crucial to have a robust credit policy in place and to regularly review and update it as needed.
Account Receivables vs Account Payables
Accounts Receivable and Accounts Payable are two very important (but commonly misunderstood) terms used in accounting to manage a company's finances.
As mentioned before, Accounts Receivable (AR) refers to the amount of money owed to a company by its customers for goods or services provided on credit. In other words, it represents the amount of money that the company is yet to receive from its customers for the sale of its products or services in the past.
On the other hand, Accounts Payable (AP) refers to the amount of money that a company owes to its suppliers for goods or services purchased on credit. In other words, it represents the amount of money that the company is obligated to pay its suppliers for the purchase of goods or services. Accounts Payable is considered a liability on the balance sheet, as it represents the money that the company owes to its suppliers and needs to pay in the future.
When exchanges between companies occur, AR and AP coexist. For example, when Company A purchases goods from Company B on credit with a repayment period of 30 days, Company B will record the transaction as accounts receivable, while Company A will record it as accounts payable since it has an obligation to pay Company B.
To summarize, Accounts Receivable and Accounts Payable are both sides of the same coin.
How does offering credit affect your business?
As we explained before, Account Receivables only occur when a purchase is made on credit. But if AR carries so much trouble, why should you offer credit in the first place?
Benefits of offering credit
- You can gain customers: By providing more payment options and making it easier for customers to purchase from you will bring in new customers and increase the number of recurrent buyers.
- It shows stability and builds trust: If you offer credit, it shows that your business is stable and trustworthy. It tells people that you have enough money to offer credit and that you're a reliable business.
- Encourage more expensive purchases: If you offer credit to customers, they're more likely to buy expensive things from your business. This is because they can pay over several months, which makes it easier for them.
- Stand out from the competition: Not all businesses offer credit, so if you do, it can make you stand out as you offer broader payment options.
Drawbacks of offering credit
- Dealing with missed payments: The primary risk of providing credit is the potential for missed payments. While the majority of customers will pay on time, there will be instances where they may be late in making payments or require alternative payment arrangements.
- You might have to hire a collections team or pay legal fees: If a customer fails to make payments, you may need to hire a collection agency to recover the debt, and they typically charge a big percentage of the amount collected. Moreover, you may also need to engage a lawyer to sue non-paying customers, which can result in legal fees that may not be recoverable.
- Slower cash flow: Credit sales may result in slower cash flow, as there will be more goods going out than cash coming in. This can adversely affect your ability to pay bills, especially if customers make late payments.
- A-game record keeping is needed: Keeping good records is really important when you offer credit. You need to keep a separate account for each customer with credit, and keep track of how much credit they have, how much they use, any interest they pay, and other important details.
How to turn Account Receivables into cash efficiently
While there are some major drawbacks, there’s no doubt that offering credit and dealing with Account Receivables is the best bet to drive a successful business.
In order to get most of the upsides, and reduce the downsides of dealing with Account Receivables, you’ll need to solve the problem of how to collect debt efficiently and, most importantly, consistently.
For that, there are all-in-one debt collection platforms like Arrears that take care of fully automating your collection process and make keeping track of your debtors an easy task for you, so you can keep the focus on growing your business.