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Managing Receivables and Payables

As a business advisor with over 15 years of experience, I am often asked about best practices when it comes to managing a company’s accounts receivable and accounts payable. These are important components on the balance sheet that can greatly impact a business’s financial health and cash flow. In this article, I will explain what accounts receivable and accounts payable are, provide guidance on recording and analyzing them, and outline the key differences businesses should understand between the two.

What is Accounts Receivable?

Accounts receivable (AR) refers to money that customers owe to a company for goods or services that have already been delivered but not yet paid for. It represents an asset for the business since there is an expectation that payment will be received in the future to settle these outstanding amounts. For example, if my consulting firm completes a project for a client and sends them an invoice for $5,000, that $5,000 moves from being unbilled revenue to accounts receivable as soon as we issue the invoice. It stays in AR until the client pays us, at which point it moves to cash.

Best Practices for Recording Accounts Receivable

I coach my clients to record accounts receivable in their general ledger and include it in their balance sheet’s current assets, since the expectation is that these short-term receivables will be paid within a year. When my client issued that $5,000 invoice above, they would debit accounts receivable for $5,000 and credit consulting revenue for $5,000. On their balance sheet under current assets, their accounts receivable balance would show as $5,000 higher than before the project was completed and invoiced. Once they receive the payment from the client, accounts receivable is debited again and cash is credited.

Benchmarking with Accounts Receivable Turnover Ratios

A useful financial metric I often use related to accounts receivable is the accounts receivable turnover ratio. This tells you how many times average receivables are collected during the year. It is calculated by dividing annual net credit sales by average accounts receivable. This ratio benchmarks the liquidity of a company based on how rapidly it collects what it is owed. As a business advisor, I aim to have my clients achieve a turnover between 5-8x annually in their industry. Much higher could indicate they are not offering reasonable payment terms to loyal customers. Much lower could signal problems with collections, processes, or maintaining strong customer relationships.

What is Accounts Payable?

Accounts payable (AP) is essentially the flip side of AR on the balance sheet. While accounts receivable represents money owed to a company, accounts payable represents money that a company owes to others, typically suppliers or vendors. It may be helpful to visualize your AP as an interest-free loan you have received from your vendors, allowing you to maintain cash flow before needing to pay your bills. For example, if my consulting firm orders $2,000 worth of office supplies on 30-day payment terms from an office supply company, we have a new $2,000 liability on our books called accounts payable. We will not need to pay this amount or reduce our cash for 30 days thanks to our supplier’s terms.

Comparing Accounts Receivable and Accounts Payable Cycles

Understanding the relationship between accounts receivable and accounts payable is where financial management gets interesting. As a business advisor, I aim to have my clients structure payment terms with their own clients to be shorter than terms they receive from vendors and suppliers. For example, if my consulting firm has 30 days to pay our office supply vendor, we require payment from our own clients within 15 to 20 days on all invoices. This ensures our accounts receivable cycle feeds our accounts payable cycle, maintaining healthy cash levels. Companies run into trouble when their receivables cycle is longer than their payables, forcing them to use other cash or financing to bridge the timing gap between collections and payments.

In summary, properly recording, benchmarking, and comparing accounts receivable to accounts payable provides critical insights into the short-term financial health of a business. Mastering working capital management takes experience, but can provide great rewards in the form of consistent, predictable cash flow. Reach out anytime if you have questions on benchmarking your own AR and AP performance.

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