Businesses record accounts receivable as assets as they can be used as collateral to secure a loan. But what is accounts receivable and what are its benefits for a company, let’s find out in this blog –
What are accounts receivable?
Accounts receivable is a current asset which denotes the money due to a business from its debtors, i.e., customers who have purchased goods or services from the business on credit and haven’t paid for such purchases.
In other words, accounts receivable is the outstanding invoice that a business draws on its customers. It also means the line of credit that a business extends to its customers for their purchases.
Accounts receivable in financial accounting are an asset because the business expects to convert them into a monetary value. It is a current asset because the dues are settled within a short time.
Here’s an accounts receivable example – if Ms ABC sells Rs. 1 lakh worth of goods to Ms XYZ on credit, Ms XYZ will become the debtor of Ms ABC. For accounting purposes, the account of Ms XYZ would be recorded under accounts receivable. If the business has no other credit sale, its accounts receivable would stand at Rs. 1 lakh.
Suppose Ms XYZ pays Rs. 20,000 against outstanding debt. Then the accounts receivable balance would be reduced to Rs. 80,000.
Return on equity: Highlights
- Accounts receivables denote the amount a business expects to receive from its customers to whom credit sales are made.
- Accounts receivables are vital because they determine the liquidity of a business and cash flow for managing working capital needs.
- Accounts receivables are recorded on the asset side of the balance sheet under current assets.
- Accounts receivables are different from accounts payable.
Importance of accounts receivable
- Accounts receivable depict the revenue of a business which is tied up in credit. It represents the outstanding bills and is important to be managed to maintain cash flow.
- If the business extends longer credit to its customers, the accounts receivable may take longer to convert to cash. This hinders cash flow and might become a problem if the business depends on its sales to generate funds. As such, businesses try to manage their accounts receivable effectively so that they can meet their working capital needs.
- Also, it can be used as a collateral to secure a loan to meet a short-term obligation. Businesses can generate instant funds by factoring their accounts receivable. Under factoring, cash is advanced against the discounted value of outstanding invoices. So, businesses can utilise their accounts receivable to generate funds for emergency needs.
Benefits of accounts receivable
The benefits of accounts receivable can be enumerated in the following points –
- It helps in the fundamental analysis of a business as stakeholders can use the accounts receivable metric to assess a business’s customer base, credit policy and liquidity.
- Accounts receivables are part of current assets and can generate liquid funds for the business when they are realised.
- By granting credit, a business can attract customers who prefer credit purchases.
Why businesses track accounts receivable?
It is recommended that businesses and their stakeholders track accounts receivable. The reasons are as follows –
- To maintain cash flow and meet the business’s working capital needs.
- To ensure that the credit policy of the business is sound.
- To make changes if the accounts receivable are stuck for a long period of time (so that the cash flow can be freed up).
- Stakeholders can use the value of accounts receivable to calculate important financial ratios to assess the fundamentals of the business.
- The accounts receivable can be factored in for raising funds. So, keeping track of it is essential.
Where is accounts receivable recorded?
You can find accounts receivable on the asset side of the balance sheet. It is listed under ‘Current Assets’ since the invoices are expected to be realised within the year.
Difference between accounts receivable and accounts payable
Accounts receivable and accounts payable are recorded on the opposite ends of the balance sheet spectrum. While accounts receivable are assets, accounts payable are liabilities. Here are the main differences –
|Accounts receivable||Accounts payable|
|They are a part of the current assets of a business.||They are part of current liabilities.|
|They represent the debtors of the business, i.e., the money that a business is owed.||They represent the creditors of the business, i.e., the money that the business owes.|
|If the business sells on credit, the amount due from its customers forms the accounts receivable.||If the business purchases on credit, the amount payable to the seller forms the accounts receivable.|
For example, say Company A buys raw materials from Company B on credit. Company A then uses the raw materials and creates a finished product. Such products are then sold to Company C on credit.
In this case, the accounts of the companies would be as follows –
|Company A||Company A would feature in accounts receivable in the accounts of Company B. |
Company A would record Company B in accounts payable.
Company A would record Company C in accounts receivable.
Company A would feature in accounts payable in the accounts of Company C.
|Company B||Company B would record Company A in accounts receivable.|
|Company C||Company C would record Company A in accounts payable.|
Accounts receivables in financial accounting denote what businesses owe from their customers and third parties. It is classified as a part of current assets and is denoted as the same on the balance sheet. Understand what accounts receivable is and how it impacts the company’s finances. Use the figure to calculate important ratios of the business that you want to invest in so that you understand its liquidity position.
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