Accounts receivable represent the outstanding invoices or money owed to a company (unpaid sales transaction) from its clients for goods or services provided, which the clients purchased on credit from the company. Here, the word receivable refers to the payment not being realised. Thus, any amount of money owed by customers for purchases made on credit is AR.
The strength of a company’s AR can be analysed with the accounts receivable turnover ratio or days sales outstanding. A turnover ratio analysis can be completed to expect when the AR will be received.
An easy-to-understand example of accounts receivable includes an electric company that bills its clients after the clients receive the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills.
Recorded as current assets on the balance sheet, they signify the legal obligation of customers to pay their debts, meaning account balance is due from debtors in one year or less. If a company has receivables, this means that it has made a sale on credit but has yet to collect the money from the purchaser.
Accounts receivable are considered assets, because they represent a future resource (usually cash). The accounts receivable process involves customer onboarding, invoicing, collections, deductions, exception management, and finally, cash posting after the payment is collected. These are generally in the form of invoices raised by a business. Accounts receivable can make an impact on the liquidity of the company, since the balance sheet is organised around the fundamental accounting equation, which is represented as: Assets = Liabilities + Equity. Thus, it is important to pay attention to these metrics. Therefore the investment risk must be as small as possible.
In the United States, the revenue recognition policy for accounts receivable typically adheres to the guidelines outlined in the Generally Accepted Accounting Principles (GAAP). For accounts receivable specifically, revenue is recognized when a sale is made on credit, meaning the goods or services have been delivered to the customer, and the right to receive payment is established. This is regardless of when the actual cash payment is received. However, if there are uncertainties regarding the collectibility of accounts receivable, such as concerns about the customer's ability to pay, provisions for bad debts may need to be made to ensure accurate financial reporting.
Overall, the revenue recognition policy for accounts receivable in the US follows the principles of GAAP to ensure consistency, transparency, and reliability in financial reporting.
Also Read: Understanding Debt Collection Analytics and Its Role in Recovery
The day sales outstanding (DSO) metric is majorly used in the projection of accounts receivable of financial models. It measures the average number of days taken by a company to collect the cash from the customers that paid on credit.
The formula for calculation of DSO is as given below-
Day Sales Outstanding (DSO) = (Average Accounts Receivable ÷ Total Credit Sales) × 365 Days or Number of Days in the Period
Proper forecasting of the accounts receivable should be done after following the historical patterns and change in DSO trends in the past couple of years or just the average of the same.
In a financial model, the standard modelling convention is to associate accounts receivable to revenue, since the relationship between the two is closely linked for the purposes of forecasting accounts. The projected accounts receivable can help in estimating future cash flows and managing working capital effectively.
Projected Accounts Receivable (A/R) = (DSO Assumptions Assumption ÷ 365) × Net Credit Sales)
The AR Turnover Ratio is calculated by dividing net sales by average account receivables. The formula for calculating the AR turnover rate for a one-year period looks like this:
Accounts Receivables Turnover Ratio = (Net Annual Credit Sales) ÷ (Average Accounts Receivables)
Where:
Here:
To calculate the average accounts receivable, you sum the beginning and ending accounts receivable for the period and divide by 2. The formula is:
Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
A higher Accounts ReceivableTurnover Ratio indicates that the customers are paying on time and the company is at a good collection rate. A bigger number can also point to a stronger balance sheet or income statement and even stronger credit worthiness of the company. Conversely, a low ratio may indicate that collections are slower, potentially indicating issues with credit policies or customer payment behaviours.
The relationship between accounts receivable and free cash flow (FCF) is :
Eventually, an increase in accounts receivable represents a reduction in cash on the cash flow statement, whereas a decrease in accounts receivable reflects an increase in cash and cash flow.
Since an increase in A/R signifies that more customers paid on credit during the given period, it is shown as a cash outflow (i.e. “use” of cash) – which causes a company’s ending cash balance and free cash flow (FCF) to decline.
While the revenue has technically been earned under accrual accounting, the customers have delayed paying in cash, so the amount sits as accounts receivables on the balance sheet. The starting line item is net income in cash flow statements and accounts receivable calculator, which is then adjusted for non-cash add-backs and changes in working capital in the cash from operations (CFO) section.
Accounts receivable serves as the fuel gauge for a business, offering critical insights into cash flow, the lifeblood of operations. Without accurate tracking, sales tied up in outstanding receivables can create a deceptive illusion of prosperity. Monitoring receivables turnover and utilising tools like Tratta’s software platform enable businesses to optimise collection processes, forecast cash flow, and enhance bottom-line stability. Moreover, a solid track record of accounts receivable turnover strengthens the business's position for securing bank loans, as it signifies lower lending risk to financial institutions.
Understanding accounts receivable goes beyond textbook definitions. Let's explore how it functions in everyday business scenarios:
In the current scenario pertaining in 2024, purpose-built accounts receivable softwares like Tratta offers a significantly more powerful toolkit to analyse your receivables and gain actionable insights.
It helps to manage customer relationships by automating receivables at scale and eliminating manual follow-ups, by helping customers with finance, by providing real-time visibility into critical receivable accounts, by providing proactive approach with collections and predictability on cash inflow and by giving them real-time visibility into the collection team's activities.
Software empowers you to move beyond basic calculations and gain a comprehensive understanding of your accounts receivable health. By leveraging its capabilities, you can optimise your credit and collection processes, improve cash flow, and make data-driven decisions for a thriving business in 2024.
Beyond automation, accounts receivable software offers additional functionalities that go beyond basic calculators:
In conclusion, understanding accounts receivable and managing them effectively is essential for any business. By utilising the power of accounts receivable software like Tratta in 2024, you can gain valuable insights, automate tasks, and implement strategic collection practices. This translates to faster payments, improved cash flow, and a stronger financial position for your business. Remember, a healthy accounts receivable is the lifeblood of a healthy business.
