Understanding the Importance of Accounts Receivable, in an Accounting context.
We frequently hear the term “Accounts Receivable” and I often wonder if it is consistently understood. It is considered an important factor in a company's working capital, let me explain why (in layman’s terms).
Accounts Receivable can be too high. If your Accounts Receivable is too high, the business may be at fault, possibly the team is a bit lax in collecting what is owed or your processes may be too vague or ad hoc. The major risk of this approach is the impact on cash flow and your business may quickly find it is struggling to find the cash to pay bills.
Accounts Receivable can be too low. If your Accounts Receivable is too low there is a risk that you are putting a strain on your customer relationships. It is possible your payment terms are harsh, perhaps customers find it challenging to meet your terms. In practice, Accounts Receivable levels normally correspond with changes in sales levels.
Other Uses of Accounts Receivable. It is worth remembering that businesses may occasionally use their Receivables as collateral for borrowing money. The level of Accounts Receivable also affects other financial performance measures including working capital, days payable and the current ratio.
Another interesting point is that Uncollectible Receivables do not qualify as assets (these uncollectible amounts are reclassified to the allowance for doubtful accounts, which is essentially a reduction in receivables); thus, companies usually allow only creditworthy customers to pay days, weeks or even months after they've received the company's services or goods. Sometimes companies sell their receivables for pence in the pound or outsource the collection work to other companies that specialise and focus solely on collecting the owed amounts.
Here’s a simple example of how it works. Let's assume that Company XYZ sells £1 million of widget parts to a widget manufacturer and gives that customer 60 days to pay for those parts. Once Company XYZ receives the order and/or sends the parts and/or sends the customer an invoice, it will decrease its inventory account by £1 million and increase its accounts receivable by £1 million. When 60 days has passed and Company XYZ is paid, it will increase cash by £1 million and reduce its Accounts Receivable by £1 million.
Accounts Receivable is an asset, and as such, it appears on the balance sheet. In particular, Accounts Receivable is a current asset, meaning that the amount owed is expected to be received within the next 12 months.
When Accounts Receivable go down, this is considered a source of cash on the company's cash flow statement, and as such, it increases the company's working capital (defined as current assets minus current liabilities). When Accounts Receivable goes up, this is considered a use of cash on the company's cash flow statement because the company is "stretching out" the time it takes to receive money owed to it and thus is using cash more quickly.
If you think that your business would benefit from a review of your Accounts Receivable, please contact me at JohnEnnis@thorntonhope.co.uk.
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